3 Assets to Hedge Against US Debt Bubble: Wharton Professor

The US economy is rapidly heading into a credit bubble that will burst. At least, that’s what some market veterans believe.

The hedge fund manager Mark Spitznagel, whose firm helps to protect investors from unforeseen Black Swan events, predicts that the bust will send the stock market into its worst crash since 1929. Billionaire hedge fund manager Ray Dalio has also said that we are heading into a debt crisis.

But how bad can things be, and when could this happen? It’s hard to say for certain. But Wharton Professor Kent Smetters, a faculty director for the Penn Wharton Budget Model, which provides budgetary projections and economic analysis of US legislation, says we could hit the point of no return in 20 years.

Federal spending ballooned after the global financial crisis and then accelerated during the pandemic, outpacing tax revenue and creating a deficit. The government has been borrowing the difference.

To put things into historical perspective, the general measurement of gross federal debt as a percent of gross domestic product is at 123%. In WWII, at the height of military spending, it was 119%. But, the number economists care about is the US federal debt held by the public as a percent of GDP because it removes debt held internally by the US government, Smetters noted. This ratio is now above 96%. At the height of military spending in World War II, it peaked at 106% in 1946.

A report Smetters co-authored estimates that if federal debt held by the public to GDP surpasses the 190% to 200% threshold, the US economy would be past the point of no return; interest payments owed on the debt would be so large that even steep tax hikes couldn’t fix it. The government would be out of options outside a massive decrease in spending, which isn’t plausible, Smetters said.

“We are in an unprecedented position today because not only is debt very large relative to the size of the economy, the big major difference relative to World War II is that debt is not projected to go down relative to the size of our economy,” Smetters said. “In fact, just the opposite: it’s projected to continue to increase, and we’ve never been in this situation before.”

Economic growth alleviated the situation after WWII, bringing the debt held by the public as a percent of GDP down to 22% by 1974. But Smetters said the US can’t grow its way out this time. Even if the economic growth rate doubles over the next 50 years, the federal debt relative to the size of the economy will still climb. Social Security, Medicare, Medicaid, and defense are among the biggest contributors to the rising deficit.

“What governments do when they face high debt everywhere else in history is that they tend to print a lot more money to pay off that debt, and that printing of money causes inflation,” Smetters said.

It’s impossible to predict exactly what an implosion of this nature may look like. On one end, markets are forward-looking and politicians should understand that and take corrective action, he said. But if we continue on this path, inflation could hit 8% to 9% and remain there for a few decades. Interest rates, including mortgage rates, would hit double digits. And credit card interest rates could be near 30% to 40%, he noted as theoretical examples.

He noted that defaults and deleveraging would follow, even on a corporate level, which would hurt many companies and trickle into the stock market.

It’s a tough scenario for an investor to win because shorting the economy over a long duration is difficult. But you can hedge it, Smetters said. The most significant way is buying assets that the government would be last in line to default on. While people say they offer lousy returns, they offer protection, he noted.

These include bonds that adjust for inflation, unlike the standard Treasury bonds that do not. For example, Treasury Inflation-Protected Securities (TIPS) have fixed yields, but their principal adjusts to match inflation. I bonds are another example, except in this instance, they have a fixed interest rate and an inflation rate, which adjusts every six months to match the prevailing levels. Each individual can buy up to $10,000 a year in I bonds. So, you can buy $40,000 a year for a household of four.

“For the non-TIP bonds, what the government can easily do without defaulting is that they can just increase the money supply and basically pay off those bonds by printing more money,” Smetters said. “And that’s going to cause inflation. But for the people holding the TIPs, they’re going to still be protected because they get an inflation payment that makes up for that.”

To diversify, an investor should also consider emerging and developed markets where the country has balanced its budget well.

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