Last Thursday, I was presenting at our annual Solving for 2024 conference in London. This event is always a great opportunity to see some of our U.K. and European clients, and get a feel for what’s on their minds.
Last year, the talk among these investors was the explosion in the U.K. gilt market, triggered by the disastrous mini-budget crisis two months earlier. Twelve months later, amid speculation about inflation, rates and the likelihood of a soft landing for the economy, debt sustainability was still high on the agenda.
That didn’t surprise us. One of our “10 for 2024” Solving themes anticipates “More Fiscal Policy Dispersion (And Debt Sustainability Questions),” and that was where I focused during my time onstage.
After three years of near-universal agreement on deficit spending during the pandemic, consensus is breaking down. Some countries are reasserting fiscal discipline (such as Germany, under instruction from its Constitutional Court), but many others appear likely to continue spending (often, like the U.S., shifting from supporting consumers to pursuing a more assertive industrial policy).
While easing inflation and declining rates have brought some relief over recent weeks, last week’s news on yield-curve control from the Bank of Japan, as well as strong U.S. payrolls data, served as reminders of how quickly sentiment can shift.
We think all of that means concerns about fiscal measures counteracting monetary policy have not gone away.
Since the U.S. Federal Reserve started raising rates from 1.8% in 2019 to the current level of 5.5%, the U.S. fiscal deficit has widened from 4.7% to 6.1% of GDP. Both the eurozone and the U.K. have added three percentage points to their deficits since rates started going up. The effects of that spending could make it harder to cover the “last mile” of above-target inflation, or even push it back up again, and we think that could be a substantial challenge for 2024.
Longer term, however, we think debt sustainability is an even bigger concern.
The U.S.: A Worrisome Case Study
Global nonfinancial debt sits near an all-time high of $230 trillion and counting, according to the Bank of International Settlements.
The U.S. stands out as a worrisome case study. Since the Global Financial Crisis, its nonfinancial debt has climbed from around 190% to over 250% of GDP. Over the same period, the lion’s share of that indebtedness has shifted from corporations to the U.S. government, where debt now stands at more than 100% of GDP.
Researchers working on the Penn Wharton Budget Model (PWBM), a non-partisan academic initiative to analyze the fiscal impact of public policy, estimate that U.S. debt could become unsustainable, and subject to implicit or explicit default, at somewhere between 175% and 200% of GDP.
Under the Congressional Budget Office’s (CBO) latest baseline assumptions, U.S. government debt hits 170% of GDP in 2050. But those assumptions already look optimistic: Real rates, which the CBO expected to rise gradually to 1.53% in 10 years’ time, are already around 2%; revenues and discretionary spending were expected to rise at their long-run average rate.
In October, the PWBM researchers looked at these CBO revenue and spending assumptions under various long-term interest-rate scenarios. The picture they paint is even more alarming.
Their baseline assumption has real rates gradually rising to 2.3% in 10 years’ time, which takes U.S. debt to 188% of GDP in 2050. Should real rates rise by 250 basis points above baseline, debt would be above 200% of GDP by 2040 and above 300% by 2050, according to the model.
Moreover, if the bond market reacts today to concerns about these long-term projections, rates could rise even faster and accelerate the debt-sustainability crisis.
The chances of avoiding one of these paths do not look good.
There are very few easy wins. Around 70% of U.S. government spending goes on interest repayments, major health care programs and social security. Higher rates and an aging population mean that spending is likely to grow faster rather decline or remain steady over the coming years. More than a third of the rest goes to defense spending.
As we said when we laid out our Solving for 2024 debt sustainability theme, a “packed election calendar worldwide” is likely to bring this topic firmly to the forefront.
For a bitterly divided U.S., in particular, we see economic populism, albeit with differing priorities, being the one common characteristic of 2024 election pitches from both the left and the right.
Longer term, the reshaping of developed economies toward knowledge-based sectors, where technology is increasingly substituting for the labor force, looks likely to inspire further populist measures.
A general turn to more government activism in the economy could include more assertive industrial policies, higher trade barriers and a greater propensity to use security as a pretext for deglobalization. That, in turn, could stifle productivity growth, embed structurally higher inflation, make economic cycles more volatile and raise risk premia—including in interest rate markets.
What might this mean for investors?
Where governments are pushing the fiscal envelope, where there is political dysfunction or where fiscal and monetary policy are pulling in different directions, we would be cautious about long-dated government bonds. These dynamics can only raise concerns about debt sustainability, inflation and market supply and demand.
More broadly, we favor quality across corporate bonds and equities—companies whose strong balance sheets and market positions enable them to absorb higher rates and pass on higher costs. Indeed, as the debt-sustainability story darkens, these high-quality companies could push out government bonds to become the new source of portfolio stability, as well as portfolio growth. Real assets, particularly those exposed to the decarbonization and electrification trend, could provide important growth, inflation exposure and diversification.
After a 60-basis-point drop in the U.S. 30-year real yield, some of the discussion about rising deficits has subsided. We think that is premature. A 2% real yield is still well ahead of the PWBM’s baseline model, and our outlook on inflation and risk premia suggests these levels could prove sticky.
In our view, the debt-sustainability challenge—and all its investment implications—has not gone away.
In Case You Missed It
- Tokyo, Japan Consumer Price Index: +2.6% year-over-year in November
- U.S. ISM Services Index: +0.9 to 52.7 in November
- JOLTS Job Openings: -617k to 8,733k in October
- Eurozone Q3 GDP (Final): -0.1% quarter-over-quarter
- Japan Q3 GDP (Final): -2.9% quarter-over-quarter annualized
- U.S. Employment Report: Nonfarm payrolls increased 199k, and the unemployment rate decreased to 3.7% in November
- University of Michigan Consumer Sentiment (Preliminary): +8.1 to 69.4; 1-year inflation expectations -1.4% to 3.1% in December
What to Watch For
- Tuesday, December 12:
- U.S. Consumer Price Index
- Wednesday, December 13:
- U.S. Producer Price Index
- December FOMC Meeting
- Thursday, December 14:
- European Central Bank Policy Meeting
- U.S. Retail Sales
- Friday, December 15:
- Eurozone Manufacturing Purchasing Managers’ Index (Preliminary)
- Eurozone Services Purchasing Managers’ Index (Preliminary)