The debt doom loop

The debt doom loop

Government bonds have been a poor investment in the last five years. $100 invested in a global bond index in January 2020 would be worth $95 today. Invested in UK gilts, it would be worth just $67. Factor in an increase in the US and UK price level of over 20% in this time and real returns on bonds are much worse. The same pattern holds for European government bonds.

• It wasn’t always so. Between 2000 and 2020 government bonds offered good returns, easily beating inflation and, in the case of the UK and the euro area, outperforming equities. US bonds outperformed equities between 2000 and 2016. Thereafter returns on US equities roared powered by the tech boom.

• Bond prices move inversely with inflation and central bank interest rates. The steady downtrend in inflation and rates in the first two decades of this century set bond prices soaring and was a boon for bond investors.

• The high inflation of the last five years has reversed that process, forcing central banks to raise interest rates to levels that have not been seen in more than 16 years. No one expects a return to the sub 1.0% level of interest rates that prevailed for over ten years, between the financial crisis and the pandemic. 

• Bonds have done badly in the last few years because markets think interest rates will need to run higher to control inflation. Investors have also become more nervous about rising levels of government indebtedness.

• This is not really about the risk of governments defaulting.  Governments, such as the US or UK which print their own currency, can always create more money to pay creditors. The greater real risk is that governments reduce the real value of bonds by running higher inflation. A subtler approach would be to use regulation and taxes to force the private sector to hold more government bonds or to reduce the return on bonds.

• The borrowing numbers are not attractive. Even at a time when the West is growing many governments are running high levels of borrowing. Worryingly, much of this debt is being used to fund current costs, such as benefits and public sector wages, rather than investment. Governments are not households, but a rough analogy is of a consumer using a credit card to finance everyday spending.

• Borrowing to finance public investment, such as infrastructure, can raise growth rates and pay for itself. The same cannot be said of current spending.  High levels of borrowing and rising debt risk a doom loop, with debt servicing costs eating up a rising portion of tax revenues, forcing the government to raise taxes to fund interest payments. In turn, heavier taxes weigh on growth and tax revenues, renewing the cycle.

• It is easy to identify such risks and imbalances - and impossible to predict when, or if, they will turn into a full-blown crisis. In markets, as in life, timing is everything.

• In 2010 Bill Gross, founder of Pimco, the world’s largest bond fund manager, memorably warned that UK government bonds were, “resting on a bed of nitro-glycerine.” Gross argued that heavy government borrowing and the possibility of sterling devaluation, “present high risks for bond investors.” 

• The logic was impeccable. Yet notwithstanding weak UK growth, a sharp fall in the pound after the Brexit referendum and high levels of government debt, UK bonds did pretty well over the ensuing ten years.

• The final word goes to Ray Dalio, founder of the investment firm Bridgewater. He is willing prepared to make predictions. His latest book, How Countries Go Broke, argues that the countries of the rich world are, “in the late stages of their Big Debt Cycles…if they are not controlled in some way, the probability of an unwanted major restructuring or monetization of debt assets . . . is very high - something like 65 per cent over the next five years”.

• But if we stick to the current path worries about debt sustainability are almost certain to mount.

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week down 0.6% at 9,228.

Economics

• The US Federal Reserve cut its interest rate target for the first time this year, by 0.25 percentage points to 4-4.25%, and projected two more rate cuts this year. The Fed commented that “the downside risks to employment have risen” while inflation remains “somewhat elevated”
• The US administration filed an application to the Supreme Court to allow US president Donald Trump to sack governor Lisa Cook from the Federal Reserve board, following previous court rulings that allowed Ms Cook to remain in post while the legal case progressed through the court system
• The Bank of England maintained interest rates at 4%, as expected, and reduced the pace of its bond selling programme, easing pressure on rising government borrowing costs
• The UK government borrowed £84bn between April and August this year, £11bn more than expected, due to lower-than-expected tax revenues
• The Office for Budget Responsibility indicated to the Treasury that the UK’s productivity estimates are likely to be downgraded in its economic forecasts for the government’s Autumn Budget, increasing the risk of future tax rises
• UK think tank The Institute for Fiscal Studies said that the UK government will face an £18bn spending shortfall by the end of the year if the government’s estimates on public sector productivity gains do not materialise
• UK inflation remained stable at 3.8% in the year to August
• UK consumer confidence fell in August, according to GfK, with consumers less optimistic about their personal finances and the economic outlook. GfK commented that “sentiment is sliding sharply” 
• UK payroll employment continued to fall in the three months to July while the unemployment rate was unchanged at 4.7%
• Former ECB president Mario Draghi warned that the EU’s complacency in implementing his proposed economic reforms threatens the bloc’s competitiveness and sovereignty
• German investor sentiment unexpectedly rose in September, according to research institute ZEW, however ZEW warned of the continued uncertainty from US tariffs and Germany’s ‘Autumn of reforms’
• The Bank of Japan held interest rates at 0.5%. Japanese equity prices fell on the news that the BoJ also planned to offload $250bn of exchange traded funds
• Japanese exports fell for the fourth consecutive month in September, compared with the same period last year, driven by falling exports to the US in response to higher import tariffs 

Business

• US companies announced £150bn of investment in the UK over the coming years during Mr Trump’s state visit to the UK
• Nvidia announced a prospective deal to invest $500m in the UK self-driving car company Wayve
• Shares in struggling US tech company Intel rose 25% following the announcement of a $5bn investment by rival Nvidia
• Donald Trump signed a proclamation introducing a $100,000 fee for US H-1B visas but did not say whether it would apply to existing holders. Many affected companies responded by asking visa holders not to leave the US
• China dropped an antitrust investigation into US tech company Google, the FT reports, as China and the US intensify trade negotiations. However, China banned large Chinese tech companies from buying Nvidia’s AI chips as it aims to boost its domestic semiconductor manufacturing industry to compete with the US 
• The FT reports that Chinese tech stocks have outperformed the US this year as China pushes for greater self-sufficiency in technology
• Dealers and suppliers of UK car manufacturer Jaguar Land Rover said it may take another few months for production volumes to normalise following a recent cyberattack
• Media group Sky announced plans to cut nearly 600 jobs in an effort to increase competitiveness with US streaming rivals
• UK phone maker Nothing raised $200m at a recent funding round as part of efforts to challenge Apple and Samsung in the smartphone market
• Energy supplier Octopus Energy announced plans to offload its software company Kraken in efforts to speed up its global expansion
• Consumer goods giant Mars announced plans to invest $1bn in its European operations amid slowing US demand and plans to rebalance its operations
• Qatar’s sovereign wealth fund said it will invest $500m in Canada’s Ivanhoe Mines as part of diversification plans beyond oil and gas

Global and political developments

• The UK, Australia and Canada formally recognised the state of Palestine
• Saudi Arabia and Pakistan signed a strategic mutual defence pact, whereby “any aggression against either country shall be considered an aggression against both”
• Mr Trump said that control of Afghanistan’s Bagram air base should be returned to the US, citing the base’s proximity to China’s nuclear weapons as the reason
• The UK government returned the first asylum-seeking migrants to France under the UK-French ‘one-in, one-out’ deal
• More than 500,000 protested in France last Thursday against the government’s efforts to reduce the public deficit

And finally… a cheating scandal rocked this year’s world stone skimming championships, held on the tiny island of Easdale off the Scottish Coast. More than 2,200 people attended the event, however several competitors were disqualified after admitting to tampering with their stones – skimming-over the rule book