Middle East Turmoil and U.S. Debt Surge: ETFs in Focus

With the U.S. national debt standing at $38.9 trillion, economic concerns are mounting for investors and markets alike. Adding to these worries, the ongoing conflict in the Middle East could place a strain on government finances through higher war-related costs and expectations of increased military spending, deepening income concerns for investors.

Rising national debt levels can create economic headwinds, including the risks of elevated inflation. If the government decides to repay its debt by increasing the money supply, it risks devaluing the currency, pushing up the inflation level.

According to the Congressional Budget Office’s Budget and Economic Outlook for 2026 to 2036, published in early February, the federal budget deficit is projected to reach $1.9 trillion in fiscal 2026 and climb to $3.1 trillion by 2036.

The projected rise in large and sustained budget deficits between 2026 and 2036 is expected to push debt levels even higher over the next decade. According to data from the Treasury Department, as quoted on CNBC, for the fiscal year through February, the U.S. budget deficit rose above $1 trillion, although it was significantly lower than that in the same period last year.

However, the impacts of the recent Supreme Court ruling against many of President Trump’s tariffs have not yet appeared in the data. At the same time, the ongoing conflict in the Middle East is likely to worsen budget deficit concerns as war-related costs and expectations of higher military spending build.

Budget Deficit Threat Is Building

If the Middle East conflict persists longer than expected, the federal budget could come under even greater strain. A moderately prolonged war with Iran would materially worsen an already difficult fiscal backdrop, with estimates suggesting that a 60-day conflict could add $66.4 billion to the deficit, including $1.4 billion in interest costs, per Fortune.

Per the estimates of the Committee for a Responsible Federal Budget, as quoted in the above-mentioned Fortune article, if President Donald Trump replaces the previous border duties with a blanket 10% tariff, the United States would collect about $74 billion less in revenues this year compared with the prior regime.

When combined with the estimated $65 billion in war-related spending, the total fiscal impact could reach $139 billion, increasing the deficit projected by the Congressional Budget Office by 7.5%.

Unlike war spending, tariff-related revenue losses would not be a one-time hit. If made permanent, removing a large portion of import duties would result in a recurring structural increase in federal deficits.

Growing Debt Burden on the Economy

For fiscal 2025, the debt-to-GDP ratio stands at 124%. The debt-to-GDP ratio compares a country's public debt to its GDP, reflecting its ability to repay debts relative to economic output. The high debt-to-GDP ratio of the United States indicates the difficulty that the world’s largest economy is facing in repaying its public debts, potentially leading to financial instability, default risks and a slowdown in the country’s economic activities.

ETFs to Consider

With markets facing potential turbulence, preserving capital and managing volatility should remain top priorities. Investors may benefit from adopting a defensive and conservative stance in the near term, as caution can help mitigate unexpected shocks.

With ETFs offering diversification and tax efficiency, investors can use them to increase exposure to defensive funds. Investing in these sectors provides dual benefits, protecting portfolios during market downturns and offering gains when the market trends upward.

Below, we have highlighted several ETF areas that investors can consider to better navigate the uncertain debt environment and protect themselves from potential economic headwinds.

Consumer Staple ETFs

Increasing exposure to consumer staple funds can bring balance and stability to investors’ portfolios. Investors can put more money in consumer staples funds to safeguard themselves from potential market downturns.

Investors can consider Consumer Staples Select Sector SPDR Fund XLP, Vanguard Consumer Staples ETF VDC and iShares U.S. Consumer Staples ETF IYK.

Quality ETFs

Amid market uncertainty, quality investing emerges as a strategic response, providing a buffer against potential headwinds. This approach prioritizes identifying firms with robust fundamentals and lasting competitive strengths. Investing in such high-quality companies can mitigate volatility for investors.

Investors can look at funds like iShares MSCI USA Quality Factor ETF QUAL, Invesco S&P 500 Quality ETF SPHQ and JPMorgan U.S. Quality Factor ETF JQUA.

Utility ETFs

The utilities sector, being capital-intensive, also benefits from reduced financing costs when interest rates fall. As a low-beta sector, utilities are relatively shielded from market volatility, making them a defensive investment and a safe haven during economic turmoil.

Investors should gain from funds like Utilities Select Sector SPDR Fund XLU, Vanguard Utilities ETF VPU and iShares U.S. Utilities ETF IDU.

Healthcare ETFs

The healthcare sector is non-cyclical, providing a defensive tilt to the portfolio amid market turmoil. The long-term fundamentals remain strong, given the encouraging industry trends.

Investors can look at funds like Health Care Select Sector SPDR Fund XLV, Vanguard Health Care ETF VHT and iShares U.S. Healthcare ETF IYH.

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State Street Consumer Staples Select Sector SPDR ETF (XLP): ETF Research Reports

State Street Health Care Select Sector SPDR ETF ETF (XLV): ETF Research Reports

iShares U.S. Healthcare ETF (IYH): ETF Research Reports

Vanguard Health Care Index Fund ETF Shares (VHT): ETF Research Reports

State Street Utilities Select Sector SPDR ETF (XLU): ETF Research Reports

Vanguard Utilities Index Fund ETF Shares (VPU): ETF Research Reports

iShares MSCI USA Quality Factor ETF (QUAL): ETF Research Reports

Invesco S&P 500 Quality ETF (SPHQ): ETF Research Reports

Vanguard Consumer Staples Index Fund ETF Shares (VDC): ETF Research Reports

iShares U.S. Consumer Staples ETF (IYK): ETF Research Reports

iShares U.S. Utilities ETF (IDU): ETF Research Reports

JPMorgan U.S. Quality Factor ETF (JQUA): ETF Research Reports

This article originally published on Zacks Investment Research (zacks.com).

Zacks Investment Research