In the astute analysis that follows, Lisa Shalett and Vibhor Dave, in a special report from Morgan Stanley, deliver a timely and important message: “Investors need to prepare their portfolios for the impact of high deficits and debt levels on the economy and higher interest rates.”

Excerpt from the special report, “Deficits and Debt: The Legacy of Quantitative Easing,” by Lisa Shalett and Vibhor Dave, Morgan Stanley Wealth Management Report

With the benefit of hindsight, we can see that the long period of low interest rates ushered in by the Federal Reserve to help pull the country out of the financial crisis of 2008-2009 was a success on many levels. Low rates, high fiscal deficits and easy credit helped stimulate the economy, resulting in high employment and years of steady growth. Households were able to reduce their debt levels. Banks are now in the best financial shape they’ve been in for decades. Investors enjoyed strong gains in both stocks and bonds. Since March 2009 to last year’s peak, U.S. equities nearly quadrupled in value.

However, the long period of low rates and large fiscal stimulus has had some unintended consequences. It’s increasingly clear now that low rates created incentives to use debt in potentially destabilizing ways. Below are six examples:

• The U.S. government increased spending dramatically after the financial crisis to stimulate the economy. Recent legislation around tax reform and federal spending has added to an already high debt level relative to GDP. Treasury bond issuance has soared, leaving the government fewer options to spur on the economy if recession looms. One measure of just how indebted the U.S. has become: The ratio of government debt to GDP has climbed from 60% in 2010 to 78% currently and is projected to reach 150% by 2045 (see Table 1). Issuing more debt to fund deficit-driven economic growth could push public debt levels to a magnitude last seen during World War II.

Debt as a Percentage of GDP Has Risen to a Post-World War II High and Is Projected to Keep Rising

Source: Congressional Budget Office, Office of Management and Budget, Bloomberg as of April 30, 2018

• As rates rise and debt continues to grow, government debt service could rival outlays for major social programs like Medicaid and Social Security. This makes it harder for the federal government to spend on discretionary programs and maintain leadership in education, technology, defense and medicine.

• Many companies have taken advantage of low interest rates to raise more capital by issuing debt, using the proceeds for shareholder-friendly stock buybacks and dividends—not to invest in innovation and productivity improvements. That lack of investment has kept productivity low and could impede future growth.

• The ability to issue corporate debt at low rates may be sustaining “zombie” companies that don’t turn a profit and are economically unproductive. Furthermore, easy credit and an abundance of yield-hungry investors have led to deterioration in the overall quality of corporate debt. Bonds issued with the lowest investment grade rating (BBB) have surged (see Table 2). If the economy slows, many of these bonds could be downgraded to below investment grade.

BBB Bonds Are Now More Than Half of All Investment Grade Issues

Source: Morgan Stanley & Co. Research, The Yield Book® Software and Services. © 2019 FTSE Index LLC. All rights reserved. Data as of Jan. 18, 2019

• A flood of downgrades could overwhelm the high yield bond market, creating liquidity problems for companies that need to regularly refinance their debt.
• Wealth inequality may have been exacerbated. Shareholders benefited from buybacks and higher dividend payouts, while workers saw tepid wage growth and savers were penalized by low interest rates. This may have contributed to the current polarized political environment.

What Should Investors Do Now?

For investors, understanding the interplay between debt, interest rates and stock and bond markets is important for forming a successful investment strategy in the years to come. As a result of higher U.S. deficits and debt, the average level of interest rates will likely be higher over the next cycle, which creates headwinds to growth. That doesn’t mean there won’t be opportunities for investors.

Cash-like investments could regain their status as a critical part of portfolios. Investors should consider money-market funds and short-term bond funds as attractive options, not just for capital preservation and income, but also to have some cash ready to reinvest, as market volatility can create opportunities to buy equities at potentially attractive prices.

Stocks that may prove the most favorable buys will likely be those with strong cash flows, sound balance sheets and growing dividends. Actively managed portfolios are likely to outperform passively managed index funds, as stock selection becomes more important. Hedge-fund and market-neutral strategies that can have positive returns in down markets may also be worth considering.

As for fixed income, I believe we are in a secular bear market for bonds for the first time in 35 years. But investors who desire the portfolio ballast and potential income generation of bonds can use a strategy of buying high-quality bonds with staggered maturity dates (laddering), holding them to maturity and rolling over the principal each year to new bonds that may be issued with higher rates. That way, they can reduce the risk of losing principal and benefit from the potential higher yields we expect to see in the coming years.

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