Fiscal Follies – The Unsustainable path ahead
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Article Type
Insights
Topic
Opinion
Published
July 17, 2025
Read time
5 mins
Authors
Jacob Vijverberg, CFA
Jordy Hermanns, CFA
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The US government is running a unsustainably high government deficit, which is expected to increase further after the passage of the tax bill. Also on the European side of the Atlantic, several countries are either increasing deficits or are already facing elevated debt levels.  Investors must navigate these developments with caution, as financial markets could force a course correction. The key takeaway for European investors: be wary of unhedged USD assets, consider hedging (part of) equity portfolios, and prefer real assets, like equities, over treasuries.

 

Deficit Spending

Governments on both sides of the Atlantic are gearing up for a period of higher deficits. The United States, already grappling with a substantial deficit, is set to see this gap widen further due to recent tax extensions and cuts. Projections suggest that the deficit could average around 7% of GDP in the coming years. Normally, these deficits only happen temporarily during recessions, while now the economy is at full employment. So one doesn’t need to be an economist to see that this trajectory is unsustainable without an economic miracle.

 

In Europe, Germany is leading the charge with plans to invest heavily in infrastructure and defense. Unlike the US, Germany starts from a relatively strong fiscal position, with low debt and deficit levels. However, other European nations, such as France, are not as fortunate. France faces high deficits and significant unfunded pension and health liabilities. While Greece, the epicenter of the eurozone crisis, is once again running a 7% current account deficit.

 

Projections Are of Limited Use

Various forecasts predict an ever-rising US debt-to-GDP ratio, with the Congressional Budget Office (CBO) estimating it could reach 124% by 2034. However, long-term projections are often not very instructive. What is clear is that a 7% deficit is unsustainable in the very long run. However, debt levels will not rise indefinitely; financial markets will eventually force policymakers to change course. Therefore, it is more pertinent to consider how investors will react.

Debt-to-GDP (%)

Source: Aegon AM, Bloomberg. Data as per 2024.

 

Steady as She Goes, Except in a Crisis

A important reason for having limited government debt levels, is that the government can stimulate the economy in times of crisis. A high debt load limits a government's ability to do this.

 

During the Global Financial Crisis (GFC) and the COVID-19 pandemic, the US was able to run large deficits to support the economy. In contrast, during the eurozone crisis, heavily indebted countries like Italy and Spain could not provide similar support due to sustainability concerns, necessitating intervention from Europe and the central bank.

 

Germany's recent response to the threat posed by Russia, which included significant boosts in defense spending, also highlights the importance of running a prudent fiscal policy. Many other European countries with higher debt levels were unable to follow suit.

 

Not having the government being able to step in, will imply that future crises might be deeper and more prolonged.

 

Someone's Deficit is Another's Surplus

Deficits and lending are always counterbalanced by surpluses and borrowing elsewhere. This principle applies to countries and sectors within countries. Understanding the flow and stock of net lending and borrowing is crucial for predicting financial market behavior.

 

During the eurozone debt crisis, Southern Europe's large current account deficits were financed by Northern Europe. When the private sector realized these deficits were unsustainable, lending stopped, and the states and central banks had to intervene to prevent a larger financial crisis.

 

In the US, the government runs a large deficit while corporate and household sector surplus are limited (see chart below). This means foreign investors must finance the gap, which is the current account.  

 

United States: Net lending or borrowing per sector

Source: Aegon AM, Bloomberg. Data as per Q1-2025.

The chart also clearly shows that the US government was able to expand its deficit during periods of crisis, like in the GFC in 2008/2009 and the Covid crisis from 2020. This balanced the negative consumption effect from the household and corporate sectors which wanted to run high surpluses in the face of uncertainty about economic prospects.

 

This chart also highlights a key point in the current trade war. The US is trying to lower the trade deficit, which is a significant part of the current account deficit, by imposing tariffs. However, lowering excessive spending by the government will likely be a more productive way to pursue this. High government deficits push the current account towards negative territory.

 

Stock and Flow

The current account balance represents how much a country needs to finance from foreigners on a yearly basis. This is therefore a flow measure. It is also instructive to look at the total stock of foreign lending.

 

For instance, before the eurozone crisis, peripheral countries had large liabilities to the private sector in Northern countries. When private lending ceased, the European Central Bank (ECB) had to step in, effectively becoming a middle man. This was evidenced by the large TARGET balances. Germany, for instance, still holds a €1 trillion surplus via the ECB.

 

For the US, its most instructive to look at the Net International Investment Position (NIIP), which tracks the net assets minus liabilities relative to the rest of the world. This has steadily decreased to a net liability of $26 trillion or 90% of GDP (see chart below). While this might not be an issue for a growing and competitive country, it could lead to a sudden freeze in lending if investors question the willingness or ability to honor these liabilities.

 

US - Net International Investment Position (NIIP)
(trillion US dollar)

Source: Aegon AM, Bloomberg. Data as per 2024.

 

“If You Owe the Bank $100, That's Your Problem. If You Owe the Bank $100 Million, That's the Bank's Problem.”

 

The large deficits of the US might, on first sight, seem to be mainly a risk for the US. However, non-US investors are on the hook, if there is a repricing of US assets. They run the risk that there claims, whether equity or debt, won’t be paid in full.

 

 

Financial market reaction: Gradually, Then Suddenly

So, how will financial markets behave if this imbalance is not corrected? It is safe to assume that the US will continue running large deficits considering there is no realistic plan to lower them. Intuitively, one would expect higher interest rates, similar to the eurozone periphery during its crisis. Although we do expect US treasury rates to remain elevated, a rate spike is unlikely as the central bank, the Federal Reserve (Fed), will intervene if a crisis looms.

 

This means the remaining escape valve is the US dollar. By suppressing rates, the Fed would allow higher inflation and currency depreciation. This is already being priced in, as evidenced by the significant decline in the US dollar this year. Non-US asset investors, who owning those $25 trillion in net assets, must have felt that already in their wallets.

 

A lower US dollar combined with higher inflation will, in the long run, be constructive for real assets. US equities, especially does with global exposure, might therefore still be a decent place for long-term investors. Be careful with assets with high leverage ratios due to higher lending rates in this scenario.

 

Hemingway described a bankruptcy as happening “Gradually, then suddenly” in one of his novels. A bankruptcy is very unlikely, however the same adage applies to any financial market reaction. Debt imbalances can build for decades before suddenly bursting into the open.

 

Conclusion for Investors

  • Be cautious with unhedged assets in USD
  • Consider increasing USD hedges on equity portfolios
  • Be wary of long-duration US debt, which is most sensitive
  • Prefer real assets in the US, such as equities, if you have a long investment horizon

 

Be cautious with highly leveraged assets  

Important Information

Authors

Jacob Vijverberg, CFA
Head of Asset Allocation

Jacob Vijverberg, CFA, is head of asset allocation. He is responsible for both strategic and tactical asset allocation. The team is managing a wide range of multi-asset funds  

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Jordy Hermanns, CFA
Portfolio Manager

Jordy Hermanns, CFA, is a portfolio manager in the multi-asset group and serves as an investment strategist in the asset allocation team.

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