The word likes not to be spoken, but stagflation is indeed what the global economy is currently undergoing: slow (or almost no) GDP growth together with stubborn core inflation. The positive news is that a recession seems to have been avoided for now and growth should pick up going forward, owing to large government investment programmes in infrastructure – be they in the defence or energy transition spaces, or else made necessary by ageing demographics. There is a lot of work to be done. The drawback to such future spending? Ever-increasing public indebtedness, the burden of which will only expand as interest rates move up.
As the recent saga about the US debt ceiling again highlighted, government debt levels across the globe stand at historical highs. From USD 9 trillion before the Great Financial Crisis (GFC), US federal debt has more than tripled to USD 31.5 trillion – 120% of GDP – of which ca. 30% held within government institutions (read: the Federal Reserve) and more than USD 25 trillion – 90% of GDP – financed otherwise. The fact that the upward trajectory of US federal debt accelerated during the GFC and then, even more so, the Covid pandemic is certainly not surprising, but the pace of accumulation has unfortunately not abated since. Nor is it likely to do so given the rising funds allocated to defence and the huge financial cost of the pending inevitable energy transition – estimated by some at thousands of billions between now and 2030.
On this side of the Atlantic, the Maastricht conditions that allowed for entry into the eurozone have long been forgotten. Very few member countries still boast a government debt level below 60% of GDP – with Germany no longer even part of that select group. And although the eurozone average, at 93%, looks much better than the US’s 120%, the picture is not that clearcut from a longer term viewpoint. Indeed, Europe’s demographic structure argues for considerably greater future government obligations: unlike the US, the old continent is having to cope with a gradually shrinking working age population. Also, there is much greater scope (though admittedly no political appetite) for raising government revenues in the US: tax income currently only represents less than 25% of GDP (with about half of Americans paying no income taxes), versus close to 50% in Europe. Finally, the US financing model, with a barbell mix of very short-term borrowing (40% of US federal debt is set to mature in 2023-2024) and very long-term Treasury bonds, differs markedly from that which prevails across Europe, where the bulk of debt will come to maturity in only a decade or so. As such, US government debt is thus more quickly subject to the upward movement of interest rates, and the current budget deficit already includes part of its impact, which is much less the case in Europe.
This greater “sustainability” of US debt arguably explains why the dollar actually appreciated, rather than depreciated, during the recent tense discussions surrounding the lifting of the debt ceiling. Currency traders/speculators were apparently confident (as were we, for that matter) that a last-minute agreement would be reached between the Democrats and Republicans to raise the maximum allowed national debt, such that the US could continue to meet all its obligations. The opposite would have been a disaster, with unforeseeable consequences for the financial system.
Perhaps the dollar also rose against the euro because of stronger US growth prospects and the realisation that persistently high inflation in the US will force the Federal Reserve to keep interest rates higher for longer than the ECB? This would indeed seem dollar-supportive at the moment, although the greenback is now looking very “toppy” versus the euro according to the purchasing power parity (PPP) theory (which is signalling an overvaluation of ca. 20-25% depending on the measurement method). Unfortunately, PPP is not a useful tool to predict short-term currency fluctuations. It serves rather to indicate the trend several years out, recognising, however, that the normal process of automatic adjustment of exchange rates in a free trade market is currently severely hampered by all kinds of protectionist measures, e.g. high import duties and numerous global economic and financial sanctions. Still, despite all this, the fact remains that the greenback is significantly overvalued and now is thus not, in our view, the time to drop our dollar hedges.
The sustainability of current public debt levels and their foreseen increase over the course of this decade, in a context of higher interest rates, is of concern and certainly so in Europe. The southern European countries (Greece and Italy in particular), among others, are already bumping against the limit of the maximum achievable. And their debt differential relative to northern and eastern European countries continues to expand, which sooner or later could/will again lead to a problem situation and a new crisis for the EU. For the time being, the holiday countries are benefiting from European consumers’ post-Covid revenge leisure spending, but this will come to an end sooner rather than later.
The rampant growth of US public debt will also have to be addressed at some point, be it through spending cuts or higher taxes, even though the problem there seems at first glance more manageable than in Europe.
Not to mention the rapidly rising debt mountain in the Far East (including China) and other developing countries. Central bank printing presses might well have to come to the rescue again, with the impact on inflation that we now well know…
All told, we are far from “out of the woods” and investors have little choice today but to suitably diversify their holdings across all possible asset classes, in order to preserve the purchasing power of their savings. Including some gold perhaps?