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The US federal debt has increased by more than US$15 trillion since 2020, pushing the country’s debt-to-gross domestic product ratio to its highest level since World War II. Over that same period, the standard bond benchmark index, adjusted for inflation, has fallen into the red.
Investors looking at these two facts have reasonably chased assets that can protect portfolios against inflation and currency debasement. US equities, particularly large-cap technology stocks, fulfilled that role well, delivering strong real returns, robust earnings growth, and pristine balance sheets. That may be starting to change.
The substantial debt that tech companies are taking on is making them a less attractive hedge against inflation and currency debasement. At the same time, changes in the fiscal and monetary outlook mean that bonds might deserve another look.
Most explanations for the exceptionally long tech rally focus on outsized earnings growth and investor enthusiasm for AI’s potential. But those don’t fully explain why investors have been willing to pay such extraordinary valuation multiples. At least some of the rally stems from investors’ growing concerns about the fiscal sustainability of the world’s leading economy and the US Federal Reserve’s balance-sheet expansion.
As the US government’s balance sheet deteriorated, tech companies’ fortress-like balance sheets looked relatively attractive. Investors also sought assets capable of preserving purchasing power amid sticky inflation. Because tech company earnings are to a large degree tied to nominal GDP, their revenues and cash flows rise alongside inflation, making equities an effective US inflation hedge. Since 2020, the S&P500 has outperformed bonds by roughly 14% annualized.
These factors helped justify unusually high valuation multiples and, to a large degree, insulate tech stocks from higher interest rates. That investment case is beginning to weaken as hyperscalers continue to take on significant debt to finance their AI infrastructure spending. As leverage rises, these companies’ balance sheet attractiveness compared to the US government’s will decline.
This year is likely to see record investment-grade issuance approaching US$2 trillion from a handful of hyperscalers. Many people are focused on whether these investments will generate sufficient returns and ultimately prove accretive to earnings. The more important question may be what increased leverage does to multiples.
Demand for reflation and debasement hedges may also fall due to some changes in the macroeconomic backdrop.
Washington’s fiscal impulse is fading. Tax cuts in the One Big Beautiful Bill Act were a big boost this year. But fiscal policy is likely to become modestly contractionary from here on out, especially if Democrats regain control of the House in November, squashing any Republican plans to pass large spending packages via party-line reconciliation. After years of rapidly expanding Treasury issuance, the relative supply dynamics between government and corporate bonds are beginning to reverse.
The growth outlook appears less robust as the economy enters the second half of the year with considerably reduced momentum. Persistently elevated energy costs due to the Iran conflict are weighing on household purchasing power. Real personal income, excluding government transfers, is declining 1% year over year, which is a rare occurrence outside of a recession.
Monetary policy also appears to be shifting in ways that could hurt equities. In his first press conference in June, Fed Chair Kevin Warsh emphasized his commitment to price stability and argued that current interest rates aren’t restrictive to financial markets. Warsh has also long criticized the Fed’s large balance sheet and is less willing to deploy it to support markets. A less activist central bank would push the Fed “put” further out of the money, reducing one of the key supports for the elevated equity valuations.
Bonds, by contrast, may have a more encouraging forecast. The conflicts in Iran and Ukraine have demonstrated the increasing effectiveness of drones and the limitations of conventional military power, potentially lowering the probability of a near-term China-Taiwan conflict. Since bonds do poorly in wars as they tend to be inflationary, a reduction in geopolitical risk from today’s elevated levels would only improve the outlook for fixed income.
If investors become less concerned about debasement, the leadership that has defined markets since 2020 may begin to reverse. In this environment, bonds deserve a place again in investors’ portfolios.
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