TwentyFour Asset Management
Government budget deficits and debt stacks around the world will increase dramatically in 2020 compared to 2019, and except for a handful of countries, it is difficult to see debt-to-GDP ratios returning to pre-COVID levels in the near future, even if the virus is defeated.
According to the IMF, in 2020 the government debt-to-GDP ratio in the Eurozone will increase by from 84% to 97%, while the figure for the US will jump from 109% to 131%. In emerging markets the prediction is for an increase of just under 10% on average, from 53% to 62%. Regarding specific countries, Japan continues to be in the lead with a projected government debt-to-GDP ratio of 251.9% for 2020, though we note that Greece at 200.8% is set to close the gap slightly. Italy is in third position at 155.5%.
From a mathematical point of view, the increase in these ratios is the result of a projected contraction in GDP of just over 3% for the world as a whole in 2020, along with budget deficits (as a percentage of GDP) of 10.7% and 9.1% on average for developed and emerging markets, respectively. We note that these numbers are from the IMF’s April update to its database, with the next update due in October. It is likely some of these numbers will look even worse by then as more stimulus plans have been approved since April.
While these somewhat scary forecasts have been caused by the swift reaction from governments globally to the economic consequences of the virus, it is undoubtedly the case that the world’s credit quality has deteriorated as a result. How worried should we be about the sustainability of government debt burdens? Could we see a worldwide sovereign crisis? After all, the fiscal situation in certain developed countries such as the US and Italy was already worrisome to begin with. “This time is different” is of course a very dangerous statement in financial markets, but we do have some observations regarding how sustainable this situation is.
Firstly, almost every single country around the world is in the same boat. Most countries will see similar deteriorations in credit metrics and these are the result of policy action perceived necessary by market participants. From a financial markets perspective, it is much easier for investors to attack a weak link with a specific issue not shared by the rest. European investors will no doubt remember quite clearly what happened in 2011 when the sustainability of certain Eurozone countries’ government debt was called into question. The popular trade back then was to short Portugal, Ireland, Italy, Greece and Spain and go long the likes of Germany and the Netherlands or even US Treasuries. Banking sectors in the periphery were seen as weak, current account deficits were large, housing bubbles had popped up almost everywhere and there was no appetite for debt sharing in any form across the Eurozone. Nowadays there is a clear path for common issuance of government debt in the Eurozone precisely to prevent that from happening again, banks are strongly capitalised, current account deficits have closed significantly and the ECB is buying billions worth of Eurozone government debt every month. We are most definitely not saying that the periphery’s credit quality is the same as Germany’s, but we do think that trade doesn’t look quite so obvious today.
Secondly, in spite of debt loads being the largest in modern history, the same is not true for the affordability of that debt in developed and emerging countries (though we note this does not apply to low income countries). Interest rates are much lower than they used to be, so measures such as interest-to-government revenue ratios are within historical ranges. The graph below is from the IMF’s latest Fiscal Monitor published in April. The yellow lines represent the interest/tax ratio. As can be seen, in spite of debt loads essentially doubling, this ratio has remained relatively constant with the exception of lower income countries. Looking at longer time frames, data for the US government actually shows that affordability is a lot better than it was in the 1980s, as can be seen in the second graph below. It is also worth keeping in mind that with every maturing legacy bond, the issuance of a new one with an ultra-low or zero coupon should make debt affordability even better. The ratio might even improve in the future.
Finally, we are often asked “who is going to pay for all this debt?” when we think a more relevant question would be “who is going to roll all this debt?”
The former question implies that at some point in the future it would be desirable that all the debt issued by a government is paid off. There are many reasons why corporates, individuals and governments issue debt. Furthermore there a few reasons why it is appropriate that these economic actors actually do so and live their economic lives with some debt outstanding. In the case of governments, very few people would rather have no roads, no schools and no rubbish collection services for the sake of having no debt. The distinction is important as paying back debt with internally generated revenue (taxes) would be virtually impossible, while rolling debt tends to be much easier.
Many things go into the mix for assessing an issuer’s ability to roll its debt, but a good summary is that the issuer needs to find demand for the supply on offer by means of a reasonable interest rate. In the G7 monetary policy rates are at historic lows, which along with forward guidance anchors the short end of the curves, while subdued inflation expectations should prevent the longer end from moving dramatically higher (in the context of debt sustainability). In addition, countries with current account surpluses have maintained their surpluses while those with current account deficits have narrowed their deficits, and in the case of Italy even switched to a surplus over the last few years. This means that from a country point of view there are excess savings from Italian households and companies available to fund government deficits, which should be “stickier” compared to foreign cash. Private savings ratios are also likely to increase as a result of the virus, which will help. Government bond supply is set to increase enormously, but so will demand, as central banks are buying billions on a daily basis. In this scenario, investors demanding a significant premium for credit risk in G7 government bond markets looks unlikely in our view. Europe, and in particular Italy, was clearly the weakest link but the recently announced joint issuance plan by the Eurozone is a game changer.
Our conclusion is that we are unlikely to see issues in G7 government bond markets in the short term, in spite of the deterioration in credit metrics around the globe. There might be some lower rated EM governments that lose market access, but financial markets can handle that. Given most countries are going through the same issues and their fiscal expansions are justified, the relative value has not changed that much. In addition, a big part of the extra supply will be absorbed by central banks, and the Eurozone (which was clearly the fragile spot) has made progress in sharing the debt load of its most indebted members. Given the lack of a clear weak link, a sovereign crisis in this environment would need market participants to simply lose faith in the system as a whole. We would be looking at a situation where market participants doubt the ability of the Fed or the ECB to continue keeping rates in check in spite of QE. Regime changes have happened in the past, so we would not say the probability is zero. Money was backed by gold some decades ago, just as an example. But the frequency with which these events happen is low. At the moment we do not think this is a bet worth taking.