Global debt resumes upward trend
By Alexandre Hezez, Group Strategist
Macro point
Tweet from the Institute of International Finance
Source : X (ex twitter)
Although a significant reduction in global debt was observed in 2022, the challenges of debt sustainability remain. According to the latest IMF data, global debt is still above its pre-pandemic level. It will account for 238% of global GDP in 2022, an increase of 9 percentage points on 2019. Debt stood at $235,000 billion, $200 billion more than in 2021. The global debt burden has fallen in 2021 and 2022 thanks to low interest rates driven by central bank action. Despite this further decline, global debt remains high and its sustainability a cause for concern.
A temporary rise during the pandemic
Source: IMF
In 2020, debt saw its biggest annual jump since the Second World War, peaking at $226,000 billion in the midst of a recession and a pandemic. Pre-crisis levels were already worrying, but countries were faced with unprecedented levels of public and private debt, viral mutations and galloping inflation.
Despite a rebound in growth from 2020 and inflation well above forecasts, public debt remained stubbornly high. Budget deficits are one of the main reasons for this, as many countries spent more to stimulate growth and respond to soaring food and energy prices, even as they ended pandemic-related budget support.
As a result, public debt has fallen by only 8 percentage points of GDP over the past two years, offsetting only about half of the pandemic-related increase.
US household debt as % of GDP
Source : Bloomberg
Private debt, which includes the debt of households and non-financial companies, fell faster, by 12 percentage points of GDP. But this drop was not enough to neutralize the increase due to the pandemic.
Almost 40% of today’s global debt is public, a level not seen since the 1960s. This phenomenon is largely attributed to two recent economic crises: the global financial crisis and the COVID-19 pandemic. The massive fiscal measures taken in response to these crises have seriously worsened deficits.
Debt dynamics vary considerably from country to country. Developed economies and China account for over 90% of the $28,000 billion in additional debt. In contrast, developing countries face restricted financing conditions and high borrowing rates.
Tweet from the Institute of International Finance
Source : X (ex twitter), https://www.iif.com/
A long-term phenomenon
Prior to the pandemic, global debt-to-GDP ratios had been on an upward trajectory for decades. Global public debt has tripled since the mid-1970s, reaching 92% of GDP (or just over $91,000 billion) by the end of 2022. Private debt has also tripled to 146% of GDP (or almost $144,000 billion), but over a longer period, between 1960 and 2022. This increase in global debt is largely attributable to China, as the volume of borrowing has outstripped economic growth.
China’s level of debt as a share of GDP has almost caught up with that of the United States, while in dollar terms its total debt is still significantly lower ($47,500 billion versus nearly $70,000 billion). In terms of non-financial corporate debt, China’s share (28%) is the largest in the world. The debt of low-income developing countries has also risen considerably over the last twenty years, albeit from an initially lower level. Even if the debt of these countries, particularly private debt, remains on average relatively low compared to that of advanced and emerging countries, its rapid increase since the global financial crisis is creating difficulties and vulnerability factors.
More than half of low-income developing countries are over-indebted or at high risk of over-indebtedness, and around one-fifth of emerging countries have issued sovereign bonds that are trading at heavily discounted prices.
Latest IMF report
Source : IMF (Click here)
A headache for Governments
The authorities will have to make a firm commitment to keeping debt at a manageable level to preserve its viability.
Public authorities must take urgent action to reduce debt vulnerabilities and reverse its long-term trends.
As far as public debt is concerned, the establishment of a credible fiscal framework could guide the process of better reconciling spending needs and its sustainability.
For low-income developing countries, this means, above all, strengthening their capacity to collect more tax revenue. For those whose debt is unsustainable, a more comprehensive strategy is also required, combining fiscal discipline and debt restructuring under the Group of Twenty’s common framework (the multilateral sovereign debt cancellation and restructuring mechanism), where appropriate, as outlined in the IMF’s World Economic Outlook.
Some experts claim that by reducing the debt burden, fiscal space is freed up for new investments, thus stimulating economic growth in the years to come, in particular through the energy transition. The IMF insists in a ” working paper ” on the possibility of reducing debts through increased carbon taxation.
France : Interest expense on public debt
Source: IMF
However, recent events show that in times of social and political tension in many developed countries , it is difficult to act against purchasing power. In Europe, people’s expectations are high . This makes it more difficult for governments to take action in this area.
Source : X
The United States is not immune to this phenomenon as the presidential elections approach, and a predictable clash between Trump and Biden is likely. The world’s leading economy is once again facing the threat of government paralysis due to political deadlock, four months after coming close to default.
Total debt and authorized ceiling
The US national debt has surpassed a staggering $33,000 billion. The trajectory of this ever-increasing debt gives cause for concern in terms of long-term economic viability.
However, debt dynamics are far from the same in all countries. Advanced countries and China are responsible for over 90% of additional debt. By contrast, most developing countries find themselves in the opposite financial situation: their access to financing is limited, and they are often already forced to borrow at higher rates.
Around 80% of new debt was generated by developed markets, with the United States, Japan, the United Kingdom and France the main contributors. At the same time, emerging market debt was driven by China, India and Brazil.
Interest rate risk
The global debt burden has fallen in 2021 and 2022. The report from the Institute of International Finance warns that rising interest rates could make debt repayment more difficult, particularly for highly indebted countries and households. It is therefore crucial that governments and central banks manage this debt prudently. It’s worth noting that household debt levels are at their lowest in two decades, creating some room for maneuver in the face of rising interest rates. It’s worth noting that the sudden rise in inflation two years ago made it easier for governments to repay their existing debts. Today, however, it is governments and financial institutions that are contributing to the rise in the debt/GDP ratio.
In the United States, this is due to the fact that the federal deficit has increased. This increase in overspending is causing concern, with some fearing that it could lead to even higher interest rates.
Although this will take time, the rate levels paid by economic agents will be higher. In our scenario, inflation will remain a constant fear for central banks over the next few years.
In terms of interest expense, the rise in interest rates will only gradually be reflected in debt, as governments have increased their debt and the duration of their bonds during a period of very low interest rates. Coupon payments remain low. However, given current rates, they will increase gradually.
Government debt coupon level versus 5-year rate level.
Sources: Bloomberg, Richelieu Group
What’s more, overall debt maturities remain relatively high, leaving time for action on budget deficits.
Average duration of government debt.
Sources: Bloomberg, Richelieu Group
How high can interest rates go ?
As we’ve been explaining for many months now, the 2010s were marked by an ongoing fear of deflation, which led to constant action by central banks to revive the monetary machine when necessary (financial crisis in 2008, sovereign crisis in 2011, oil crisis in 2015, trade war in 2018, pandemic in 2020).
5-year rate
Sources: Bloomberg, Richelieu Group
This time, central banks will mirror the previous cycle. We believe they will keep up the pressure on governments and credit distribution to avoid another inflationary wave as far as possible. The fight against inflation will be paramount in the face of the desire for growth.
Jerome Powell bases his analysis on the last episode of stagflation in the 1970s. In his view, the Fed’s mistake in the 1970s was to fear plunging the economy into a sharp recession and then rapidly lowering interest rates. Jerome Powell prefers to be seen as a second Paul Volcker rather than a second Arthur Burns (Fed Chairman from 1970 to 1978). It wasn’t until 1975, far too late, that Burns admitted the U.S. had an inflation problem. The lesson of this whole episode is a painful one: it’s very dangerous to ignore transitory factors. At the time, when Carter appointed Volcker as head of the Fed in July 1979, he decided to reverse U.S. monetary policy. So the question is whether Jerome Powell has an unlimited capacity to normalize the situation.
The United States experienced high inflation in the 1970s and into the early 1980s. Looking back to the 1970s, interest rates reached historic highs of nearly 20% to extinguish the inflationary fires. Even if rates can still be raised (which is not our scenario), we believe we are not in the same paradigm for two reasons:
– Inflation has not reached the level of the 1970s.
– Paradoxically, the current level of debt allows for greater leverage of monetary policy.
The impact on interest expenses is multiplied.
A simple and rudimentary calculation can be made by considering the level of debt to GDP and the US central bank’s reference rate. By multiplying the two terms, we obtain what could be the monetary intensity on debtors.
Sources: Bloomberg, Richelieu Group
In the 1970s, the debt-to-GDP ratio in the United States was 30%; it is now 130%. Monetary intensity is therefore equivalent to or even higher than in the 1970s, as shown by the green curve. The series of stop-start efforts to fight inflation in the 1970s eventually necessitated Volcker’s drastic interest rate policies, which would have far more disastrous economic consequences today, given current debt levels. Difficult as it may be, history teaches us that it’s best to tackle problems when they’re still relatively small.
Clearly, as Jamie Dimon wrote this month, the world is not ready for 7% rates.
Sources : Youtube, Bloomberg TV
Accumulated COVID savings in the United States stand at around $2.7 trillion, according to data from the Bureau of Economic Analysis. These savings were built up during the COVID-19 pandemic, when American households received substantial social benefits and consumption was curbed by confinements and restrictions. It is likely that American households will continue to draw on their COVID savings as long as inflation remains high. This could have a negative impact on economic growth, as households will have less money to spend on other goods and services. It is important to note that COVID savings are not an unlimited resource. American households will eventually have to start paying down their debts and rebuild their savings for the future, which will put less pressure on inflation.
Source: Refinitiv datastream
Americans outside the country’s top 20% have depleted their extra savings and now have less cash on hand than they did at the start of the pandemic, according to the Federal Reserve’s latest survey of household finances. For the poorest 80% of households in terms of income, bank deposits and other liquid assets were lower in June this year than in March 2020, after adjusting for inflation.
Source : Bloomberg
So it’s unlikely that even if rates stay high for a long time (as we’ve explained many times), they’ll stay more or less at this level.
However, we are confident that central banks will keep interest rates high and that the supply of new bonds will continue to increase as the federal government faces growing deficits. A structural difficulty for States that will weaken future potential growth.
It’s crucial to emphasize that high global indebtedness is not necessarily negative. If used to invest in productive projects, it can contribute to economic growth. On the other hand, if it is used to finance consumer spending or unprofitable projects, it can become problematic.
Asset risks and opportunities
Inflation should return to normal in the medium term, as central banks have shown they are ready to act. The four major central banks of the advanced countries have all reaffirmed their medium-term price stability target of 2%. This unity is important because it shows that central banks are determined to work together to fight inflation.
We expect rates to remain at high levels for an extended period.
After a long period in which the risk premium favored equities over bonds, a rebalancing has taken place. The yield spread between a US government bond and the S&P 500 dividend is back to where it was before the great financial crisis of 2007.
Spread between US 10-year yield and S&P 500 dividend yield
Sources : Bloomberg, Groupe Richelieu
Bond assets are finally regaining their appeal, both in terms of profitability and portfolio construction on assets whose correlation allows diversification according to the investment horizon.
There’s no such thing as a free lunch, which means the most fragile private or state issuers are at risk. Refinancing will be more delicate and investors will have to be more selective. We focus on the quality of issuers and their ability to generate cash flow.
Annual default rates for speculative-grade companies
Source : Standard & Poor’s Financial Services
The “almost flawless” era is well and truly over. The percentage of “zombie” companies in the Russell 3000 index is at an all-time high, far higher than what was seen during the dot-com bubble (a “zombie” company is defined as one that cannot pay the interest on its debt from its operating revenues). Rising interest rates could push the percentage of “zombies” even higher and ultimately produce a wave of debt defaults that will impact the most fragile markets.
Percentage of “zombie” companies in the Russell 3000 index
Source: The Leuthold Group and Bank of International Settlements
Banking economists expect credit conditions to weaken over the next six months, according to the American Bankers Association’s latest Credit Conditions Index.
Source : American Bankers Association
On the other hand, companies with a capacity for investment and growth will be the big winners from this structural rather than cyclical change. A period when fundamental analysis will regain its lost stripes, whether for equities or bonds.
Global Allocation
We remain cautious in view of the many uncertainties and scissor effects that will materialize over the coming months.
1st scissor effect: China
We believe that markets are concerned about China’s decoupling from the global economy. If China plunges into deflation as a result of its real estate collapse, the repercussions on the global economy will be significant (especially in Europe). Conversely, if China rebounds, the deflation imported into developed countries since the start of the year, which has partly stabilized inflation in Europe and the United States (raw materials), will come to an end. Additional inflationary pressure could arise.
Producer and consumer prices in China
Sources: Bloomberg & Richelieu Group
2nd scissor effect: real estate
If property prices fall significantly (linked to rising interest rates), the consumer wealth effect will be undermined, defaults will increase significantly and a return to savings will be necessary, impacting consumption. In the opposite situation, the disinflation dynamic will be over, pushing central banks to do more.
Annual change in US house prices and real estate rates
Sources : Bloomberg & Groupe Richelieu
3rd scissor effect: employment
The labor market must deteriorate to limit cyclical wage inflation.
In the United States, employment is starting to deteriorate, and an unemployment rate above 4.5% would be necessary. While this will be good news for inflation (and therefore for central banks), it will be very bad news for growth, which is largely driven by consumption (mainly in the United States). We expect wage pressures to remain strong in Europe.
Unemployment and participation rates in the United States
Sources : Bloomberg & Groupe Richelieu
4th scissor effect: companies
Over the past twelve months, companies have been able to pass on inflation to their customers while maintaining (or even increasing) their operating margins. The central banks’ goal of lower inflation is taking shape. Nominal growth will weaken and be unfavorable. At the same time, labor and energy costs will remain tight. Margins will adjust significantly downwards.
The main central banks will remain permanently committed to reducing their asset portfolios, while the Bank of Japan will tighten monetary policy very gradually in 2024, limiting support for global equity markets.
We believe that, at present, the downside risks for risky assets are greater than the upside risks : little short-term potential in a context of economic slowdown. Further reassurance on inflationary dynamics will be needed to return to of potential. Valuations are high, investor positioning is aggressive and macroeconomic fundamentals are deteriorating. We believe that the headwinds for risky assets (Quantitative Tightening, rate hikes, slowing growth, geopolitical risks) are stronger than the headwinds (China reopening, etc.).
Bloomberg World Large, Mid & Small Cap Price Index in Euros
Sources : Bloomberg & Groupe Richelieu
We anticipate a delicate phase for growth. The slowdown in US growth and continued weakness in Europe will lead to a stabilization, even a fall in sovereign rates and a weaker dollar. This phase should be unfavorable to the riskiest assets, with violent bullish phases that should be taken advantage of.
US EQUITIES
The year-to-date return premium for US equities over the rest of the major asset classes persists. Certain themes, which we favor in our portfolios, linked to the development of artificial intelligence, of robotics and relocation support American companies. Earnings momentum has also improved recently, with S&P 500 EPS expectations revised upwards since July. We still insist on the increased credibility of the US central bank and the defensive characteristics of the US equity market in a period of volatility.
U.S. economic indicators
Sources : Bloomberg & Groupe Richelieu
We remain in a soft landing scenario and rates should stabilize. Even if our central scenario is depreciation, the dollar’s safe-haven status is an advantage from a portfolio construction perspective. We continue to favor growth stocks unless the manufacturing index rises above 55 or 10-year government yields reach 5%.
EUROPE EQUITIES
We remain negative on European equities and underweight cyclical sectors relative to defensive ones. We expect growth to weaken and underlying inflation to remain high, in line with stagflation. The European Central Bank cannot relax the pressure on price dynamics, which are still important despite the economic downturn. Inflation, which was only exogenous, linked to external shocks, gradually became endogenous due to the length of the inflationary period. This means higher risk premiums.
Despite a slowdown in growth this summer, the labor market remains solid. Unemployment remains at fairly low levels, thanks in particular to improved participation. Unemployment is expected to remain moderate before rising slowly by 0.2 pp to reach 6.6% in 2024. Pressure from wage costs is still in its early stages, and margins will be under pressure for several quarters. We expect cyclical sectors to underperform defensive sectors. Industry and energy-intensive sectors are likely to be in a delicate situation in terms of both European and foreign (notably Chinese) outlets.
Eurozone unemployment rate
Sources : Bloomberg & Groupe Richelieu
JAPAN EQUITIES
The Governor of the Bank of Japan has backed down on a possible rise in rates before the end of the year, twelve days after having said the opposite in an interview, arguing that Japan is still not “a situation where inflation and wage growth are stable and sustainable“.
The resilience of activity could be further bolstered by public spending. Prime Minister F. Kishida showed his determination to strengthen fiscal support by hinting at a government reshuffle and forthcoming announcements (a year ahead of his party’s elections) to ensure that the economy continues to rebound.
We expect a great deal of volatility in this market for both equities and currencies, depending on the BoJ’s statements. Stocks experienced profit-taking in September due to their year-to-date performance, as shown by the weekly figures published by the Ministry of Finance (“foreign outflows “.). If the statistics for the next few months show that both growth and inflation are holding up well, and that annual wage increases are on the rise, the BoJ will be able to free itself from control of the sovereign yield curve (YCC) and raise its key rates in the second half of 2024. As long as the BOJ does not tighten its interest rate policy, we are maintaining a neutral position in relative terms on other geographic zones..
Core and headline inflation in Japan
Sources : Bloomberg & Groupe Richelieu
EMERGING EQUITIES
The offshoring of supply chains is a worrying issue, as safety and resilience now take precedence over profitability. Large private Chinese companies have been the driving force behind China’s export growth, building new global supply chains. These companies have also invested heavily abroad. In the end, it’s China that wants to globalize.
The Chinese government has introduced stimulus measures such as tax cuts and business subsidies. However, structural difficulties, such as an ageing population and excessive debt, are limiting the growth potential of the Chinese economy. Chinese growth is recovering moderately, but is unlikely to return to historical levels. Sino-American relations are tense, which could weigh on emerging markets.
Chinese index CSI 300
Sources : Bloomberg & Groupe Richelieu
China’s economy appears to be showing stronger signs of recovery in September, according to SpaceKnow’s analysis of satellite data. Activity around Chinese shopping malls remained at relatively high levels, and cement production has continued to recover since June. However, although these indicators point to a recovery, questions persist as to the sustainability of this trend, given the persistent weakness of the real estate sector. World Economics’ all-sector sales index for China hit a six-month high in September, and the emerging industries PMI index rose to 54 in September.
Source : BloombergNEF
SOVEREIGN BONDS
The withdrawal of central banks continued. In Japan, the latest adjustments to the YCC (yield curve control) have encouraged an acceleration in the long end of the yield curve. This is already contributing to upward pressure on all other global rates, which have returned to their August highs. We believe that the decline in growth potential in the US will allay market concerns about a major Fed rate hike.
Investors will focus on economic growth. The target levels set at the beginning of the year, 4.50% on the US 10-year, have been reached. The withdrawal of all central banks is well integrated and the central bank distortion well corrected, which will now reduce upward pressure. The market has largely taken on board the fact that Jerome Powell will remain restrictive for many months to come. This is now an entry point given our preference for quality. In Europe, conviction is more measured. Germany, which will benefit from a discount as long as it aims to balance its budget, serves as a reminder. Conversely, a precarious fiscal balance in Italy is likely to increase the spectre of a rise in the risk premium. The European Central Bank will have no choice in the face of inflation, which is nevertheless taking hold. With the exception of US bonds, we are maintaining low durations.
US state rates
Sources : Bloomberg & Groupe Richelieu
CREDIT IG BONDS
Despite the sharp rise in sovereign interest rates, particularly in the United States, Investment Grade (IG) spreads remained stable overall, demonstrating their resilience in the face of renewed fears of excessive monetary tightening by central banks. The Investment Grade segment should remain sheltered from fluctuations in the economic environment, and the slowdown in activity that we anticipate should not have a significant impact. Investment grade yields remain at very attractive levels, which should always be protected, especially as the upward movement in sovereign rates will only be temporary in our view, and will be reversed when the lasting pause in central bank activity can be confirmed. With this in mind, maturities of up to 5 years seem particularly attractive. The primary market should liven up, opening up opportunities. Investment Grade corporate bonds will play an important role as income generators in portfolios.
Investment grade credit spread / Crossover
Sources : Bloomberg & Groupe Richelieu
CREDIT HIGH YIELD BONDS
The resilience of High Yield spreads continues to surprise, as they reacted neither to the increasing number of signals of weakness in European activity, nor to the uncertainty surrounding the evolution of central bank monetary policy.
However, investors’ reluctance to invest in the riskiest companies is beginning to show on the primary market, and should gradually be reflected on the secondary market as refinancing conditions remain difficult over the long term and growth remains insufficient. The current economic slowdown will not be accompanied by fiscal or monetary measures, which should contribute to a continued rise in corporate default rates. The persistently low levels of the iTraxx indexes illustrate the discrepancy between investor perceptions, which are still positive (if not overly so), and the challenges of the coming months.
Number of bankruptcies in the United States
Source : Apollo Research, WhaleWire
The US is likely to be more sensitive to rising defaults, given current refinancing levels. In this segment, we’re still focusing on Europe and the crossover segment (the least risky part). Against this backdrop, we are paying particular attention to hybrid IG corporate debt with step-up after call dates on good-quality assets.
High-yiel spreads versus implied equity market volatility (VIX)
Sources : Bloomberg & Groupe Richelieu
EMERGING BONDS
The correlation between emerging and US yields has fallen to almost zero. Accustomed to inflationary shocks, central banks were much quicker to react (from 2021). The disinflation process in emerging markets is proceeding faster than we had previously anticipated – this should enable central banks in emerging markets to cut rates sooner and faster than those in developed countries. The Hungarian central bank cut its key rate for the third time in a row last month, while monetary easing is also being discussed in Poland and the Czech Republic. The correlation with risky assets and the current strength of the dollar lead us to be more cautious. We are waiting for a movement of mistrust to return to the asset class. Should emerging market bonds fall, any loss could be seen as a buying opportunity, given the many positives.
Emerging central bank rates
Sources : Bloomberg & Groupe Richelieu
RAW MATERIALS
Oil consumption has never been so high this year. Saudi Arabia and Russia, via OPEC +, maintain a restrictive policy. Beyond geopolitical uncertainties, the question remains of market balance between shrinking supply and sustained demand.
Without a hard landing for the economy, prices are likely to remain buoyant, without going too far above $100 a barrel for Brent. In fact, moving to this level could have a negative effect on consumers, lowering overall consumption. This would be the opposite of what oil producers want. China will make a massive contribution to this growth in consumption, despite recent signs of normalization. US demand is also robust, supported by positive economic data. To repeat , the energy sector should benefit from this situation. This framework could be a further catalyst for the sector, especially with recent dividend increases and share buybacks.
OPEC production and oil prices
Sources : Bloomberg & Groupe Richelieu
CURRENCIES
USD : A permanently restrictive monetary policy is now widely accepted. In fact, we believe it to be excessive in view of the forthcoming slowdown in growth and inflation. Statistics pointing in this direction should enable the dollar to settle into a downward trend, with the expectation of a reduction in key rates from Q3-2024. We remain negative on USD/EUR, with a 6-month target of 1.12.
CHF: The SNB will seek to allow the Swiss franc to recover partially once inflation has been brought under control, by maintaining a delay in the normalization of monetary policy compared with the ECB, especially as it is much closer to the long-term rate for the key interest rate. The aim of this strategy is to support the Swiss economy, which is highly export-oriented. It will no longer raise its key rates, and may even lower them well before the ECB does. We are negative on the currency.
JPY: Financial investors significantly lowered their expectations of an imminent monetary policy adjustment, pushing it back to 2024, which weighed heavily on the yen. The upward movement is set to resume as the BoJ reassures itself of the permanence of inflation and its ability to be more restrictive. We are positive on the currency.
Currencies against the euro
Sources : Bloomberg & Groupe Richelieu
Allocation table
