Fiscal Policy

Systematically important central banks continue to compound policy errors, which will feed higher headline inflation. Hiking interest rates to induce labor-market slack – i.e., higher unemployment – to bring down core inflation will reduce demand for scarce commodities as incomes fall. It also will increase the cost of conventional and renewable capex and slow the final-investment-decision (FID) process. Net, supply will tighten as demand is squeezed. This will resolve itself in higher volatility and prices. Separately, we were stopped out of our XOP and XME ETFs spanning energy and mining equities, respectively, with a loss of 11.9% and a gain of 4.4%. We will be re-establishing these exposures at tonight’s close.

This week’s Special Report goes over the structural problems facing the UK economy and our outlook for UK gilts and the sterling following turbulent moves in 2022.

In this Special Report, BCA Strategist Ritika Mankar highlights that India may prove to be a sanctuary of safety in what promises to be a volatile 2023. Indian equity outperformance could continue, as India ends up offering relatively high growth at a time when EMs at large must contend with the effects of declining exports, high global interest rates, and exhausted fiscal stimulation capabilities.

Why will Chinese consumer spending recover but not its industrial sectors? Will China's reopening boost the global business cycle and inflation? How fast will US core inflation fall and what are the implications for corporate profits? Are global equities pricing in enough bad news/profit contraction?

Relative to beaten-down expectations, global growth will surprise on the upside in 2023. Investors should overweight equities for now but look to turn more defensive in the second half of the year.

In this <i>Strategy Outlook</i>, we present the major investment themes and views we see playing out next year and beyond.

Long-term deflationary forces in Japan are weakening, setting the stage for inflation to make a comeback over the remainder of the decade. Investors should prepare to structurally reduce exposure to Japanese bonds starting early next year. Higher Japanese bond yields will lift an extremely undervalued yen. To the extent that global growth should surprise on the upside over the next 12 months, Japanese equities could see some modest outperformance.

The kinked supply framework helps explain why US inflation rose so suddenly shortly after the pandemic began and why the economy is likely to experience a benign disinflation over the next six months.

Falling inflation will allow bond yields to decline in the major economies over the next few quarters. As such, we recommend that investors shift their duration stance from underweight to neutral over a 12 month-and-longer horizon and to overweight over a 6-month horizon. Structurally, however, a depletion of the global savings glut could put upward pressure on yields.

Dear Client, Section II of this month’s Bank Credit Analyst report is a guest piece written by Martin Barnes, which we are making available to all clients. Martin, who retired from BCA Research last year after a long and illustrious career, discusses the long-run outlook for government debt and the possibility of an eventual crisis. I trust you will find his report both interesting and insightful. Jonathan LaBerge, CFA The Bank Credit Analyst Highlights Recent developments in the UK highlight the power of financial markets to reimpose discipline over wayward fiscal policies. However, the bond vigilantes remain notably absent in the US. The strong dollar and lack of a fiscal premium in Treasury yields indicates investor complacency about the US fiscal position. However, the long-run trajectory of US government debt and deficits is unsustainable. It will take market pressures to force an inevitable change in US fiscal policies. This is very unlikely to occur in the coming year but there are good odds of it happening within five years. The ‘solution’ to a market-induced US debt crisis will involve a mix of higher inflation, financial repression, increased taxes and spending restraint. Feature I, however, place economy among the first and most important of virtues, and public sector debt as the greatest of the dangers to be feared. Thomas Jefferson I used to think that if there was reincarnation, I wanted to come back as the president or the pope. But now I want to be the bond market: you can intimidate everybody. James Carville, adviser to former US President Bill Clinton. If something cannot go on forever, then it will stop. Herb Stein, renowned US economist A remarkable feature of the economic and financial landscape during the past two decades has been the markets’ calm acceptance of an explosion in government debt throughout the developed world. In many countries, public sector debt-to-GDP ratios have hit peacetime records as a share of GDP yet until recently, bond yields remained at historically low levels. What happened to the bond vigilantes that so impressed James Carville? With the benefit of hindsight, we can look back and explain why soaring public deficits and debt levels did not cause major disruptions. Central bank purchases of government bonds reduced the supply available for private investors at a time when the demand for ‘safe’ assets was very strong. Meanwhile, private sector savings were abundant and, again until recently, inflation was quiescent. But that is the past, what about the future? There is little prospect of a significant reduction in public-sector debt burdens in the major developed economies in the coming few years. Uninspiring economic growth implies ongoing pressures for fiscal stimulus, aging populations will underpin growth in pensions and health care spending and geopolitical tensions will support increased defense spending. The rise in inflation gives some help to revenues, but higher interest rates provide an offset. The long-standing concern about large public sector deficits is that they threaten to push up interest rates, crowd out private sector investment and lower potential growth. And along the way, there is the threat of financial volatility and crises. I could fill several pages with quotes and analyses from eminent economists during the past two decades predicting impending economic and financial doom unless government finances were brought under control. Not surprisingly, the failure of any crises to emerge has discredited such gloomy forecasts, fostering complacency about the issue. Recent developments in the UK warn of what can happen. The announcement of an aggressive program of tax cuts and increased borrowing rattled investors, leading to a sharp drop in the exchange rate and rise in bond yields. As a result, the government was quickly forced to abruptly change policy, abandoning its planned tax cuts. The economic and financial fallout also led to a change in political leadership with the new government warning that tax increases and spending curbs will be needed to restore fiscal stability. The market vigilantes clearly are alive and well in the UK, even if they are missing in action in the US. The US dollar’s status as the world’s premier reserve currency gives the country protection from the wrath of investors that is not always available to others. However, this is a mixed blessing because it gives policymakers more rope with which to hang themselves. The trend in US public debt burdens is unsustainable, and as Herb Stein noted, this means something will change. The key questions relate to how and when this will occur. The Disturbing Path Of Government Debt Chart II-1The Historical Sweep Of Debt The Historical Sweep of Debt The Historical Sweep of Debt Historically, major spikes in government deficits and debt generally occurred only in wartime (Chart II-1). However, the past 15 years have witnessed two extraordinary surges in public sector indebtedness – firstly in response to the 2007-09 economic and financial meltdown and secondly because of the Covid pandemic. In both episodes, tax revenues declined, and governments boosted spending to shore up economic activity. In the major advanced economies, net government debt as a percentage of GDP jumped by around 20% from pre-crisis levels in each of the periods (Chart II-2). And when indebtedness ratchets higher, it is difficult to reverse. Despite concerns about crowding out, it is hard to find an empirical relationship between the size of budget deficits and either interest rates or the growth in private investment. For example, deficits rise when the economy is weak and this is when interest rates tend to fall, not rise. Even if the analysis uses cyclically-adjusted budget balances (i.e. removing the impact of swings in the economy) it is hard to find a good relationship. But that does not mean rising deficits and debt do not matter. At some point they impact market confidence about how policy may be forced to change in the future. Uncontrolled fiscal finances ultimately will lead to financial turbulence. Public sector dynamics are a function of two key variables: the difference between the average interest rate on the debt and nominal GDP growth, and the primary budget balance (i.e. the budget balance before interest payments). The debt-to-GDP ratio will decline if the primary budget is at least in balance and the borrowing rate is below the GDP growth rate. Conversely, it will soar if there is a primary deficit and the borrowing rate is above the economic growth rate. Currently, most countries face primary deficits (Chart II-3) and interest rates are not likely to be far enough below growth to stop debt-to-GDP ratios from rising in the years ahead. Chart II-2Economic Crises Cause Spikes In Debt Economic Crises Cause Spikes in Debt Economic Crises Cause Spikes in Debt Chart II-3Lingering Primary Deficits Lingering Primary Deficits Lingering Primary Deficits   Chart II-4The Long-Run US Debt Outlook The Long-Run US Debt Outlook The Long-Run US Debt Outlook The picture in the US is particularly disturbing given its outsized role in global markets. According to the Congressional Budget Office (CBO), absent any policy changes, the federal budget deficit will average 5% of GDP over the next decade, with the primary deficit averaging 2.5% of GDP. As a result, the ratio of federal debt to GDP will be close to 110% of GDP in ten years’ time. Importantly, these projections do not allow for any recessions and use optimistic assumptions for interest rates (averages of 2.4% and 3.5% over the next decade for 3-month rates and 10-year Treasury yields, respectively). The uptrend in indebtedness continues over the longer run, taking the federal debt-GDP ratio to 140% by 2042 and 185% by 2052 (Chart II-4). Of course, this won’t happen because markets will force a change long before we get to that point. Signposts For A Debt Crisis It is impossible to predict what level of indebtedness will trigger a market reaction because much will depend on the circumstances at the time. Nevertheless, several signs can help to warn when a country is approaching a debt wall. Warnings signs include the following: Surging debt interest payments An increased dependance on issuing short-term or foreign currency debt A limited ability to raise taxes to reduce budget deficits Rising risk premia on government yields and/or a plunging exchange rate Surging Debt Interest Payments: Failure to service the debt means falling into default – something inconceivable for any developed country. Thus, debt interest payments must be made and if they rise sharply then they can crowd out other forms of government spending, creating political and/or economic problems. Canada faced this problem in the early 1990s with federal debt interest payments exceeding 30% of total revenues and more than 25% of total spending. This forced the government into a major fiscal retrenchment, eventually leading to several years of budget surpluses. In 2021, interest costs were a mere 6.5% of federal revenues. The past 15 years have been a period of exceptionally low interest rates, dramatically reducing borrowing costs, even as debt levels have climbed. In the US, federal interest payments represented only 8.7% of revenues in fiscal 2021. This was less than half the level of the early 1990s even though the ratio of outstanding debt to revenues doubled over the period (Chart II-5). While interest rates have risen this year, it will take time for this to feed through into a significant increase in the average cost of debt financing. The fact that the Fed holds more than 20% of outstanding Treasuries also helps because the interest payments on these securities are returned to the Treasury. In sum, there are few signs of an imminent problem in the US on this score. Increasing dependence of short-term or foreign currency debt: If investors are worried about a country’s fiscal stability then they will become increasingly reluctant to take on duration risk. This should show up in increased risk premia on longer-term debt, forcing governments to rely more on short-term financing. Once again, there are few signs of problems in the US. The spread between 30- and 10-year Treasuries has fallen sharply in the past year and there has not been any notable change in the average maturity of debt (Chart II-6). It is surprising that the Treasury did not use the opportunity of historically low yields to lock in more longer-term debt. Chart II-5Low Interest Rates Have Cut Debt Servicing Costs Low Interest Rates Have Cut Debt Servicing Costs Low Interest Rates Have Cut Debt Servicing Costs Chart II-6No Evidence Of A Fiscal Risk Premium No Evidence of a Fiscal Risk Premium No Evidence of a Fiscal Risk Premium   A financial revolt against economic policies typically shows up in the foreign exchange market as investors abandon the perceived risky currency. Collapsing currencies put upward pressure on inflation and interest rates and typically force a change in government policy. And countries that depend on overseas buyers of their debt may be forced to start issuing debt in foreign currencies, creating a vicious cycle as a weak currency then adds to debt servicing costs. A rise in the issuance of US dollar-denominated debt was another sign that Canada was facing problems in the 1990s. US dollar-denominated issues as a percent of foreign purchases of Canadian public sector bonds rose from 6% in 1983-88 to 45% in 1988-93. The US is in a very favorable position because the dollar’s reserve currency status means that the US can borrow freely in its own currency. Even when the dollar suffered long-run declines such as in 1985 to 1995 and 2002 to 2011, the US never needed to issue foreign-currency debt. The last time the US issued non-dollar debt was in 1978 when it issued bonds denominated in Deutschemarks and Swiss Francs in an effort to prop up the dollar (the so-called Carter bonds). Without the dollar’s reserve status, the US would be in a very different position because it is, by far, the world’s largest external debtor to the tune of $18 trillion (79% of GDP) at the end of 2021. The combination of high ratios of public debt-to-GDP and external debt-to-GDP normally would be toxic for a currency and the US is at an extreme in both measures compared with other major countries (Chart II-7). The US position compares to countries such as Germany, Canada and Switzerland that are net international creditors and have relatively low government debt-to-GDP ratios. There is a particularly interesting contrast with Japan as it has extremely high government debt but is a massive net external creditor. The fact that Japan does not rely on foreigners to buy its debt helps to explain why bond yields have stayed low in the face of huge budget deficits. And it helps that the Bank of Japan owns close to 50% of outstanding government bonds. Since 2016, the Bank of Japan has pledged to keep 10-year bond yields within 25 basis points of zero, but yields remained low even before that policy. It seems odd for the world’s largest international debtor nation to have the major reserve currency, but there has been no major competition from other countries. Given the economic problems faced by Europe, Japan and China, no change is in prospect any time soon. Room for tax hikes: A return to fiscal discipline can come from increased taxes, lower spending, or a mixture of both. Lowering the path of spending is politically challenging, especially given that in most countries, aging populations mean that non-discretionary spending (e.g. pensions and health care) accounts for a rising share of the total. Meanwhile, if tax burdens are already high, then further increases could be self-defeating via weaker economic growth and thus revenues. Not surprisingly, structural budget deficits rise more easily than they fall. Throughout much of the developed world, overall tax burdens are at historically high levels (Chart II-8). The UK experience highlights the challenges: the government used the record level of tax burdens as the case for cutting taxes, even in the face of high deficits and debt. But there was strong opposition to any attempt to finance lower taxes with real cuts to social programs. As noted earlier, bond vigilantes did not play along with the UK government’s plans. Chart II-7External And Government Debt Ratios November 2022 November 2022 Chart II-8The US Is A Low Tax Country The US is a Low Tax Country The US is a Low Tax Country   The US is in a different situation. Overall tax burdens (total general government receipts as a percent of GDP) are not at historically high levels and are by far the lowest of any industrial country, except for Ireland. While there is strong political resistance to higher taxes in the US, this is a viable route to pursue should market pressures force action. The long-term solution may be to introduce a federal sales tax.1 Options to reduce federal spending are limited given that non-discretionary spending and interest payments account for more than 70% of total outlays, a share that will continue to rise. The Changing Pattern Of Treasury Ownership Where will market pressures for US fiscal restraint come from? A long-standing concern has been that it will come from overseas – perhaps a decision by China to dump its Treasuries as a deliberate political act. This was never a very realistic possibility as it would represent an aggressive act of economic warfare, leading to serious retaliation via sanctions and curbs on Chinese exports. Nevertheless, it is reasonable to assume that, as with smaller more open economies, foreign investors will sell Treasuries and the dollar if they expect major economic and financial instability in the US. Chart II-9Ownership Of US Federal Debt Ownership of US Federal Debt Ownership of US Federal Debt The potential impact of foreign selling was greater in the past because overseas investors have accounted for a shrinking share of outstanding federal debt. The peak was in 2008-16 when the share fluctuated in the 40% to 44% range. It has since dropped below 30% (Chart II-9). Between 2002 and 2008, foreign investors absorbed two-thirds of Treasury issuance, with the two largest holders Japan and China accounting for 8.5% and 10% respectively of total outstanding debt by the end of the period. By the middle of this year, Japan’s share was down to 4.7% while China’s was 3.7%. Of course, changes occur at the margin, and it may not need much foreign selling of Treasuries to trigger panic among domestic investors. At that point, the Fed would likely step in. The launch of the Fed’s quantitative easing in 2008 represented the start of a new era of central bank intervention in the markets.2 The Fed holds more than 20% of outstanding Treasury debt and although it wants to further reduce its holdings, there is little doubt that it would resume purchases in the event of a market panic. The Bank of England recently did just that when the UK bond market went into freefall in response to the government’s reckless fiscal announcements. The Debt End Game Chart II-10Beware Of Budget Forecasts Beware of Budget Forecasts Beware of Budget Forecasts A frequently-asked question is “how will the debt ever be paid off”. The answer is that it will not get paid off because the only way to do this is to run budget surpluses, a remote possibility for the foreseeable future. The US did run federal budget surpluses for four years between fiscal 1998 and 2001 and the CBO’s January 2001 baseline projections showed the federal debt (then at $3 trillion) being almost entirely paid off within ten years. This prompted then Fed Chairman Alan Greenspan to worry about the technical challenges of conducting monetary policy in a world without government debt. Of course, things did not pan out as expected with Treasury debt reaching $11 trillion in fiscal 2011 rather than disappearing. The trend in Federal debt versus the CBOs baseline projections makes for a dismal picture and most of the divergences can be attributed to policy actions rather than economic forecasting errors (Chart II-10). Unfortunately, it is hard to imagine how the federal budget could be returned to surplus given the high and growing burden of non-discretionary spending. The solution is to make the debt easier to live with and this can be done in a few ways. Most importantly, the debt-to-GDP ratio can be reduced by boosting the growth in the denominator – nominal GDP. Ideally, this would happen via faster real growth but that seems unlikely given the demographic outlook and the lackluster trend in productivity. So it will have to occur via inflation. Reducing debt burdens by inflating nominal GDP growth will require the cooperation of the Fed. Otherwise, higher interest rates would make the fiscal situation even worse by slowing the economy and boosting debt servicing costs. The Fed’s current tightening stance should not be taken as a sign that it would never tolerate some increase in inflation. As we wrote a few months ago, inflation is set to fall over the coming year, but this will be a temporary respite.3 It will prove extremely difficult to return to sustained inflation near 2% over the medium term and a new base of 3% to 4% is likely. Another way to ease the debt problem will be via financial repression. This means keeping interest rates below ‘normal’ levels (one of the reasons to expect higher inflation) and having regulatory rules requiring financial institutions to hold high levels of government debt for supposedly prudential reasons. And finally, we will have the Fed as the ultimate backstop, stepping in if private and overseas investors cease to be buyers of Treasury debt. Finally, there will be some measures to reduce structural deficits. Taxes will increase, and actions taken to reduce the trajectory of non-discretionary spending. For example, there is scope for savings in health care spending by negotiating better prices for drugs. While it will prove near impossible to return to surpluses, it should be possible to reduce deficits from current levels. However, no politicians will impose fiscal austerity willingly and it will thus require a market crisis to force action. The bond vigilantes will have to reemerge from the shadows. Conclusions Public finance is a kind of Ponzi scheme where the proceeds of new debt issuance are used to pay existing investors. As long as new debt can be issued at reasonable yields, the show can go on. Problems emerge when investors take fright at the path of government finances and demand ever-increasing yields to compensate for perceived risks. As with all Ponzi schemes, it falls apart when new buyers fail to emerge. Proponents of Modern Monetary Theory (MMT) argued that public deficits and debt do not matter because they can be financed by central banks. However, even MMT advocates accept that this can only persist for as long as inflation stays under control. The past year’s rise in inflation has taken the wind out the sails of the MMT movement and there is very little support for the view in the economic and financial community. Chart II-11What Debt Problem? What Debt Problem? What Debt Problem? Clearly, the US is not facing an immediate problem, despite the worrying trajectory of public deficits and debt. For example, the dollar’s trade-weighted index is at a new all-time high, up 40% in the past 12 years (Chart II-11). Higher inflation and a tightening in monetary policy have pushed up bond yields, but there is no sense of a fiscal-induced investor revolt. The near-term outlook for the economy is gloomy with high odds of a recession in the coming year. That will help ease inflation pressures and bring an end to Fed rate hikes. Against that backdrop, Treasury yields will eventually reverse some of their recent rise and bond vigilantes will remain out of sight. But that will not last. Remember: what cannot go on, will stop! We should not expect politicians or voters to willingly seek fiscal austerity. For politicians, raising taxes and cutting spending is not a vote-winning proposition. And while voters may pay lip service to the idea that governments should live within their means, few people want higher taxes or the kind of cuts in spending that would make a difference. This means that financial markets have to be the ultimate disciplinarian on profligate governments. It would be nice to put a date on when markets eventually will revolt against fiscal excesses, but any attempt would be pure speculation. I am quite confident it will not be in the next 12 months but would put a 75% probability it will be within the next five years. At that point, debt-servicing costs could be at new highs. This would make it a problem for the next administration. What has happened in the UK in terms of fiscal policy and market reactions is a good indicator of what the US ultimately will face. Martin H. Barnes Former Chief Economist, BCA Research mhbarnes15@gmail.com   Footnotes 1    The US is the only industrial country that does not have a federal sales tax. 2    The Bank of Japan embarked on quantitative easing in 2001, but it was alone in doing so at that time. 3    Please see The Bank Credit Analyst “Inflation Whipsaw Ahead,” dated June 30, 2022, available at bca.bcaresearch.com