Big government

Governments that want their debt burdens to diminish must follow one of three broadly defined paths. First, they can try to pay back the loans. Second, they can decide not to pay, or agree with creditors to pay less than they owe. Third, they can wait it out, rolling over their debts while hoping that they shrink relative to the economy over time. Our Counterpoint 2021 suggests that, with the first two options quite unpalatable, and absent strong growth and/or high inflation for now, the third option has to do with monetary and fiscal policies acting together: to ensure that higher debts don’t push bond yields sharply higher (but, rather, only gradually as the economy recovers), central banks fund the stimulus measures of governments so that they can borrow cheaply and spend vast sums. This supports pro-cyclical recovery and reflation.

There are three options to deal with high debts and wide deficits:

Option #1 | Tighten the belt: The likely constraint on paying off debt is that such a strategy requires a mix of raising taxes and/or cutting spending. Public appetite for paying off pandemic debts through a return to significant austerity seems likely to be limited. In the US, Biden’s first fiscal package is 100% financed via extra borrowing.

Option #2 | Don’t pay or pay less: The second option – defaulting or restructuring debts – is very rare in advanced economies (though not in emerging markets). This is because they’re so integrated into global financial markets that they have huge problems if capital providers lock them out as a bad risk.

Option #3 | Grow out of the debt: Rich-country politicians unwilling to shift away from spending and towards taxing, or to face the consequences of an outright default, are likely to choose policies ensuring that the economy’s real growth plus inflation stay above the interest rate the government pays on its debt. That allows the debt burden to shrink over time.

Here’s why this matters:

Fiscal is the new monetary: Growing out of the debt isn’t easy. This is because the pace of real growth and inflation that would be needed to inflate the debt away seems very unlikely to materialise anytime soon. So what’s left is the interest-rate lever: if rates rise, debt sustainability becomes even more challenging; if they fall, it gets easier. This time around, governments are unlikely to introduce significant austerity measures during the early stage of the new cycle. Covid-19 triggered the first-ever recession by decree through widespread lockdowns. With funding costs kept at very low levels by central banks, fiscal authorities will be able to raise more debt and spend more aggressively to jumpstart the economy when reopening becomes possible on a larger scale.

The harder the fall, the bigger the bounce: By keeping the liquidity taps wide open, corporate default rates shouldn’t spike as much as in past cycles, supporting lower-quality, high-yield credit. This should also support a recovery in distressed sectors, and leave the economy less structurally impaired than previously thought given the magnitude of the Covid-19 shock. The more cyclical sectors and/or smaller businesses that have been hard-hit by the pandemic are likely to bounce back more strongly post-reopening, in our view, especially if there’s still a ‘gap’ relative to where normalisation is further advanced. Our asset allocation team has recently increased the tactical risk exposure, adding an overweight in UK Small Caps against global equities.

Meanwhile, there are many key data and events this week…

Taking the pulse: The upcoming GDP reports for Q4 are mostly a look at the economy from the rearview mirror: of course, tighter lockdowns have caused slower growth in the US and an outright contraction in Europe. We expect this weakness to extent for a while longer. A likely strong acceleration in German inflation isn’t really the start of a trend. Rather, it’s the result of the reversal of the VAT cut implemented last summer. More interesting will likely be forward-looking indicators such as the German Ifo business climate and US consumer confidence – which should incorporate expectations of an improving economy later this year, as vaccination programmes gather pace and reopening takes place. And markets will likely focus on the Fed’s assessment of the outlook too.

Daniele Antonucci | Chief Economist & Macro Strategist