US Trip: learning from those who drive the largest market in the world.

I was fortunate to spend time in New York over the last two weeks, by invitation of Moelis Australia, a preeminent alternative investment manager. As a young Australian advisor, this was a unique opportunity. The US is arguably the world's most important financial and investment jurisdiction. Home to the highest number of billionaires, the largest asset management firms, the most significant family offices, and many of the most well-known businesses worldwide. The New York cityscape is enormous and impressive. The city design follows a grid structure, allowing one to stand in middle Manhattan and witness the hustle and bustle of corporate life for kilometres' in any direction.

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Yellow cabs operate all day and all night. You can hear them with the constant beep of their horn throughout the streets. Police cars and fire truck sirens ring every hour. Underneath the city is a massive network of subways, humidity drifting above ground and oozing steam. The town smells of marijuana everywhere. It is now legal to have and consume limited amounts for personal consumption — and it seems a lot do.

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For all the talk about potential recessions, slowing economic growth, and remote work, New York was impressively busy at all hours of the day. Other than the first night I arrived and the following day, my time was consumed in back-to-back investment meetings, and the city was active well before and well after each day finished.

We were fortunate to be introduced to several titans of the industry. These names might be unfamiliar to many but include:

1. Robert (Bobby) Jain, for example —is the former CIO of Millenium Management, one of the world’s most reputable hedge funds, overseeing US $64B in assets, with a history of delivering outsized returns consistently for 30+ years. Prior to Millennium, he was the head of Asset Management at Credit Suisse, overseeing $240B. Bobby also chairs the Harvard Endowment Fund.
2. Ken Moelis, the CEO and Founder of Moelis & Co. is quite possibly the most prolific investment banker in history. Moelis & Co. is one of the world's most prestigious independent investment banks and advises on more than US $4 trillion in transactions.
3. Sonny Kalsi, the CEO of BGO, is a global real estate manager with more than $82B in funds under management. Sunny was previously the head of Morgan Stanley’s Global Real Estate Platform and was appointed CEO of BGO’s parent company, Sun Life Financial, on the day we met him. Sunlife manages over USD 1.5T globally.
4. Brian Weinstein, the head of Global Markets for Morgan Stanley and its former head of Fixed Income. Previously, Brian co-founded a large private credit asset management business and was the head of fixed income at Blackrock, overseeing $300 billion in assets.
5. Eric Felder, CEO of Moelis Asset Management — a bespoke US-based alternative asset manager. Eric was previously a Senior Managing Director at Citadel, covering equities and global credit. For context, Citadel is one of the largest hedge funds in the world and has generated approximately $74 billion in gains since its inception in 1990. This makes it the most successful hedge fund of all time. Eric has served as the Head of Global Markets at Barclays Capital, leading global trading across equities, fixed income, currencies and commodities.
6. We met Priya Misra, Managing Director of JP Morgan’s Global Fixed Income, Currency, and Commodities Business (CFICC). This team manages over $700 billion in assets. Priya has regular access to key members of the Fed and the largest fixed-income market participants globally. She has held senior roles with Bank of America, Nomura, Barclays and Lehman in rates research and debt coverage.
7. We also met with a senior research team at Wall St Journal. It was a valuable discussion to understand sentiment and the conversations their journalists have been having with companies, consumers and other participants. To summarise, we met with global industry leaders across equities, fixed income, direct property, and large multi-asset portfolios, who control some of the most significant flows globally.

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I say the above not to feel self-important but out of admiration. The level of executives we met was humbling, especially as an advisor travelling from Australia—a much smaller and younger market. Of their insights taken back home, there is far too much to unpack in one note, so I want to focus on one topic—rate expectations. Readers are probably sick of hearing about this topic now. However, aside from economic activity and Fed policy, investors should be cognizant of other drivers of rates—specifically, US debt levels and creditworthiness.

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The professionals we spoke to agreed that we would not see further rate rises by the Fed. Almost all acknowledged that inflation could be stickier than expected, but the expectation was that rates would be higher for longer but lower than where they are today. They spoke about the reasons why, which, to summarize, was cooling CPI and other economic data. This isn’t occurring as fast as expected, but there is evidence that higher rates are having their intended effect, and the same restrictive policy to reduce inflation at 7–8.00% shouldn’t be required at 4–5% (hence modest cuts).

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However, something less commonly discussed was the impact of the ballooning US Government Deficit. The talks about rates centred around the US consumer, corporate activity, jobs, Fed intentions, etc. However, the cause of much inflation (globally) appears to be post-pandemic government spending, not private activity. The US Government debt has increased by USD 15T since the COVID-19 pandemic ($35T+ total). The current interest bill on this debt now exceeds $1T a year, and the deficit is $1.7T, up from $1.3T in 2022. For context, the interest bill on US Government debt each year is more than the entire debt burden the Australian Government has. Year after year, the government argues about lifting its debt ceiling to avoid a shutdown. Yet fiscal responsibility, or the lack thereof, will or certainly should eventually be repriced.

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Think about this for a minute. If the US government was a private company and continued to accelerate its level of debt, worsening its credit quality, wouldn’t this have consequences? Of course. Credit agencies would mark down the credit quality of the debt. Given the higher relative risk, investors would then reprice this debt by demanding a higher yield or lower price for bonds. To date, the only change we have seen in the yield curve has come from the Central Bank (Fed) Policy and expectations around potential changes to its policy.

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There is a misconception, however, that the US government doesn’t need to be concerned about this. The US Dollar is the world's reserve currency, so there will always be demand for dollars, right? The government can print its own money and use it to buy its debt, can’t it? Yes, this is called Quantitative Easing (QE) but is inflationary. When you increase the monetary supply, it reduces its value. Some argue that the US government can ‘inflate’ its way out of debt. That is — if spending drives economic growth at a faster rate of inflation, then tax collected (on businesses earning more) will pay off this debt. However, this argument appears flawed given the sheer volume of indebtedness the US now has. I will touch on this in detail below. Without seeing US treasuries, particularly longer-duration, e.g. 10-year treasury notes yield increase as the fiscal position of the US government worsens, there will (at some point) be less demand for US treasuries from investors. We have already seen some alarm, with weakness in US Treasury bond auctions.

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In recent treasury bond auctions, e.g., $39B of 10-year notes saw weak demand—the weakest participation since November 2022, according to BMO Capital Markets and the Wall Street Journal. Treasury Dealers, mostly large U.S. Banks, were forced to absorb far more of the debt than usual. Yields also extended their climb to ~4.70%. I believe this trend will continue. With continued weak treasury demand, we should see long-duration debt continue to be repriced and bond prices fall. Moreover, if systemically important US banks are forced to buy treasuries at a time when their prices are falling, this should raise concerns similar to the recent US bank failures we have seen or the cause of the UK LDI crisis. Put another way — if US banks are forced to buy US government bonds that will decline in value, this can create huge liability mismatches.

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Ballooning US government debt, record levels of government spending and a rapidly snowballing interest bill on said debt could be one of these outliers. As stated by Jamie Dimon, CEO of JP Morgan, the deficit is “why we have higher inflation”, and he hopes that the US government “really focuses” on reducing the deficit. “At one point, it will cause a problem, and why should you wait…at some point, the problem will be caused by the market, and then you will be forced to deal with it and probably in a far more uncomfortable way than if you dealt with it to start?” he said. (CNN Business, 21/05/24).

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Economist and former dean of Columbia Business School, Glenn Hubbard, recently said that interest “payments on the national debt, which were essentially zero a couple of years ago, are now as big as defence spending. The next president will have to deal with this issue.”

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One of the issues associated with the ballooning government debt levels and deficit is that if (or when) the US hits a recession, the government will be less able to afford or implement stimulus programs without tipping a deficit into double-digit percentages of GDP which is unsustainable. As deficits grow, the government also needs to issue more Government securities and increase yields to attract more investors to compensate for this indebtedness. This raises borrowing costs across all financial markets, hurting economic growth.

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Over recent weeks, the US has sold $180b of treasuries with lacklustre demand, at around 4.65%—higher than the auction level. Yields are rising in the US and elsewhere. European bonds, for example, have tumbled, sending yields to multi-month highs after higher inflation reports in Germany.

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Last month, the International Monetary Fund (IMF) said the highest risk and rising level of US government debt risked driving up borrowing costs worldwide and undermining global financial stability. Or, taking it a step further, the Head of the Congressional Budget Office, the US Congress’s independent fiscal watchdog, said the United States risked a bond market crisis of the kind that engulfed the United Kingdom under former Prime Minister Liz Truss.

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Metlife Investments has stated that in every scenario it examined, publicly held debt rises (up to 139% of GDP by 2029). Annual net debt issuance is expected to remain four times as high as before the pandemic, raising questions on how easily markets can absorb issuance. Debt metrics are poor and projected to worsen. The U.S. debt-to-GDP is far worse than Fitch’s AA-rated median, and its interest-to-revenue ratio of over 10% resembles a BBB-rated country. Therefore, the probability of further downgrades and outlook revisions will increase significantly if drastic fiscal action is not taken. According to Metlife's model, stabilizing the current US debt trajectory would require aggressive budgetary adjustment to the tune of 3–4% of GDP. Although this seems small, 3% of GDP amounts to 50% of the government’s discretionary spending or the entirety of defence spending in 2022. It is roughly half the annual expense of all healthcare programs combined or 60% of 2022’s social security expenditure. So, to contextualise the earlier argument that the US government can inflate its way out of debt — it just doesn’t seem likely given how significant the volume is and the level of tax collection required.

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Alongside this question about the demand for US treasury issuance, many are watching the Bank of Japan policy. It seems set to exit its hostile interest policy (NIRP), allowing target interest rates to rise just above zero. However, gradual steps may be taken to enable the yield on the 10-year JGBs to fluctuate more freely. Shifts in Japanese monetary policy are of global interest because it is one of the largest foreign/US paper purchasers. The yield available outside of Japan is significantly higher than locally (encouraging carry trades). Still, if there are questions about the stability or value of foreign bonds owing to ballooning deficits, we may see repatriation of funds for other reasons.

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The wide currency differential, moving from 100 to 150, for example, could significantly increase the cost of hedging, and fear of eventual Yen strengthening could disincentivize against the current spread between JGBs or other foreign bonds vs US treasuries. We saw significant inflows back to Japan in 2022 — coinciding with higher cash rates; so again, potential catalysts for higher yields and lower long-term US gov prices could cause repatriation, widening a demand shortage for treasuries. If this were to happen, it would likely be sudden and a shock — and if this left a large hole in treasury demand, you could start to see how this might result in similar repercussions to the LDI crisis in the UK under Liz Truss. Further downgrades could accelerate the diversification of central bank reserves and undermine the status of the U.S. dollar as the world’s reserve currency.

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As I reflected on the above topic, during my 30-hour transit back home to Australia, I read ‘Same as Ever’ by Morgan Housel. I will spare you the bulk of the book, but one of the critical themes emphasized was that the risks or opportunities that matter in markets are outliers. The stories or events are almost entirely unpredictable or unseen. The 2008 Financial Crisis. Covid. Skyrocketing inflation. The collapse of Silicon Valley Bank or Credit Suisse. If outliers matter to markets, we should spend more time thinking about the big ‘what ifs’, the farfetched, left-field possibilities that few people discuss. Not consensus — which is inevitably already priced in markets.

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Interestingly, I don’t know of any time in my career when fiscal irresponsibility by the US government has been a larger risk than corporate or consumer behaviour. For example, Brian Weinstein from Morgan Stanley posited that perhaps we would see the price and yield of Apple bonds trade tighter (more expensive) than US government debt, given its better balance sheet. This type of thinking has important repercussions. If US government debt is not correctly priced to reflect a growing risk, many of the largest investors in the world (think life insurers, banks) will need to diversify into other, less correlated assets—high-quality companies with strong balance sheets, private companies, and private businesses, high-quality asset-backed securities.

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Questions about US Government debt and rising deficits are concerning and relevant because markets will eventually need to know how these will be reduced and financed. Spending will need to be repaid later, e.g., through higher taxes and we have known this for years. Experimental Quantitative Easing kicked off in the global financial crisis. It was tripled through Covid. Spending still continues. At some point, politicians can’t keep kicking the can down the road. As emphasised by Morgan Housel, this is a potential outlier that investors should consider and plan for.

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