The amount of debt that governments owe gets called out on a regular basis by commentators and analysts as one the key economic risks that we face.
The IMF has been to the fore talking about the fiscal and financial risks of a high debt, slow growth world. In their view, higher long term interest rates, lower growth, and higher debt will put pressure on medium-term fiscal trends and financial stability.
High government spending following the Great Financial Crisis, and then driven by the Pandemic, have pushed up government debt levels persistently since the start of the century. This was manageable when interest rates and government bond yields were at rock bottom.
But now these rates have shifted up, increasing funding costs. So public debt is taking an increasing fraction of GDP. At the start of this century government debt as a share of GDP for Advanced Economies was about 75%. The IMF expect it to reach 120% over the next 4 years.
And this is at a time when projections for global economic growth have fallen to the lowest level in decades.
So – rising debt burdens with declining ability to pay.
The IMF have especially highlighted the impact this can have on the health of the financial sector. High debt levels may reduce governments’ ability to support ailing banks, should the need arise. At the same time the more banks hold of their countries’ sovereign debt, the more their balance sheet is exposed to potential weakness and fragility of the state finances.
In short, higher national debt levels make for a more vulnerable financial sector.
This is clearly important – but does it matter to investors?
It seems to be something of a “frog in boiling water” issue as far as financial markets are concerned. As debt levels have risen, stock markets have really paid little heed and pushed on regardless. Incremental increases, year by year, in the level of government debt play little role in day to day investment decisions.
However, this may be changing.
Firstly, the IMF are getting very specific in their warnings on debt levels. Last week it singled out the UK, US, China and Italy as needing to take urgent action on their debt levels. With the UK for example, it highlighted the fundamental imbalances between spending and revenues. Specifically the fund noted the recent cut in national insurance in the March budget which is only part-funded.
Secondly, many of the rating agencies are now more explicitly taking account of the overall debt position in their country reviews, and scoring accordingly. For instance, Moody’s have urged France to rein in their spending, and both Fitch and S&P are set to review France in the coming weeks.
Finally I’m starting to see some fund managers systematically include overall debt (household and government) in their allocation framework to government bonds. A recent M&G piece noted the varying levels of total debt across a range of countries and recommended weighting towards those with relatively lower levels of total debt. This would imply positioning away from countries like Japan and Greece and leaning towards the likes of Poland and Hungary. Assuming the individual investment case stacks up, countries with low outstanding debt offer greater fiscal resilience and policy flexibility.
In M&G’s view this presents an attractive insurance policy against a debt sustainability crisis.
For this fund manager, debt levels will continue to move into the spotlight as there is minimal appetite anywhere to bring borrowing levels down.
Tradewinds 