Editor’s note: The following was adapted from our 3Q 2024 Commentary

In the months leading up to election day, both presidential candidates made promises of tax cuts and credits, housing incentives, childcare assistance, and other proposals. Unfortunately, little explanation was provided for how they’d be paid for.

Par for the course in Washington, we know, but no less concerning when it comes to the future of deficits, our nation’s balance sheet, and, by extension, interest rates.

Amid the rhetoric, The Wall Street Journal estimates that such promises would widen the deficit over the next 10 years between $3.5 and $7.5 trillion. While true that candidates for office routinely promise the world, and many of these proposals never come to fruition, what is unavoidable is the expiration of the Trump tax cuts in a little over a year.

Most estimates peg a full extension of the expiring tax cuts at an over $4 trillion increase to the deficit. The GOP’s sweep of the White House and both houses of Congress makes a full extension likely.

Source: Wall Street Journal

Even now, with the votes tallied and Donald Trump preparing his return to the White House, it is hard to know which proposals will be enacted. But as the chart below shows, neither Republicans or Democrats have shown the ability or desire to balance the budget.

Source: Wall Street Journal

Debt Piling Up

Additionally, as deficits pile up year after year, it is increasingly difficult to manage the overall debt situation given the relatively small portion of the budget that is deemed “discretionary.” Interest on the federal debt continues to grow, and cutting any piece of the pie below will be unpopular.

With the ever-increasing U.S. debt in relation to GDP, we’re wondering when heavy debt might move to the forefront of investors' minds. Currently, the state of the U.S. balance sheet doesn’t appear to be raising investor concerns, as indicated by the term premium on the 10-year Treasury, which remains well below long-term averages. As a refresher, the term premium is the excess yield investors require to hold a longer-term (10 years in the current example) bond versus what would otherwise be implied were they to continue reinvesting in shorter-term bonds over that 10-year period.

Interest Rate Ripple

Historically, the average term premium investors demanded is significantly higher than we are seeing today, as shown in the chart below. Simply getting back to the long-term average would put the 10-year Treasury yield 100+ basis points higher than where it currently sits.

If, at some point, the bond market truly starts to fixate on the state of the U.S. Government’s balance sheet and deficits with no end in sight, could it not be argued that investors might command an even higher premium? If so, this could have major ramifications on long-term interest rates.

While we see evidence that supports a case for a more inflationary and higher interest rate environment than seen in the past ten years, we believe it does not argue for a recession. Nonetheless, the unexpected can occur. Should a recession happen in the near term, recent economic data leads us to believe it could be less significant than the previous two recessionary periods.

Following years of lower interest rates fueling the rise of growth stock valuations, we believe value investing is primed for a period of outperformance. We continue to uncover attractive opportunities to invest in high-quality businesses with strong balance sheets and robust cash flows, where share prices have drifted from our assessment of their true fundamentals.

For deeper insights, including our near-term outlook for the markets and economy, read our 3Q 2024 Commentary.