Government debt has become one of the defining economic issues of our time. Headlines regularly warn of record borrowing, rising national deficits and increasing interest payments. Whether it’s the UK, the United States, Japan or many European nations, governments around the world owe more money today than at almost any point in modern history.
It’s understandable that many investors ask the question: Should I be worried?
The short answer is yes—but perhaps not for the reasons you might think.
Government debt is an important issue that has implications for inflation, taxation, interest rates and economic growth. However, history also shows that successful investing isn’t about reacting to alarming headlines. Instead, it’s about understanding how these forces influence markets over the long term and positioning your portfolio accordingly.
Understanding Government Debt
Government debt is simply the accumulation of money a government has borrowed over many years. Governments borrow by issuing bonds (known as gilts in the UK) which are purchased by investors, pension funds, insurance companies and central banks.
Borrowing itself isn’t necessarily a bad thing. Governments often borrow to fund infrastructure projects, healthcare, education or to support the economy during periods of recession. During exceptional events such as the Global Financial Crisis and the COVID-19 pandemic, borrowing increased dramatically as governments attempted to protect businesses and households.
The concern arises when debt continues to grow faster than the economy itself.
If a country’s debt grows significantly faster than its ability to generate tax revenues, servicing that debt becomes increasingly expensive. As interest rates rise, governments can find themselves spending more on debt interest than on essential public services.
Why Investors Should Pay Attention
High levels of government debt can influence financial markets in several ways.
Firstly, governments may need to issue more bonds to finance their borrowing. An increase in the supply of bonds can place upward pressure on bond yields, particularly if investors begin demanding higher returns for lending money to governments.
Secondly, large debt burdens can restrict future government spending. Instead of investing in productive areas that help economic growth, increasing proportions of tax revenues are used simply to service existing debt.
Finally, governments facing mounting debt may eventually look towards higher taxation or inflation as ways of reducing the real value of what they owe.
None of these outcomes are particularly attractive for investors.
The Inflation Question
One of the biggest long-term concerns surrounding excessive government debt is inflation.
While inflation has many causes, governments with large debt burdens may have an incentive to allow inflation to remain above target for a prolonged period. Inflation reduces the real value of outstanding debt over time, effectively making it easier for governments to repay what they owe.
Unfortunately, inflation also erodes the purchasing power of savings held in cash.
Someone who leaves money sitting in a bank account earning less than inflation is effectively becoming poorer each year, even though their account balance continues to rise.
For long-term investors, owning productive assets such as shares has historically been one of the most effective ways of protecting purchasing power against inflation.
Companies can often increase prices, grow revenues and generate higher profits over time. Those higher profits are ultimately reflected in company valuations and shareholder returns.
What About Bonds?
Many investors traditionally think of government bonds as one of the safest investments available.
While governments of developed countries are unlikely to default on their debt, that doesn’t mean bond investors cannot lose money.
The sharp rise in interest rates during 2022 provided a timely reminder that bond prices can fall significantly when yields rise. Investors who believed government bonds were “risk free” discovered that low credit risk does not eliminate investment risk.
This is particularly relevant when governments carry large debt burdens. If investors demand higher yields to compensate for inflation or fiscal concerns, existing bond prices may fall further.
For investors with long investment horizons, this highlights the importance of understanding the different types of risk within an investment portfolio.
Should Equity Investors Be Concerned?
Ironically, periods of high government debt have often coincided with strong long-term returns from global equity markets.
Why?
Because businesses are remarkably adaptable.
Well-run companies continue to innovate, improve efficiency, develop new products and expand into growing markets regardless of government borrowing levels. While individual businesses may struggle, diversified global equity portfolios benefit from owning thousands of companies across different countries and industries.
History has repeatedly demonstrated that businesses have an incredible ability to create wealth over long periods despite recessions, political uncertainty, wars, changing governments and periods of elevated public debt.
This doesn’t mean share prices won’t experience volatility—they almost certainly will—but successful long-term investing has always required looking beyond today’s headlines.
Diversification Becomes Even More Important
Periods of economic uncertainty reinforce one of the fundamental principles of investing: diversification.
No one knows with certainty how governments will deal with today’s debt levels.
Possible outcomes include:
- Higher inflation.
- Higher taxes.
- Slower economic growth.
- Lower interest rates in future.
- Continued borrowing.
- Some combination of all of the above.
Rather than attempting to predict which outcome will occur, diversified investors own a broad range of global companies, sectors and geographical regions.
This approach accepts uncertainty rather than attempting to forecast it.
The Bigger Risk May Be Doing Nothing
One of the biggest dangers is allowing concerns about government debt to stop you investing altogether.
History shows that markets have consistently overcome enormous economic challenges.
Global financial crises.
Wars.
Oil shocks.
Pandemics.
Political instability.
Periods of high inflation.
Through all of these events, diversified investors who remained invested have generally been rewarded over the long term.
Holding excessive amounts of cash because the economic outlook appears uncertain can often prove more damaging than remaining invested through periods of volatility.
The Bottom Line
Government debt deserves attention. It has implications for inflation, taxation, bond markets and future economic growth, and investors should understand how these factors interact.
However, it shouldn’t become the sole driver of investment decisions.
Markets have always faced uncertainty, and today’s debt levels represent just one of many variables influencing future returns.
Rather than trying to predict government policy or second-guess the next economic crisis, successful investing is usually built upon timeless principles: maintaining a diversified portfolio, keeping costs low, investing for the long term and avoiding emotional decisions driven by short-term news.
No one can control government borrowing. What you can control is how your own investments are structured to navigate whatever the future may bring.
Carl Roberts, Director
If you want to learn more about this topic, please find the link here.
More information about our fund, the YFS Intelligent Wealth Fund, can be found here: Hargreaves Lansdown or AJ Bell.
Risk warnings
The value of investments and the income derived from them may fall as well as rise. You may not get back what you invest. This communication is for general information only and is not intended to be individual advice. You are recommended to seek competent professional advice before taking any action. All statements concerning the tax treatment of products and their benefits are based on our understanding of current tax law and HM Revenue and Customs practice. Levels and bases of tax relief are subject to change. This blog is based on my own observations and opinions.
