As global economic dynamics become more volatile, investors watch with anticipation every occurrence that could have a dramatic and profound effect on U.S. markets. Rising bond yields in Japan, declining Treasury holdings by China, and concerns over U.S. fiscal policy create a complex backdrop. The S&P 500 has shown remarkable strength, including a heroic bounce in mid-May. Foundational concerns need close consideration when assessing where the market should go moving forward.
Japan’s recent rise in bond yields may be the trigger for a more sizeable capital repatriation from the United States. Investors are hungry for increased yields on their home country investments. This trend would be an added stress to the already delicate balance of the U.S. financial landscape. These capital movements have massive consequences. They would all significantly worsen the existing pressure on U.S. interest rates and borrowing costs.
China’s recent announcement that it will cut its Treasury holdings to a 14-year low. Beyond the fallout from the coronavirus, this move marks a sea change in the country’s investment strategy. China is already taking steps to diversify away from U.S. debt. Fast forward to today, and its holdings are getting lapped by the United Kingdom. This structural change is indicative of a broader trend amongst foreign investors. One of the implications is to cast doubt on future demand for U.S. Treasury securities.
Record Deficits and Downgraded Debt
After all, the U.S. is facing unprecedented fiscal challenges, now running record deficits with no plan in sight to credibly consolidate. According to the newest House budget resolution’s projections, U.S. debt could skyrocket to an alarming 125% of GDP by 2034. This scary forecast remains the case even under the best of all possible scenarios. All of these projections should cause serious alarm about the sustainability of U.S. fiscal policy—and what that means for future economic vitality.
Though equity markets seem ready to overlook the U.S. debt downgrade, the underlying story is more disconcerting. Investors are not yet fully realizing the potential consequences of rising debt levels and fiscal instability. As the threat of increased premiums to cover U.S. deficits increases, market participants will have to reckon with this truth. The challenges that lie ahead are becoming as equally inescapable.
The further narrowing leadership in U.S. equities makes this a more complicated market outlook. The S&P 500 index had an impressive rise of more than 6% in May and is up over 12% on the year so far. Yet the concentration of a handful of large tech stocks is problematic for market breadth and sustainability. These high valuations of tech companies may be a signal that they are overvalued. This situation puts state and local governments at risk should the market correct.
Trade Tensions and Policy Uncertainty
While most of the world grapples with high inflation and other economic woes, U.S.-China trade tensions still bubble under the surface. President Trump’s recent frustrations with deal-making and criticisms aimed at major retailers like Walmart passing on tariff costs have raised flags regarding future trade policies and their impact on retail prices. Such uncertainties can hang like a dark cloud over market sentiment, especially if trade disputes flare up a second time.
Today, the U.S. and China are locked in a temporary tariff truce, but the same substantive issues still hang heavy over any potential U.S.-China deal. In particular, investors fear the effects that changing trade dynamics could have on the U.S. economy and the overall stability of the global order. Continued wars abroad, such as those in Israel and Iran, risk breaking overall market tone.
As policy and fiscal uncertainty remain elevated, investors must navigate a landscape marked by a cautious Federal Reserve and ongoing geopolitical tensions. The threat of a new wave of trade wars in tandem with increasing deficits would forge an explosive mix unlikely to be hospitable to growth.
Opportunities in Geographic Diversification
Analysts recommend geographic diversification to benefit investors over the long term. Their best advice is to start to look at other regions that are way undervalued including China and Europe for stability with increasing pressures in the U.S. Given the enormous over-weighting to U.S. equities, reassigning some of that capital to emerging markets stands to offer a hedge to various domestic uncertainties.
It’s about time that investors began realizing the truth. With the S&P 500 still proving surprisingly resilient, they need to be mindful of more sweeping global economic trends as well. Recent capital flow trends as well as changes in foreign holdings of Treasury securities reveal ongoing fiscal stresses. These three considerations indicate that markets are due to re-evaluate the risk premiums associated with U.S. investments.