Will $40 Trillion US Debt Collapse? Morgan Stanley Warns: Real Risk Lies in Shift of Capital from Stocks to Bonds

Morgan Stanley (MS-US) believes that the $40 trillion US debt itself does not represent an imminent crisis for the US economy. The key issue to watch is whether the high-debt environment will ultimately change investors' stock-bond allocations, and whether corporate earnings growth can continue to support current asset valuations.

The size of US federal debt has surpassed $40 trillion, raising market concerns about fiscal pressure and the economic outlook. However, Andrew Sheets, Morgan Stanley's global head of fixed income research, believes that while high government debt could indeed constrain economic activity, it is currently insufficient to trigger a systemic collapse. Continued improvement in corporate and household balance sheets will serve as a crucial buffer.

In a recent report, Sheets noted that US federal debt has increased by $20 trillion over the past decade, with over $1 trillion added in just the last three months. At the same time, government debt as a share of GDP has generally risen across major global economies.

Notably, while government sector leverage has increased, the financial conditions of US corporations and households have not deteriorated in tandem.

Sheets believes this structural difference suggests that the impact of government debt on the real economy may be lower than current market concerns.

Corporate bond issuance hits record highs, but leverage ratios show no significant deterioration

Morgan Stanley points out that driven by increased technology spending and a rebound in M&A activity, US corporate bond issuance continues to hit new highs. The firm's credit strategy team expects full-year issuance this year may break records again.

However, Sheets argues that large-scale corporate borrowing does not necessarily indicate accumulating systemic risk. Over the past decade, the ratio of US corporate debt to GDP has remained broadly flat and is even below pre-pandemic levels.

In particular, leverage among hyperscaler tech giants remains relatively low, and the returns from AI investments make it somewhat justifiable for companies to bear higher financing costs.

The report therefore expects that even if yields continue to rise, corporate financing will not be immediately disrupted, and credit spreads may only widen moderately.

US household debt falls to 67% of GDP

Household sector finances also provide some support. The report shows that US household debt currently accounts for about 67% of GDP, down from around 70% in 2000 and 74% in 2019.

It's important to note that the decline in household debt as a share of GDP does not mean households are entirely unaffected by high interest rates. Sheets points out that many US mortgages were already locked in at fixed rates during past low-rate periods, and rising household asset values such as home prices have helped support overall household financial health, contributing to resilient consumer spending.

However, interest-rate-sensitive sectors like housing have already been clearly suppressed, so the impact of interest rate changes on household spending may take longer to fully materialize.

This phenomenon of 'government leveraging up while the private sector improves its balance sheets' is also seen in other major economies. In some European countries, while government debt-to-GDP ratios have risen, corporations and households have actually continued to reduce debt. In Japan, despite increased public sector borrowing, private sector leverage has remained broadly stable.

Sheets believes this is linked to past policy choices across countries, including tax cuts in the US, France, Japan, Sweden, Switzerland, Italy, and the UK over the past decade, which have led to a more pronounced deterioration in public sector finances relative to the private sector.

The real risk may lie in the reallocation of capital between stocks and bonds

Compared to corporations halting borrowing or households drastically cutting spending, Sheets believes the key way high government debt could impact financial markets is whether investors begin to perceive bonds as offering more attractive risk-return profiles than stocks.

The report notes that the current 30-year US Treasury yield is about 300 basis points above expected inflation, while long-term US investment-grade corporate bond yields have reached 6.2%.

However, current capital flows and stock-bond price relationships do not yet show clear signs of asset reallocation. Stock and bond prices have recently continued to move in the same direction, with no clear signal of large-scale capital shifting from equities to bonds.

In this environment, corporate earnings growth remains a critical factor in maintaining market stability. Year-to-date, the S&P 500 Index has risen about 13%, while the US 10-year Treasury yield has increased by about 50 basis points, yet the equity risk premium has remained broadly stable.

Sheets compares the current environment to market conditions in the late 1990s and warns that if corporate earnings growth begins to slow, market vulnerability could rise significantly.

Morgan Stanley favors UK inflation-linked bonds and the Australian dollar

Amid diverging global fiscal conditions, Morgan Stanley also highlights relatively attractive markets.

The report states that the UK is one of the few major economies expected to see fiscal deficits narrow, making UK inflation-linked bonds attractive.

Additionally, Australia's government debt-to-GDP ratio is only about 49%, and with relatively high interest rate differentials, the Australian dollar is also favored.

In contrast, Sheets takes a more cautious view on the US dollar. He believes that if the US Treasury further intervenes in long-term interest rates, it could pressure the dollar, and the 7- to 30-year segment of the US Treasury yield curve could steepen again.