The “cleanest dirty shirt” now has too many stains

Brij Khurana, Fixed Income Portfolio Manager
2024-09-30
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The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

“The budget deficit stimulates the economy. Without it, the recovery could not have been as fast and vigorous as it turned out to be. The recovery, combined with high interest rates and the influx of foreign capital, tends to keep the dollar strong… I shall call this benign circle the ‘Imperial Circle.’” — George Soros, Financial Times, 23 May 1984

During the early 1980s, hedge fund manager George Soros realized that the combination of Federal Reserve (Fed) Chair Paul Volcker’s hawkish monetary policy and President Ronald Reagan’s loose fiscal policy would attract capital to the US. He was right, and the US dollar (USD) went on to enjoy one of its largest bull markets. Today, however, amid a dramatically different economic and policy backdrop, soaring US deficits could have exactly the opposite effect, with a range of implications for asset allocators.

Is reckless fiscal spending making the US less attractive?

In times of economic stress, capital tends to flow to the US, owing to its reserve currency status and, until recently, low levels of debt. In addition, because most commodities are denominated in USD, countries that are net importers run the risk of a balance-of-payments crisis. Not so for the US, which can simply print money to fund its current account deficit. The combination of these advantages had led to the US being described as the “cleanest dirty shirt” for investors seeking the best option during challenging market regimes. In my view, the US fiscal authorities’ recent actions are making the US less attractive — further soiling its shirt.

Figure 1 shows the US Treasury’s rolling annual fiscal balance. Despite nominal GDP running above 6% for the past year, the government’s fiscal deficit is bigger than it was during the global financial crisis and almost as large as during the depths of the COVID-19 pandemic. Combined with the current account deficit, the total US deficit is now north of 10% of GDP, by far the highest among the G10 nations. Until now, the main result of this reckless fiscal spending has been inflation. However, inflation can continue to surprise to the downside as money supply turns negative and the velocity of money follows suit amid an inverted yield curve and banks’ reluctance to lend. From here, fiscal profligacy is likely to weaken the USD, not only reducing relative purchasing power, but also disincentivizing foreign demand.

Figure 1
Yied differential

Imperial Circle redux? Not so fast

In my view, there are several problems with the argument that today’s deficits will support tomorrow’s recovery, as Soros had predicted in 1984.

  • During the 1980s, fiscal deficits funded military spending and reduced marginal tax rates, the latter of which boosted productivity. In contrast, the fiscal deficits maintained since the pandemic have mainly supported consumption rather than investment. More recently, lower tax revenue and shrinking remittances from the Fed to the US Treasury (hardly the most productivity-inducing investments) have dug the US fiscal hole even deeper.
  • The US’s overall debt stock and contingent liabilities are much higher than they were in the 1980s. Back then, even though interest rates reached double digits, there was no question that the government could afford them. Today, that argument is less clear without serious cuts to entitlements. 
  • It is also unclear how willing foreign investors will be to continue funding ever-expanding US fiscal deficits, especially given their own domestic spending priorities and substantial existing ownership of US assets: US$16.75 trillion as of the first quarter of 2023.1
  • Asset values are much higher today than they were in the 1980s, mainly because of these higher debt levels. As I have discussed in prior pieces, higher fiscal deficits feed directly into corporate profits via the Kalecki-Levy equation. Since the pandemic, fiscal spending is the main reason why US profits have remained so high and, in turn, why US equity markets have done so well. For its part, the USD has benefited from continued foreign equity market inflows. If US fiscal spending slows, as we expect, profits at US companies will likely fall as well, taking the sheen off US equity markets and reducing demand for the USD.

Rather than an Imperial Circle, the current situation looks more akin to the dollar’s bear market of the 1970s, when the Vietnam War and “Great Society spending” led to higher inflation, a much weaker currency, and US equity market underperformance. 

Allocators may want to go global

A world in which the USD and US fixed income are not the bastions of safety they once were presents a unique asset allocation problem, particularly in an environment of decelerating growth and elevated equity valuations. Investors may need to diversify their approach to fixed income to protect their portfolios. 

On the currency side, investors may do well to focus on countries with high real interest rates, low fiscal spending, and net commodity exports. Counterintuitively, many emerging markets (EMs) fit that bill, despite historic underperformance during slow growth, risk-off environments. Compared to developed markets (DMs), many EM countries have implemented much more orthodox economic policies following the pandemic, hiking interest rates to double digits when inflation first surfaced and accumulating substantial USD reserves. Within rates, investors may want to focus on DMs with low levels of government debt, high levels of consumer debt, and a prevalence of variable-rate mortgages. High mortgage rates could mean that Canada, Norway, Australia, New Zealand, and Sweden, among others, experience economic pain (and lower government yields) sooner than the US, given its reliance on fixed-rate mortgages and aggressive fiscal spending.

If the US market is no longer the “cleanest dirty shirt,” asset allocators will need to plan accordingly.


1 Bureau of Economic Analysis.

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