The $40 trillion national debt could spark ‘lost decade’ in stocks

High stock valuations have prompted plenty of warnings of a lost decade in stocks over the last few years.

Now, there’s a new culprit that could flatten returns over the next 10 years: the staggering national debt.

US government debt hit a record $40 trillion this week. Instead of raising taxes or cutting spending to pay down the debt, policymakers are likely to try to inflate their way out of the borrowing conundrum, according to Tom Essaye, the founder of Sevens Report Research.

It’s essentially the thesis behind the so-called “debasement trade,” which is one reason for the recent surge in long-duration Treasury yields.

Yields on 10-year and 30-year Treasurys have already climbed to some of their highest levels in the last two decades as investors have worried about inflation from strong economic growth, rising oil prices, and the government spending levels.

Historically, rising long-term bond yields have put pressure on the stock market, as investors become more likely to opt for risk-free returns the more attractive those returns become.

While a plunge in stock prices may indeed happen, dampening future returns from today’s starting point, Essaye warned of a different kind of lost decade: one in which high and persistent inflation eats away at real returns in stocks.

He pointed to the period between 1966 and 1981. Stock values went nowhere, but high inflation meant the real value of portfolios actually dropped by around 50%.

“That is the actual 10-year risk, not a crash, but a decade where nominal account values look fine while real purchasing power quietly erodes,” Essaye wrote.

In an inflationary environment, Essaye also said long bonds no longer work as a hedge for an underperforming equity market. That is, if the government is inflating its way out of its debt, investors will demand higher bond yields to compensate for that inflation. That means bonds bought today would lose value, and rising bond yields mean falling prices.

It’s also what happened during that 15-year stretch from 1966.

“Through 1966-1981, stock-bond correlation was persistently positive and long Treasurys fell alongside equities in real terms, because the airbag of the 60-40 portfolio fails in inflationary, fiscally dominant market regimes,” Essaye said.

Given his skepticism about long bonds protecting portfolios, Essaye offered alternative investment ideas for assets that would deliver better returns in an inflationary environment.

They include:

• In fixed income, look to short- and intermediate-duration bonds, as well as Treasury inflation-protected securities, or TIPS, Essaye said. He called long-dated bonds the “epicenter” of the risk in this scenario.
• In stocks, he said what worked from 1966-1981 was firms with pricing power, growing dividends, and positive cash flows after accounting for inflation.
• Exposure to tangible assets is also good to have, and act as “the direct hedge against the debasement path,” Essaye said. This means investing in gold, natural-resource-linked stocks, emerging markets stocks, and commodities, he said.

Examples of funds offering exposure to these trades include the Schwab Short-Term US Treasury ETF, the Invesco Bloomberg Pricing Power ETF (POWA), the State Street SPDR S&P Global Natural Resources ETF (GNR), the iShares Core MSCI Emerging Markets ETF (IEMG), the Vanguard Dividend Appreciation ETF (VIG), and the SPDR Gold Trust (GLD).