Are investors finally starting to zoom in on countries’ high public debt levels? In the week’s Perspectives, Fund Manager Anthony Rayner looks at what’s triggered the shift in focus and the type of situations most exposed.
Government bonds markets are starting to wake from a very long slumber. Their reactive function had been blunted for many years due to very coordinated global monetary policy, a broad consensus around fiscal discipline, low inflation and, partly as a result of all of this, very low rates historically. As a consequence, bond vigilantes were largely redundant.
However, we are now in a new regime. Governments are increasingly prioritising their nation, ahead of the “greater good” and, whether you care to look at trade policy or monetary policy, it’s a more fractured world. Meanwhile, any fiscal discipline was broken during lockdown, and the threshold for stimulus has moved materially lower since. Inflation too has awoken from its slumber and, finally, turning to rates, US 10-year rates have moved from near zero as recently as 2020, to over 4% now.
In addition to this more punishing environment for sovereign bonds generally, there are increasing demands on government money from frustrated electorates. For example, reducing inequality or controlling immigration, two issues which have arisen again and again as key concerns across many Western democracies. Or more generally, the need to commit to major investment in much needed areas such as infrastructure. Furthermore, there is the higher demand for defence spending in a more fractured world, compounded by the US’s reluctance to play the role of global policeman, never mind the powerful impact demographics is having on pension liabilities.
Look no further than France to see the bond vigilantes circling, albeit currently from up high. The graph below shows the yield between French and German 10-year yields at their widest since the Eurozone crisis.
Source: Bloomberg 03.01.2000 to 03.12.2024
France provides the perfect scenario for bond vigilantes: a high debt pile, low growth, high expectations from electorates and high disfunction from the domestic political power base. In fact, French government bonds have recently yielded more than Greek bonds.
How the Eurozone hierarchy is being challenged! Even Germany is no longer looking rock solid on many of these metrics. Yes, Germany has much a lower debt to GDP than France, but it ticks the other boxes of low growth, high expectations from electorates and high disfunction politically. Interestingly, there is an increasing focus on whether Germany’s debt brake, written into the constitution, will be reformed.
It's not just in Europe that new yield levels are being tested. In Asia, Chinese 30-year yields recently fell below Japan’s for the first time, reflecting the weakness of the Chinese economy and the relative strength of the Japanese economy. This was more of a relative economic strength debate, rather than a debt serviceability one but, either way, bond markets are starting to reflect fundamentals more.
Turning to Latin America, Brazil has been under the spotlight, due to a deteriorating fiscal situation, with the currency selling off materially this year and bonds selling off more recently as President Lula tried to water down a fiscal austerity plan.
Stepping back, this reflects a wider shift from the relative poverty of governments to the wealth of corporates, for example those power houses that dominate the US stock market. This has wide ranging implications for the credibility of impoverished governments, as they try to deliver their side of the social contract. It is becoming clearer every day that the power base has moved in favour of unelected corporates: votes in democracies count for less and less.
In terms of government bonds, will this mean more manipulation of bond markets from the authorities in order to put bond vigilantes back in the box, or will it be a serious test of credibility? A large part of that answer depends on the strength of the underlying economy but clearly where fundamentals are appearing more relevant and economic performance and fiscal dynamics are diverging, diversification opportunities for active managers are improving.
In short, there is a serious reappraisal of sovereign risk underway and, to answer the question we posed at the beginning, yes, the market does increasingly care about high debt levels, especially when linked to low growth and an impotent domestic political environment. Expect some of the more vulnerable targets to become increasingly exposed in coming months.