US elections: No matter who wins, the national debt will rise. That's what you need to know.

This question can be analysed from two perspectives: firstly, from the point of view of a country that is confronted with a high mountain of debt and corresponding interest costs. In the course of the eurozone crisis, an academic approach to determining when a country is in a debt trap was attempted by Rogoff/Reinhart (2010), who set the upper limit at 90% of GDP. However, this approach falls short. Other factors, such as the foreign quota or the deadlines that are relevant in this context, can be found in the article Debt under the microscope (in german) by Martin Weder, Chief Economist at the Zürcher Kantonalbank. At the end of October, US Treasury Secretary Janet Yellen mentioned another indicator. She stated that the pain barrier for real net interest costs should not exceed 2% of GDP.

It makes a difference whether the USA issues bonds in the global currency reserve USD or whether it is a country within the European Monetary Union or a state with an independent monetary policy and free exchange rate. The latter would be at much greater risk from the deterioration of their public finances, as their dependence on exogenous factors is greater.

According to the established rating agencies, twelve countries currently have an AAA rating. Since these deeply indebted countries, by definition, have a low number of government bonds on the market relative to their GDP (and only three of them are in the G20), the market is limited and, furthermore, (with the partial exception of Germany) offers little breadth or depth. Seventeen states, including the three G7 states USA, Great Britain and France, are rated AA.

While on the one hand states are piling up more and more debt, some companies, thanks to their strong market position, are managing to achieve high profits and a very low debt ratio. This raises the question of whether the credit risk of such AAA/AA companies as Microsoft or Apple is not actually lower than that of the US government. That would certainly be a paradigm shift in relation to the ‘risk-free’ interest rate. Historically, this has only happened in a few special cases, such as during the euro crisis with companies with significant investments abroad. Investors, however, see it the same way, as evidenced by Microsoft's credit spread of only 20 basis points. However, we consider negative credit spreads for highly rated governments, namely AAA-AA, to be very unlikely, as such governments still have the ‘lender of last resort’ – i.e. the central bank.

The combination of government bonds and equities makes a portfolio efficient because the correlation between the two asset classes is low. The main exceptions are phases of rising inflation. So when it comes to replacing government bonds, the question of correlation arises, as does that of the tradability of possible substitutes. In the chart, it can be seen on the X-axis that, as expected, USD corporate bonds correlate very highly with US government bonds. However, the much smaller size of the circle shows that they are much less tradable. Ultimately, there is no specific substitute, but rather a mix of investments with government and corporate bonds with high ratings, infrastructure, real estate and insurance-linked securities.

Looking at the last three major crises (the financial crisis of 2008, the euro crisis of 2010 and the Covid crisis of 2020), a traditional LPP25 portfolio without US government securities would have fared better during the financial crisis, because US Treasuries were also sold to raise liquidity. In the Covid crisis, the portfolio would have performed less well because the Fed had decided to cut interest rates rapidly. No difference was observed in the euro crisis.

Two contrasting and intuitive scenarios are, on the one hand, a rating downgrade of the USA with a sharper fall in prices and a rise in yields than in 2011 for S&P and recently for 2023 for Fitch (estimates of around 20 basis points rise in yields since the announcement of the ‘negative outlook’). We assume a yield increase of 200 basis points for the stress test. On the other hand, there would be a scenario of a geopolitical escalation in the Middle East. In this case, we would expect a flight to safe havens such as US Treasuries or CHF and gold.

The risk stress test with model-based correlations applied to an LPP25 portfolio shows: in the event of a downgrade due to the predefined low quota of US government bonds, it is not these bonds but rather the more volatile and important categories such as equities that cause the biggest declines. Obviously, the higher the proportion of foreign government bonds, the worse the expected reaction to a US downgrade. In the event of a geopolitical escalation, however, the advantage of US government bonds is smaller because domestic bonds also serve as a hedge.

In view of the local yields (without currency influence), from the point of view of a multi-asset investor, the diversification effect of government bonds from other countries is actually limited. Nevertheless, the following two circumstances may speak in favour of this approach: firstly, if a foreign country is undergoing structural change, such as lower inflationary pressure. And secondly – tactically – if the historical yield differential is at the upper end. This is currently the case: five-year USD vs CHF bonds are close to the 30-year high. In the practice of CHF and EUR investors with a mixed universe, typical foreign benchmarks contain a mix of government and corporate bonds (the ‘Global Agg’). The weighting of governments (including government-related organisations) is around 70%. The corporate bond universe is characterised by a broad spectrum of sectors, credit ratings and purposes (e.g. green bonds). 

All other things being equal, countries with high debts should have a weak currency. Of course, this disadvantage is offset by higher yields, including real yields. Currently, the interest rate differential of USD against CHF and EUR is actually as high as 4% and 1.6% respectively. Nevertheless, the currency effect will drive up volatility. In view of the structural strength of the CHF, it is preferable for mixed portfolios to hedge foreign bonds without taking into account the currency exposure of the overall portfolio (see also the article Currency risk – how much hedging is necessary?).

In the short term, we do not expect the US elections to trigger a sell-off, even in the absence of measures to contain the debt. To some extent, the scepticism of ‘bond vigilantes’ can be seen in the rise of 60 basis points in 10-year yields in the run-up to the elections. In France, where the public deficit is at the centre of the political debate, the yield spread with Germany has increased by 30 basis points. Moreover, even a supposedly expansionary Trump administration will have a Republican treasury secretary who will campaign for the goodwill of the bond markets (as Mnuchin did in Trump's first term). In the medium term, a reduction of the allocation to government securities with negative momentum makes perfect sense from the point of view of strategic asset allocation. However, there is no specific substitute for government securities, but rather a mix of investments with governments and investment-grade corporate bonds, infrastructure, real estate, insurance-linked securities and gold.