US deficits are unlikely to detract from fixed income's appeal | Insight Investment

US deficits loom, and while that is a long-term consideration, we do not expect it to discourage investors from adding to their fixed income exposure in the near-term.

The deficit may be a hot topic for some time, but we see it as a longer-term issue

Election years tend to give rise to fiscal policy and deficit discussions, and 2024 has certainly been no exception. However, we believe that incorporating a long-term view on the deficit into strategic asset allocation decisions would be premature at this stage. In the near term, we believe fixed income is attractive given historically elevated yields and the potential upcoming easing cycle.

Deficit-related market dislocations may occur over the near term

The US budget deficit is currently 6.2% of GDP, and the Congressional Budget Office (CBO) projects it will hit 7% by next year (Figure 1). The election result is unlikely to temper this rise, given neither party stood on a platform of austerity

Figure 1: The US deficit will be a hot topic for some time yet¹

The trajectory of the nation’s debt may therefore be a hot topic for some time. Another potential debt ceiling stand-off looms in 2025. Both party’s economic platforms point to deeper deficits, particularly on the Republican side.

Nonetheless, in the words of Charles de Gaulle, the US dollar retains the “exorbitant privilege” of being the world’s reserve currency. Political trends abroad, which also point to more fiscal spending, make a changing of the guard less of a threat in our view.

For fixed income markets, there are two potential near-term considerations.

The first is the potential for another US credit rating downgrade. We would not rule that out, but we believe any fallout wou ld be limited.
Since S&P’s US downgrade in 2011, many regulatory regimes and financial contracts refer to “US Treasuries” as opposed to “AAA government debt”, which reduced the risk of forced selling. It was why there was little notable market impact when Fitch down graded the US last year.

The second potential consideration is that heavy Treasury supply (to finance the government fiscal commitments) could cause disruption in bond markets. These concerns have been building since last year’s debt ceiling stand-off, when the Treasury began relying on a higher share of T-bill issuance than recommended by the Treasury Borrowing Advisory Committee.

While it is possible that an eventual increase in longer-dated Treasury bond supply could impact yields, we would expect any sell-off would be limited. Long-dated Treasury yields in the 5% to 6% range would, we suspect, be irresistible to many global investors. Failing that, we expect the Fed would stand ready with “operation twist”-style initiatives if things were to get disruptive.

We believe deficit considerations are unlikely to impact the near-term appeal of fixed income

We expect investors to continue to weigh the benefits of adding fixed income exposure at the current stage of the cycle, irrespective of longer-term deficit concerns.

In our view, adding exposure to spread assets (such as corporate or structured credit) could offer the potential for compelling all-in yields, even considering that credit spreads are historically tight.

We believe investors may wish to rebalance from their equity and alternatives allocations (to increase the certainty of their return streams) and their cash and short-term holdings (to reduce reinvestment risks).

Fixed income may also offer the potential for near-term capital gains. The “Agg” (the Bloomberg US Aggregate Bond Index) has cumulatively delivered 16% to 32% total returns during the last five rate cutting cycles. So far this cycle, fixed income has returned ~5%, implying potential upside remains (Figure 2).

Figure 2: Are we at the early stages of cyclical fixed income returns?²

Deficits are worth watching, but we do not think they need to alarm investors over the medium term

While the forecasts clearly show current fiscal policy trends are unsustainable over the long term, we do not see a catalyst for a nearterm dislocation in US Treasuries. Moreover, we believe investors should consider adding to fixed income given current attractive yield levels and expectations for continued monetary policy easing.