The Future of Indebted Countries

Dear investors,

The problem of Brazilian public debt is well known and has worsened considerably in the recent past. Between 2010 and 2025, our public debt rose from 62.4% to 88.7% of GDP. But Brazil is not an isolated case. During the same period, several other nations have been increasing their debts. Among the 10 largest economies in the world, only Germany is moving in the opposite direction.

Public debt of the 10 largest economies

Source: IMF Data- April 2026 WEO

This widespread leverage by states cannot continue to increase indefinitely. The big questions are how long this trend will last, what can happen to reverse it, and what the effects on investment would be.

How did we get here?

Each country has its own story about how debt increased so much, but there are two common factors that explain a large part of the movement: crises cushioned by government spending and political pressure against fiscal adjustments.

In recent decades, governments have adopted measures to deal with economic shocks based on the Keynesian concept that the state should act as a counterweight to private markets during crises, increasing public spending when private spending decreases too much. Through this direct intervention in the economy, economic recessions would be avoided or, at least, mitigated.

In the face of the COVID-19 pandemic, this was done on a large scale. Several countries launched economic stimulus programs to mitigate the reduction in income caused by lockdowns, financed by increased public debt. In a milder and more recent example, some governments are adopting measures to cushion the impact of rising oil prices caused by the closure of the Strait of Hormuz. Brazil recently announced subsidies for diesel.

In theory, public spending should be reduced after crises to offset the economic stimulus granted and replenish government coffers. Since it is easier to make concessions than cuts, this recovery does not happen in most cases. Of the 10 largest economies in the world, 6 have not yet returned to their pre-COVID debt levels.

The political reality in most countries encourages a trend of increased government spending, as the population applauds the expansion of benefits while rejecting tax increases. Where would the distributed resources come from? This inconsistency is ignored in campaign speeches, but not in the accounting of the fiscal balance. Increasing benefits generate fiscal deficits that are usually financed by more debt.

Fiscal deficit (nominal) of the 10 largest economies

Source: IMF Data – April 2026 WEO

In an environment where economic growth exceeds the interest rate on public debt, some fiscal deficit would be sustainable (in the simplified case where debt is 100% of GDP, it would be stable when the deficit and nominal GDP growth are equal). Under this logic, the typical political desire to push fiscal limits to please the population, coupled with the period of low interest rates experienced between 2010 and 2021, led to the defense of maintaining deficits and increasing debt as sustainable. The problem became more evident from 2022 onwards, when the illusion of perpetually low interest rates vanished and the cost of borrowing began to weigh heavily on the fiscal result again.

This is the situation that Brazil and a large part of developed economies are facing today: high public debt, high interest rates, and popular pressure against cuts in public spending. Let's analyze what might happen next.

What are the alternatives for the future?

The most desirable solution to this problem would be to accelerate economic growth. With GDP growing rapidly, the debt would be diluted without the need for spending cuts. This is how the United States reduced its debt in the period following World War II. American debt reached 121% of GDP in 1946 and was then reduced to less than 40% in the following decades. Today, it stands at 124% of GDP, without world wars.

It is difficult to repeat the feat, especially in the face of demographic and geopolitical trends that bring headwinds. Instead of the post-war baby boom, most countries today are dealing with an aging population, which implies fewer people of working age and more spending on social security. Instead of globalization and the boost to economic growth related to the intensification of international trade, several countries are beginning to prioritize independence and national security (we talked more about this in the March letter: "The New Cold War").

The only remaining options would be increased productivity related to technological advancements or government measures that optimize the economy through better regulations, without fiscal stimulus. Perhaps advances in artificial intelligence offer some hope, but we haven't seen much progress in government intelligence. Overall, it seems unlikely that economic growth alone will be enough to solve the problem.

Another solution is good old fiscal austerity: spending less than the government collects and using the surplus to reduce debt. It's a measure eternally defended by economists and ignored by politicians. Obvious for any person or company with financial problems, but delicate for rulers who depend on an electorate poorly educated in economics and sensitive to benefit cuts. Historically, it has been implemented few times.

An extreme option would be simply not to pay the debts or to forcibly postpone payments (moratorium), since there are no supra-governmental institutions that could compel a state to honor its obligation. The problem is the day after. Access to new debt would be restricted due to loss of credibility, the financial system would enter a crisis due to the sudden loss of value of securities previously seen as safe and widely used as collateral in operations, and the exchange rate would depreciate due to the flight of foreign investors. Given the severity of the consequences, we only see countries with no alternatives resorting to this.

Most likely, governments will resort to less explicit methods, but ones well-known in economic history: inflation and/or financial repression. For this to work, the debt needs to be denominated in the national currency, but this is the case for practically all economically relevant countries. The 10 largest economies in the world have more than 95% of their public debt in their national currency.

On the path to inflation, governments increase the issuance of their own currency and use this artificially created capital to honor the nominal values ​​of their debts. Since economic value cannot be created from nothing, the arbitrary issuance of currency generates inflation and causes all assets denominated in the current currency to lose real value. The practical effect is a shift in value from the owners of these assets to the government, as if they were forced to pay an extra tax, in a veiled way.

Financial repression is the use of more sophisticated mechanisms to force government financing at rates lower than what the market would normally demand. For example, the government could issue a class of public bonds with low yields and require all pension funds in the country to invest part of their assets in bonds of this class. Several Asian Tigers practiced financial repression during their periods of economic miracle. On a smaller scale, Brazil does this with mandatory investments in the FGTS (Severance Indemnity Fund). All employees with formal employment contracts are required to invest at rates slightly above inflation, with a real return close to zero, and the invested capital is used to finance public projects.

In short, economic acceleration is unlikely and fiscal austerity is politically difficult. Among the remaining options—outright default or inflation and financial repression—governments will almost certainly choose the latter.

How does this impact investments?

The scenario we are outlining as most likely will not necessarily trigger major economic crises. Governments are expected to address the debt problem as gradually as possible. What happens slowly is less bothersome and reduces the chance of major friction. The concern is not about facing some major economic catastrophe that causes sudden losses, but about how we should position ourselves to navigate a long period of inflation and financial repression without the value of our investments being slowly eroded.

The typical Brazilian investor's instinct is to migrate to fixed income and real estate in the face of any unfavorable scenario. In the current situation, real estate is among the acceptable alternatives, but fixed income can be a dangerous path. Other asset classes to consider are commodities and stocks.

Fixed income is the asset class most impacted by measures aimed at reducing public debt, especially bonds issued by the government itself. In Brazil, this is the direct treasury. Pre-fixed bonds are the most exposed to inflation, which erodes their agreed-upon return in nominal terms. Post-fixed bonds can be affected by monetary policies that compress the basic interest rate. Bonds with a pre-fixed real return and indexed to inflation (in Brazil, the IPCA+ Treasury bond / NTN-B) are the safest within the sovereign fixed income class, but not entirely immune because they can still suffer direct actions, such as changes in the inflation index considered, the imposition of special tax regimes, and liquidity restrictions. There are countless possibilities for creative legislators.

Broadly speaking, all assets whose value is based on cash flows fixed in nominal values ​​are exposed, even if they are not related to public debt. Private credit suffers similarly to government bonds under inflation and compressed interest rates. They are only spared from direct interventions that sovereign bonds may be subject to.

Other asset classes are better alternatives because they don't directly depend on the value of the currency; they are only priced through it. If the currency loses half its value, the price of real assets doubles. This logic applies equally to consumer goods in general, commodities, real estate, and stocks, but each class deserves some additional considerations.

Commodities oferecem ótima proteção contra inflação, mas sofrem de outras maneiras. Seus preços oscilam devido a diversos fatores imprevisíveis e, como não são ativos que produzem fluxo de caixa, seu retorno em períodos longos tende a ser bastante baixo. Não é a classe de ativos que escolheríamos em busca de segurança.

Real estate is traditionally a safe investment option, but it usually offers modest real returns. Except for successful investment strategies for specific properties (appreciation due to location or some other particular reason), long-term returns tend to be close to the real basic interest rate.

Stocks are assets with more nuances. In principle, they are not affected by inflation, in the sense that a company's assets do not depreciate along with the currency, and they offer more attractive return potential than real estate and commodities. However, the intrinsic value of a stock depends on the future results of its issuing company, and the monetary policies we are discussing can affect the performance of each business in different ways. Each case needs to be evaluated individually.

The safest stocks are those of companies with pricing power. This allows for price adjustments to compensate for inflation and any other effects of imposed monetary policies. For a company to have this capability, it needs to meet demands that are not very price-sensitive (low elasticity) and face limited competition due to sustainable competitive advantages or other barriers that prevent the capture of its customers.

Not surprisingly, this business profile has a large overlap with the target profile we seek in any economic scenario. The most profitable companies in the long term tend to be the same ones that best withstand various adverse scenarios.

In challenging times, the tactical adjustment we deem appropriate to the traditional philosophy of value investing is to prioritize high-quality companies and be more cautious about bargains: highly undervalued, mainstream companies. There are times when preserving value is more important than taking risks in pursuit of high returns.