America’s growing debt mountain

America’s growing debt mountain

After a sell-off following the announcement of sweeping US tariffs early last month, equities have rallied on hopes that the US will strike trade deals. The US and UK settled on a framework agreement on trade last month and last week the US and China agreed to cut tariff rates and to open trade negotiations. Press reports suggest that other outline agreements may be in the offing. US equities have risen 20% since 8 April, more than making up losses on the initial tariff announcements.

• Investors are daring to hope that the worst news on tariffs may be past. Even if it is, US tariffs are likely to settle at levels far in excess of those at the start of the year. JP Morgan estimates that, with the rollback of tariffs on China, the average US tariff on imports has fallen from about 28% to 15%. Even this lower rate is six times higher than January’s tariff level of 2.5%.

• Forecasts for global growth have fallen in response to the news on tariffs with the US seeing an especially marked downgrade. But at least for now greater optimism on trade has quelled talk of the US falling into recession this year.

• While the media and markets have been transfixed by the tariff news the US Congress has been working on a new federal budget. Republicans want to renew Donald Trump’s 2017 tax cuts, which would otherwise lapse, and to make good on last year’s campaign pledges to reduce other taxes, including removing tax on tips and overtime income. The substantial costs of these measures would only be partially offset by planned spending cuts and revenue raising measures. Congress seems unlikely to support the sort of swingeing cuts in welfare, including Medicaid, which would be necessary to fully cover the cost of the proposed tax cuts. Republicans, who control both houses of Congress, want to pass the legislation needed for tax reductions and spending by 4 July using a procedure called reconciliation. 

• Once again borrowing is set to take the strain. The US federal government has been on a multi-decade borrowing binge. In only 4 of the last 40 years, all of them in the second Clinton administration in the late 1990s, has the US run a budget surplus. Deficits are the norm, averaging 3.0% of GDP between 1985 and 2020. COVID saw the deficit balloon to the 13% mark, but even in the ensuing robust recovery from 2021, the US has posted sizeable deficits.

• The US has locked into a vast budget imbalance, one where revenues permanently run behind federal outgoings even in periods of strong growth. The problem is getting worse. The independent Congressional Budget Office (CBO) forecasts that the deficit will average around 7.0% of GDP over the next eight years.

• America’s stock of debt is on a sharply rising path. The ratio of debt to GDP stands at 100% today, up from just 35% in 2007. The reconciliation bill would take debt to 134% of GDP by 2034 and 211% by 2055, according to the CBO. 

• Falling interest rates and, since 2008, quantitative easing, under which the Federal Reserve bought government bonds, have, so far, made a rising debt burden manageable. But things are changing. Interest rates have broken out of the sub-1.0% range that prevailed for much of the last 15 years and the Fed is no longer buying government bonds. As US government bonds issued at rates as low as 0.5% mature the US Treasury is having to refinance them at current market rates, closer to 4.5%. Rising debt servicing costs result in larger deficits, more borrowing and a heavier debt burden.

• US debt is on an unsustainable path, a point reinforced by last week’s decision by the ratings agency Moody’s to strip the US of the highest triple-A credit rating on concerns about a widening budget deficit.

• Yet there is no immediate and obvious catalyst for a fiscal crisis. US Treasury bonds are still the world’s most liquid, deepest and safest asset class; the dollar is still the world’s reserve currency. This is not an argument for complacency. As the UK found in 2022, under the Liz Truss government, market appetite for government debt can disappear overnight. A recession, sharply higher interest rates or an egregious policy mistake could quickly sharpen America’s debt problem.

• According to the University of Pennsylvania and Wharton budget model, even under today’s favourable conditions, debt levels in excess of 200% of GDP would be unmanageable: “Under current policy, the US has about 20 years for corrective action after which no amount of future tax increases or spending cuts could avoid the government defaulting on its debt whether explicitly or implicitly [through inflation]”.

• The surest way of resolving America’s debt problem would be for Democrats and Republicans to agree on a set of tax rises and reductions in public expenditure that would, in time, bring spending back into line with revenue. In today’s partisan political environment that sort of grand bargain looks almost inconceivable. That means that debt levels will keep on rising. This is one economic problem that isn’t going away.

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week up 1.5% at 8,684, boosted by the announcement of the US-China trade agreement to temporarily reduce import tariffs.

Economics

• The US and China announced a “reset” of relations, agreeing to reduce import tariffs for 90 days. US equities rose over 3% following the news
• Analysis from the Yale Budget Lab indicates that if these temporary tariff rates endure, it would reduce the negative economic effects of new tariffs by 40%. However, the US average import tariff rate would remain at a 90-year high
• US president Donald Trump said he would impose higher import tariffs “over the next two to three weeks” on some trading partners as it would not be possible to agree trade deals with all trading partners within the original 90-day tariff relief window
• Republicans in the US House of Representatives announced tax proposals including extending US president Donald Trump’s 2017 tax cuts and reducing taxes levied on tips and overtime income, in part funded by cuts to clean energy initiatives
• US consumer sentiment fell for the fifth consecutive month to its lowest level since June 2022, according to the University of Michigan, amid ongoing US trade uncertainty
• US consumer price inflation fell slightly to 2.3% in the year to April, the lowest rate in four years. Analysts expect rising inflation in the coming months due to higher US import tariffs
• US authorities are planning cuts to banks’ capital requirement rules as part of the government’s deregulatory agenda, reversing some of the reforms established following the global financial crisis, the FT reports
• UK GDP increased by a greater-than-expected 0.7% in the first quarter, up from the near-flat growth seen in the second half of 2024
• UK unemployment rose marginally in the three months to March while payroll data indicated a decline in employment. UK annual wage growth eased to 5.6% in the first quarter
• UK prime minister Sir Keir Starmer unveiled the UK government’s migration policy reforms, which include increasing the length of time before migrants can apply for permanent residency and tighter restrictions on international students
• UK chancellor Rachel Reeves did not rule out mandating UK pension funds to increase investment in UK assets if they failed to reach recently agreed voluntary targets
• Economic sentiment among the German finance industry rebounded in May from April’s sharp fall, according to ZEW, attributed to an improved political and global climate
• Japanese GDP contracted 0.2% in the first quarter this year, driven by muted domestic consumption and falling exports ahead of Trump’s import tariff announcements in April
• Abaxx, a commodity futures exchange, plans to launch a gold trading exchange in Singapore next month, challenging London and New York’s dominance

Business

• Qatari state-owned airline, Qatar Airways, announced plans to buy 210 planes from US manufacturer Boeing, worth $96bn, during Mr Trump’s visit to the Gulf state
• Mr Trump said he had “a little problem” with Apple’s CEO Tim Cook regarding the tech company’s decision to move production of its US-sold iPhone from China to India, instead of relocating to the US
• UK carmaker Jaguar Land Rover announced its strongest pre-tax profits in a decade, reflecting increased sales volumes despite uncertainty over US tariffs
• Japanese carmaker Nissan announced plans to cut 15% of its global workforce and said it may share production capabilities with Chinese partner DongFeng at its Sunderland plant in the UK as it faces falling sales
• Mr Trump signed an executive order aiming to lower US prescription drug prices by up to 80%, aligning them to the lower prices in other developed nations. Pharmaceutical equities fell following the announcement, with companies warning of reduced future innovation
• Heathrow Airport saw its busiest April on record with nearly 7.1m passengers, driven by a significant number of trips taken over Easter
• UK parcel delivery company Evri will merge with logistics company DHL, creating one of the UK’s largest delivery firms

Global and political developments

• Ukraine and Russia held their first direct peace talks. However, Mr Trump said “nothing is going to happen” on a peace deal until he meets with Russian president Vladimir Putin
• The ceasefire between India and Pakistan, announced last week following military clashes in the Kashmir region, is still holding, with both sides having claimed victory
• Mr Trump said he would lift sanctions on Syria, following discussions with Saudi Arabia and Turkey, as he travelled to the Middle East on his first official state visit
• Mr Trump also said the US were in “serious negotiations” with Iran to reach a deal that would limit its nuclear programme. The oil price fell following his comment
• A proposed UK-EU “reset” of relations has stalled following EU member states wanting more concessions from the UK on fishing rights and EU student access to UK universities, the FT reports
• The UK government plans to move 12,000 civil service jobs out of London in a bid to cut costs and disperse government jobs around the UK
• German foreign minister Johann Wadephul said the country will raise its defence spending to 5% of GDP, the target Mr Trump requested of NATO members

And finally… seven years to the day after a flying duck was captured speeding by a traffic camera in Switzerland, a similar situation occurred in the same location, with the duck travelling at the same speed: 32mph in a 12mph zone. The event left traffic wardens wondering whether it was the same duck in question – authorities are now quacking down on repeat offenders