Going forward, focusing on central bank rate cuts may not be enough to evaluate long-term securities.
The Greek poet Archilochus wrote: “The fox knows many things, but the hedgehog knows one great thing.” Global bond markets are generally more hedgehog than fox: they focus on “one big thing.” Since 2022, that big thing has been the surge in inflation caused by the COVID-19 pandemic and the efforts of G-20 central banks to bring it down. The interest rate hikes have done their job; inflation is falling almost everywhere, and (excluding Japan) the global rate cycle is moving towards easing. Unfortunately, a series of fiscal challenges has left G-20 governments in a worse fiscal situation than pre-COVID, and many of these governments have, or can expect, new leadership. In many countries, fiscal policy and its multiple ripple effects could replace monetary policy as the new challenge for fixed income valuation, in our opinion. We believe developed market (DM) bond investors may need to consider more than one big thing at a time.
Debt and developed markets
Typically, deficits don’t matter until they suddenly matter. After the global financial crisis and before COVID, debts and deficits often didn’t matter because global real interest rates were zero or negative (with the exception of the Eurozone crisis!) . This is no longer true: debt once again has a real cost. In developed market economies, a general trend of structural and cyclical deterioration in debt and deficit could indicate a future of slower growth, higher taxes and steeper and more volatile yield curves. Going forward, a narrow focus on central bank interest rate cuts may be an inadequate guide to the performance of longer duration securities. Here is an overview of debt drivers by country.
United States – A new president unlikely to reverse the deterioration of the US debt-to-GDP ratio.
If Vice President Harris wins, we expect a divided Congress with a Democratic House and a Republican Senate, and limited ability to pass important new legislation. Policy continuity indicates a federal deficit of approximately 6% of GDP, split evenly between primary deficits and debt service (Congressional Budget Office, as of June 18, 2024). COVID-related spending has increased the federal debt from 79% of GDP in 2019 to 99% currently. Current policies appear poised to increase the debt-to-GDP ratio by 2% per year continuously (Bloomberg, as of June 18, 2024). If former President Trump wins, we expect a Republican Congress and more policy changes. This could be a combination of deregulation, tariff increases and other tax cuts, the net effects of which could well widen the deficit further, while increasing goods inflation somewhat. A continued deterioration in the US debt-to-GDP ratio implies a protest from bond investors, but the timing is difficult to predict, in our view.
Germany – Unlike the US, the growth rate is the problem.
The debt-to-GDP ratio fell from 60% to just 69% during COVID, then fell back to 63% currently. The federal deficit is less than 2% of GDP (Bloomberg, as of June 18, 2024). Real GDP has remained stable for two years, and forecasts for 2025 anticipate a growth rate of just 1.0% (Bloomberg, as of June 18, 2024). We believe this is too weak to address the structural challenges of reviving the nation’s export engine, rearmament in a hostile world, and the transition to green energy, not to mention reviving voters’ incomes. Centrist parties have lost voters to the extremes, particularly in eastern states. The federal election will take place in the fall of 2025. In our view, the federal debt brake may not survive, as a future coalition may well prioritize growth over fiscal austerity.
France – Higher debt than the United States and lower growth.
The debt stock, already 100% of GDP in 2019, rose to 117% during COVID before falling to its current level of 111%. Unfortunately, deficits of 5% are too high to allow further debt consolidation. Real growth is 1.1%. (Bloomberg, as of June 18, 2024). A parliament split three ways between right, left and center makes any policy change unpredictable. But both the right and the left want to spend money – something France probably doesn’t have.
UK – Just outside the 100% club, government net debt is at 98%, up from 80% pre-COVID.
Public sector net borrowing is expected to fall to 3.1% of GDP in the 2024/2025 financial year, from around 4% in 2023 (House of Commons Library, D2, Public Finances, Net Debt, % GDP, Economic Indicators #02812, data as of August 21, 2024). GDP growth is 1.1%, and is expected to remain almost unchanged next year at 1.4%. The new Labor government hopes to continue fiscal consolidation, mainly through selective tax increases, and hopes that growth can be sustained.
