How a fiscal credibility shock could affect a diversified portfolio
A Reasonable Question
From time to time, clients ask whether America's growing national debt could eventually become a problem for investors. It is a reasonable question. The United States has accumulated a historically large amount of debt, and interest payments now consume a growing share of the federal budget. The Congressional Budget Office projects that, absent policy changes, federal debt will continue to grow faster than the economy over the coming decades.
None of this necessarily means a crisis is imminent. For decades, investors around the world have continued to view U.S. Treasury securities as among the safest and most liquid investments available. The government has financed itself successfully through wars, recessions, financial crises, and political disagreements. Even so, it is reasonable to ask whether there could someday come a point at which investors begin demanding meaningfully higher interest rates before they are willing to lend additional money to the U.S. government.
Economist Herb Stein famously observed, "If something cannot go on forever, it will stop." Whether that observation ultimately applies to the current trajectory of U.S. borrowing, and if so, when, is impossible to know. This discussion is not intended as a prediction. Rather, it is an explanation of how we believe a thoughtfully constructed investment portfolio would likely behave if investors were someday to lose confidence in U.S. government finances.
How Would Such a Change Occur?
The federal government pays for part of its operations by borrowing. It does this the same way it always has: regularly auctioning off Treasury bills, notes, and bonds. Buyers, including pension funds, mutual funds, insurance companies, banks, foreign governments, and individual investors, purchase those securities in exchange for interest payments from the U.S. government.
A loss of confidence wouldn't necessarily mean an auction fails outright, or that investors simply stop lending. A more realistic scenario is that they keep buying but demand a higher interest rate to do it.
That matters beyond the Treasury market. Treasury rates are the benchmark for borrowing costs across the entire economy: mortgages, business loans, corporate bonds, credit cards, all of it. If the government has to pay more to borrow, everyone else generally does, too.
What Might That Mean for Investors?
The initial market reaction would likely be uncomfortable. Higher interest rates generally reduce the value of existing bonds, increase borrowing costs throughout the economy, and tend to pressure stock prices by reducing the present value of future earnings. It is therefore entirely possible that both stocks and bonds could decline simultaneously, at least for a period of time.
That possibility is worth acknowledging. It is also one reason we believe investors should resist the temptation to judge a portfolio solely by how it performs during a single market event. A portfolio should be designed to withstand many different environments over many years, not to be perfectly positioned for one particular crisis. There is also no certainty that this scenario will ever occur. Building a portfolio around a single anticipated event is often riskier than preparing for a wide range of possible outcomes.
Why We Continue to Believe in Equities
Most of our clients own portfolios that are heavily invested in equities because ownership in successful businesses has historically been one of the most reliable ways to build wealth over long periods of time.
Would stocks decline if investors lost confidence in U.S. government finances? We think so, and the decline could be substantial. However, temporary declines in stock prices are not the same as permanent losses in the earning power of the businesses themselves.
Public markets often react quickly to uncertainty. Prices can move dramatically in response to changing interest rates, economic news, or investor sentiment. The businesses behind those stock prices, however, continue designing products, serving customers, investing in new opportunities, and earning profits. While market prices may fluctuate from day to day, the value of a successful business is ultimately determined by its ability to generate cash flow and create value over time.
Markets determine prices every day. Businesses create value over time.
Successful investors recognize the difference.
Well-managed businesses do not simply stand still when economic conditions change. They adjust prices, develop new products, improve efficiency, allocate capital differently, and seek new opportunities. Some businesses will inevitably struggle, but others will adapt and prosper. By owning thousands of companies across industries and around the world, we avoid depending on the fortunes of any single business, sector, or country.
Our portfolios also place additional emphasis on companies with strong profitability and sound financial characteristics. We cannot eliminate market risk, but we believe businesses with durable earnings and healthy balance sheets are generally better equipped to navigate periods of economic stress than companies whose success depends on inexpensive financing or optimistic market conditions.
The Role of Fixed Income
In plain terms: rising rates hurt bond prices in the short run, but they set bonds up to pay you more over time.
Many investors assume bonds always rise when stocks fall. Often they do, but not always. A loss of confidence in U.S. government finances is unusual because it could place pressure on both asset classes at the same time.
For that reason, our fixed-income portfolios are designed to do more than simply own a broad bond index fund. They emphasize diversification across multiple sources of income while maintaining flexibility to adapt as market conditions evolve.
Even if bond prices decline temporarily, bonds continue paying interest and eventually mature or repay principal. Those cash flows can then be reinvested at the newer, higher interest rates, improving the portfolio's future income and expected return. In other words, rising interest rates are painful at first, but they also lay the foundation for better long-term returns from fixed-income investments.
The Bottom Line
No one knows whether investors will someday lose confidence in U.S. government finances. If such a change were to occur, markets would almost certainly experience a period of heightened volatility, and portfolios heavily invested in equities could experience significant temporary declines. Those outcomes would be unpleasant, but they would not invalidate the principles on which our investment philosophy is based.
We build diversified portfolios because the future is uncertain, not because we believe we can predict it. We diversify broadly, emphasize financially sound businesses, maintain appropriate liquidity, and use fixed-income investments to help clients weather a variety of market environments. Our objective is not to avoid every difficult market. It is to build portfolios that can withstand difficult markets while continuing to participate in the long-term creation of wealth.
History offers many reminders that markets are remarkably resilient. They have endured wars, recessions, inflation, financial crises, political uncertainty, and countless predictions that "this time is different." Through each of those episodes, businesses continued to innovate, economies adapted, and disciplined investors who remained focused on their long-term plans were generally rewarded for their patience.
For that reason, we would not expect a loss of confidence in U.S. government finances to change our investment philosophy. It would reinforce why we follow it. Financial planning cannot eliminate uncertainty, but it can prepare for it. Our responsibility is not to predict every crisis. It is to help our clients build portfolios and financial plans that can withstand them.
Investing involves risk, including possible loss of principal. Diversification and asset allocation do not ensure a profit or protect against loss. This discussion is educational and describes potential market mechanisms, not a forecast or guarantee. Actual results will depend on the nature, severity, and duration of any market event, as well as each client's allocation and circumstances.
Securities offered through Cambridge Investment Research, Inc., member FINRA and SIPC. Investment advisory services offered through Cambridge Investment Research Advisors, Inc., a registered investment advisor. Cambridge and Lauer Financial LLC are separate companies.