Overview
With expanding sovereign indebtedness and few indications of interest in reining in continued fiscal deficits, many sophisticated investors (Bill Ackman, Ray Dalio, Stanley Druckenmiller, etc.) are sounding the alarms, warning of a pending cataclysm. Unfortunately, being early is synonymous with being wrong. Our focus has been and remains on providing the most accurate analysis to assist institutional investors and risk managers. This installment will address likely actions and reactions.
Sovereign indebtedness: FiscalDeficits¹
Current Conditions
Historically, when indebtedness reached a certain level, obligors had little choice but to inform their creditors that adjustments had to be made. In the case of non-developed nations that were highly dependent on outside funding, that point arrived near 60% debt-to-GDP.
For the developed countries, the inflection point arrived in the case of Italy, but quickly passed when Mario Draghi, as chair of the ECB, came to the rescue by stating that he would 'do whatever it takes' to reduce Italy’s funding costs relative to other EU countries. However, Italy’s relative indebtedness, as measured by debt to GDP, has continued to climb along with the indebtedness of many other developed countries.
As shown above, Japan is the leader in indebtedness. Like the bumblebee which doesn’t seem like it should be able to fly, Japan survives because of its minimal need for external capital. Additionally, with the rise in overall interest rates, the burden of servicing heightened debt levels has become even more difficult, with little salvation in sight.
A Sea Change
While we acknowledge the acuity of the problem, the factor that we believe massively changes the calculus is the power granted to most central banks courtesy of the COVID crisis. Central banks now hold massive amounts of sovereign debt, and in many cases, corporate debt, and therefore have the power to provide a safety net whenever needed. For those who believe these powers are only used during dire emergencies, a recent example has proven the opposite. The Old Grey Lady (i.e., the Bank of England), the supposed paradigm of central bank virtue (the old Mary Poppins movie included a parody of the BOE), felt compelled to intervene when UK pension plans were caught short of collateral as interest rates popped and the value of their gilts plunged. Setting aside morals, the BOE cut rates for a short time, enabling pensions to shore up collateral.
Prognosis
So where and when does the nonsense end? Perhaps unfortunately, not soon. If Japan is an example, debt-to-GDP can exceed 200% and the economy still functions. There is talk of some major buyers boycotting sovereign sales or even liquidating their portfolios. However, if central banks can continue to purchase bonds, they should be able to handle the increased supply. Some suggest the best route is to purchase gold, an avenue that appears to have been taken by a number of investors, given the recent rise. However, gold is not a currency, and with no inherent ability to produce returns, its value is embedded in perceptions. Furthermore, in times of strife, holding gold is likely to make one more vulnerable, not less. Lastly, to be of much use, gold has to be converted back into currency, thereby returning to the original problem.
Conclusion
Although the current situation is troubling and contrary to time-worn norms (and Calvinistic values), there appears to be no impending catalyst that will materially alter the current course. Therefore, given that we are all judged on relative performance, perhaps vigilance is the best course.
Sources
[1] https://www.oecd.org/en/data/indicators/general-government-debt.html