Wall Street just capped off its best week of the year. In the wake of Donald Trump's election victory, all three major indexes hit new record highs, and the S&P 500(SNPINDEX: ^GSPC) topped 6,000 for the first time ever. To start the year, many of Wall Street's prognosticators thought the S&P wouldn't even top 5,000.
Following Wednesday's surge, investors seem to be as bullish as ever, even with the S&P 500 at a historically high valuation. Cyclical stocks, including financials and energy, soared on the news, a sign investors are betting on economic stimulus, likely in the form of tax cuts, and an uptick in business investment and economic expansion during the second Trump administration.
Tariffs are also expected to be part of Trump's economic policy and the bond market responded to the election in a different way because of that. Yields jumped, showing investors are wary that deficit spending due to tax cuts and tariff-driven inflation would drive up interest rates and make it harder for the Federal Reserve to cut rates as it started doing in September. Yields did cool on Thursday and Friday, however.
Federal Reserve Chair Jerome Powell was asked for his thoughts on large budget deficits and the rising national debt at his press conference following the rate cut decision last week, and his comments were telling. In fact, they were a serious warning on the future of the U.S. economy. Here's what he had to say:
The level of our debt relative to the economy is not unsustainable. The path is unsustainable. And we see that. And, you know, you've got a very large deficit at -- you're at full employment at that's expected to continue. ... It's ultimately a threat to the economy.
Image source: Getty Images.
Powell's big warning
It's no secret that the national debt has ballooned substantially over the last generation.
While the pandemic accelerated U.S. borrowing, it was already ramping up, and it's continued to accelerate.
As you can see from the chart below, the national debt is about 7 times what it was in 1999, going from $5 trillion to $35 trillion, and it overtook gross domestic product (GDP) around 2010.
US Public Debt data by YCharts
You can see from the chart below how fast the debt-to-GDP ratio has grown.
Federal Debt: Total Public Debt as Percent of GDP data by YCharts
The debt-to-GDP ratio has resumed its upward trajectory after a dip a few years ago as GDP recovered following the height of pandemic lockdowns. You can also see from the chart that the ratio surged during the great financial crisis.
Powell specifically warned about the trajectory of the debt, rather than the current level, but an increased deficit, which hit $1.8 trillion in fiscal 2024, will only make the debt-to-GDP ratio accelerate higher.
What it means for the stock market
There's no rule of thumb of how high is too high for the debt-to-GDP ratio. One paper from the Wharton School of the University of Pennsylvania surmised that 200% was the limit and that the U.S. would hit that level between 2040 and 2045 under current fiscal policy.
A 2020 article from the St. Louis Federal Reserve stipulates that there's no precise number and that it depends on factors like economic growth rates, the independence of the central bank, and the interest rate on the debt. It also noted that the debt-to-GDP ratio in Japan is 200%, though that country has a much higher household savings rate making a higher ratio less risky.
For the stock market, deficit spending and rising national debt don't seem to be a problem yet based on the investor response to Trump's victory, but Powell's words shouldn't be ignored.
The top central banker believes that fiscal policy and the debt are on an unsustainable path, and the incoming administration seems poised to go even faster down that path.
Investors don't seem to be factoring that in as a risk currently, but it could become a problem down the road. Diversifying accordingly, or having a plan to, could be a smart move. One easy way is to invest out of the U.S. in an exchange-traded fund (ETF) such as Vanguard FTSE All-World ex-US Index Fund ETF(NYSEMKT: VEU) or buy individual international stocks like Philip Morris International(NYSE: PM) or MercadoLibre(NASDAQ: MELI). Safe stocks like utilities are also a good option to ride out potential volatility, and gold is likely to be popular if worries about the deficit and the debt start to build. An ETF like SPDR Gold Shares(NYSEMKT: GLD) is a good way to get exposure to gold.
For now, this strategy seems to be premature, and there's no risk of an immediate debt crisis, but at a time when market euphoria seems to be reaching a fever pitch on hope for more deficit spending, it's a good idea to plan ahead for risks that could hit the market in the coming years.
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Jeremy Bowman has positions in MercadoLibre. The Motley Fool has positions in and recommends MercadoLibre. The Motley Fool recommends Philip Morris International. The Motley Fool has a disclosure policy.
