The big rise in government debt is one of the few certainties in the outlook. Many of us are wondering how we will deal with this going forward. Will it mean higher taxes? How will some countries with more extreme fiscal positions be able to recover? Will inflation or debt relief be realistic options? In the next few years most economies will have lower GDP and higher levels of debt and at the same time we need to keep interest rates down. Government bonds might be safe but they are not likely to deliver much in the way of real returns. The problem gets worse the longer the crisis goes on. Hopefully clinical test results will improve the prospect of an economic recovery, but even then we are looking at debt levels at over 100% of GDP in many of the developed economies of the world.
Rising asset prices
A rising tide lifts all boats and the swell provided by massive central bank and fiscal intervention has lifted asset prices well off their lows in terms of equity markets and credit indices, and put government bond indices close to their highs. However, the waters remain very choppy and with the positive flow of liquidity coming from central bank purchases and the ebb of falling risk appetite as yet another eye-wateringly bad piece of economic data or profoundly sad daily mortality report is released. While volatility is still high by pre-crisis standards, it is generally getting lower as markets are fatigued by the events of the last few weeks and are not seeing enough progress through phase one of the recovery to put even bigger bets on economic recovery. The implementation phase of the central bank and fiscal programmes should help support confidence to some extent but the longer investors have to contemplate future economic issues while they wait for more countries to be on the downward slope of the pandemic curve, the more scope there is of risk assets pricing in a difficult future. The good news buoying markets at the end of this week is news reports of tentative signs that progress is being made in clinical tests towards finding an anti-viral treatment and a potential vaccine for COVID-19.
Economists are revising their GDP forecasts all the time and the numbers they produce are heavily dependent on the progress through the first two phases of the recovery – the flattening of the pandemic curve and the speed and extent of the lifting of lock-downs. Any recovery in GDP is conditional on lock-downs being lifted and the quicker and more comprehensive the lifting of restrictions is, the more economic activity can (not necessarily will) bounce back. I have looked at the current consensus quarterly GDP forecasts on Bloomberg and there is a definite V-shape to a lot of the quarterly profiles as economies return to work and some level of social gathering. However, even with what will probably turn out to be optimistic numbers, most countries will end 2020 with real GDP levels much lower than at the end of 2019. I suspect that most of these forecasts assume that there will be a total lifting of containment policies before year-end but there is always the risk of this not happening and some form of lock-down remaining in place for months. The extent to which authorities feel that have reached some level of social immunity or whether or not there is good news on a pharmaceutical solution to the virus will be important in determining how quickly restrictions are lifted. As will people’s behaviours. It may take people a long-time to get back to doing what we all used to – going to restaurants, to shopping centres, to football matches and to the theatre. Many may continue to work from home, meaning that businesses that provide services to those that work in urban centres, amongst others, will never return to pre-crisis levels of revenue. Moreover, there will be long-lasting job reductions which will also create a drag on the recovery.
Giving up growth
After the Global Financial Crisis I built a spreadsheet that tracks real GDP for a number of developed countries, updated quarterly based on OECD data. The starting point was the final quarter of 2007 where global GDP peaked before the onset of the credit crunch. The cycle bottomed in 2009 and most countries spent the following decade growing modestly until the end of last year. The US and Canada posted the biggest gains in GDP over that decade, followed by Germany, the UK and France. Spain and Italy suffered a double dip, going back into recession in 2012 in the midst of the Euro-sovereign debt crisis. Unfortunately, Italy barely recovered. On the basis of the Bloomberg consensus numbers, Italian GDP at the end of 2020 is likely to be some 10% below the level it was at in Q4 2007 – more than 12-yeas ago. On the basis of the same estimates, that means Italy will be some 18% “poorer” relative to Germany than it was in 2007. No wonder there are creaks in the Euro Area.
The Italian job
Italian government debt has continued to rise over that period. There has not been a great deal of inflation, so with rising nominal debt and falling real GDP, the debt-to-GDP ratio has risen from just over 100% to close to around 135%. Forecasts project this will be above 150% by the end of the year and will be more than 2.5trn Euros – over Eur 40,000 for each citizen. The metrics are worse than they were in 2012. The big difference is that the EU has decided and evidenced that it will do whatever it takes to save the euro. This will mean more help for Italy going forward, to help growth and to provide some kind of debt relief, either through disproportionate ECB buying of Italian debt or some form of mutual financing and burden sharing. This is the current hot topic in Europe and it will come down to what political leaders can agree on. If it seems that some northern European governments are not willing to find new ways to alleviate Italy’s debt dynamics there is likely to be a Euro-specific round of risk-aversion on top of the stresses and tensions caused directly by the virus and lock-down. This is the biggest short-term risk for European markets.
A big jump in debt
Those GDP projections look bad for all countries. They will leave all countries at levels of GDP that are well below the peak of the recovery, even on the assumption of a V-shaped bounce in Q3 or Q4. Combined with large increases in budget deficits we will see widespread increases in government debt to GDP ratios. In its April 2020 Fiscal Monitor, the IMF published projections for both fiscal balances and debt levels for its member countries for 2020. In aggregate, advanced economies will have a budget deficit of 10% of GDP this year, up from 3.0% in 2019. In the US the deficit is estimated to increase to 15% with the UK at 8.3%, France at 9.2% and Germany at 5.5% after registering a surplus of 1.4% of GDP last year. Emerging markets will see a doubling of their deficit to GDP ratios this year , on average. This will mean a big jump in the level of gross government debt to GDP. In the advanced economies the ratio is expected to increase to 122.4% from 105.2% last year with the US seeing more than a 20pp increase. The Euro Area as a whole looks better placed with a debt/GDP ratio of 97.4% but this masks big internal differences – Germany at 68.7% and Italy at 155.5%. And this is just for 2020. Of course the risk is that wider budget deficits and more borrowing are here to stay and debt levels will rise further.
Keeping real rates down
The discussions on debt sustainability were well rehearsed a few years ago. They remain relevant and if anyone wants a historical refresher then the debate around the works of Carmen Reinhart and Kenneth Rogoff provide an interesting scope of views on what could be the implications of debt levels rising to 100% and above in many countries. A relatively simplistic view is that high debt levels are dealt with either by boosting growth (not easy), generating primary budget surpluses (austerity) to pay down debt (not politically popular after it led to the rise in populism in the last decade), generating inflation (again, not easy) or providing some kind of debt relief. I guess over the last decade financial repression has been the response to the inability to generate inflation as it has kept real interest rates down and made financing debt “easier”. The rapid ratcheting up of quantitative easing suggests that this is the “go to” solution under the circumstances as it is operationally the most direct.
Expanding balance sheets
And the impact is already evident. Central bank balance sheets are ballooning. According to Bloomberg calculations, the G4 central bank balance sheet to GDP ratio stands at 40% - it was around 10% prior to the Global Financial Crisis. Since the beginning of the year this ratio has gone up by 5pp. It will go much higher. The counterpart to that is the increase in central bank reserves that, theoretically, allows a large increase in the money supply. The most recent data show that the US monetary base is up by 35% y/y and M2 up 11% in March with the M2 growth rate already exceeding the growth rates registered in the post-GFC period.
What to think about inflation?
Could inflation be part of the solution to the run up in debt? Central bankers would like it to be, they certainly don’t want deflation which is clearly the risk in a world where GDP is contracting. We also know from the last decade that betting on inflation going up has not been a worthy thing to do on the whole. It took the US ten years to get the unemployment rate down to a level that looked like it was going to start pushing wages up a little and now the rise in jobless claims numbers over the last four weeks is the roughly equivalent of all the net gains in non-farm payroll employment in the 10-years to February. The capacity utilisation argument suggests inflation will be dormant for some time. The monetary argument is not proven, even if those of us that were taught economics in the early 1980s have some sympathy for the “too much money chasing too few goods” line of thought. What is clear is that inflation will be difficult to understand for some time, given the disruptions caused to supply chains and shifts in consumer preferences and business models that will remain in place for some time. A speech by Silvana Tenreyro, an External Member of the Bank of England’s Monetary Policy Committee this week addressed these issues. Inflation will remain weak for some time and could even test the lower bounds of central bank tolerance, but the longer-term is not so clear. Government balance sheets are exploding and the counterpart to that is more money in the economy. Yes, unemployment is going up but, unlike in previous recessions, incomes have been supported. It’s a new world and we don’t know what all this means yet. But I would suggest that the inflation linked bond markets pricing in an 1% annual inflation rate in the US for the next ten years is reflective the macro experience of the last decade (monetary expansion but fiscal austerity) and not of the next one (big government everywhere you can see).
Safety and protection
Core government bonds are the safest cash-flow asset. But the real return from them could get worse unless they are of the inflation-protected variety. In Europe, the big risk is that the imbalances in growth and fiscal stability just got a whole lot worse. If the administration of the Euro Area does not adapt to that, then sovereign credit risk is going to get a whole lot worse too. US TIPS over BTPs is a trade idea that has worked well recently and could continue to work well going forward.
The Lock Down Routine
So we are locked down for a few more weeks. I don’t know about you but I have settled in to a fairly enjoyable routine. Get up and do a Peloton cycle ride. Log-on and check emails – particularly one from JP Morgan that tracks the progress of the virus through European countries - and the markets. Have a much healthier breakfast than the bacon roll I would pick-up from Brierley’s several times a week under normal circumstances. Coffee and a bit of toast at 11:30, sitting in the garden on more than one occasion recently. A solid afternoon of work and zoom calls. A walk around the block in the early evening. Dinners have been more imaginative and are largely determined by what there is and what is still fresh, but always accompanied by a nice glass of wine. Then an hour of Netflix before bed. Suits me. A few recommendations for viewing…”Fauda” (Israeli special forces drama); “Homeland”, “The Kominsky Method” and, for some food love, “Salt,Fat,Acid,Heat”. Also, on the subject of food, “Masterchef”, “The Great British Menu” and “The Hairy Bikers in the Mediterranean” always get me in the mood for whatever is on the plate. And of course, Thursday nights and #ClapForOurCarers!
Stay safe and #StayAtHome