INCREASING IMPACT ON MARKETS FROM GOVERNMENT DEBT
As our readers are very well aware, we have been banging on about the dangers of the exceptional (and still increasing) levels of Government debt.
The apathy around these dangerous levels of government debt was brought starkly into focus for us in June when our team attended a high level presentation from a household name global investment management firm – an institution which has more than US$1.3Trillion in assets under management. The presentation by one of their top economists (which followed a presentation from one of their most senior bond investment managers where he spelled out why their bond funds had lost circa -24% in the previous 12 months) centred around how markets always recover from times such as we currently find ourselves in and a plethora of graphs and examples were given going all the way back to the crash in October 1987.
At the end of the presentation, the audience was asked if there were any questions, and there was just one, from me. I asked why, in amongst all the examples and graphs shown and discussed about every other aspect one could think of about, was there no mention of the spiralling government debt, as an example for instance I quoted the US Debt levels, Japan, UK and Eurozone. The answer was “excellent question, then after a pause for thought, she replied “well as long as there are buyers of that debt on the other side, there isn’t a problem”! To my mind the entire presentation was aimed at persuading the investment managers and influencers within the room to keep investing n the markets rather than really looking at the problems that are prevalent in the world today which most certainly influence not only the markets, but the instruments of government, and the abilities of those governments to manage their respective economies properly with the best interests of their electorate at the heart of the decision making.
“How?” I asked, can there be no problem as long as there are buyers on the other side, – that is tantamount to suggesting that if an ordinary citizen with finite means can borrow £100Million then as long as there are lenders, no matter at what cost, then a problem doesn’t exist. The level of USDebt back in 1987 (the date that the presenting economist discussed re the crash in October of that year) was US$2.87Trillion. Just over the preceding 6 months the US had borrowed a further US$4.2Trillion – almost double the amount of it’s entire debt in 1987, – with the total debt now standing at US$33Trillion+ How can it not matter when interest payments have to be made on this massive debt I order to service it and to not go into default. It must be obvious to anyone with half a brain that the huge rise in debt repayments as percentage of the nations GDP would eventually cause government gridlock and ultimate default if it just went on unabated. We saw during Obama’s Presidency that the machinations of government actually ground to a halt over the disagreement between the Senate and Congress about raising their US’s ever-increasing debt ceiling, and recently the Biden administration has had to cancel the debt ceiling altogether until after the next election. On top of that we have the 2 main candidates, one currently in office who cannot string a cohesive sentence together, cannot work out which way to exit the platform he is speaking on at the time, President who is so old that he repeatedly stumbles and falls exiting the platforms and climbing the steps to Airforce One, – versus the other probable Republican candidate who is facing very serious criminal charges and who is largely held responsible for trying to fix the outcome of the last election and rallying his followers to invade the capitol Building. What the hell has happened to the US?
GOVERNMENT BORROWING AND SPIRALLING DEBT IS AN INCREASING TREND WHICH WILL HAVE A MAJOR IMPACT ON MARKETS IN THE FUTURE
Markets are having to adjust to an era of bigger government. Led by the Biden Administration in the US and European Union (EU) authorities, there is a clear trend to governments spending more, borrowing more, and taxing the decreasing number of tax-payers even higher as the unemployment of the younger generations also increases. An increasing amount of youngsters coming through have a sense of hopelessness, as highlighted in China recently, where there are significantly more graduates than jobs, let alone careers, available for those graduates. Worse was the recent spate of mass stabbings in South Korea by youngsters who have never before stepped the wrong side of the law, which was brought into focus when one young man arrested for stabbing 9 people at random and killing 2 of them, when asked why he did it simply replied “I live a miserable life and I wanted to make other people miserable”. The gap between the unspeakably rich and the desperately poor is widening, as are the tax revenues and the spending plans of governments. Social unrest and spiraling debt have to be thought through properly.
The EU has removed the old Maastricht controls over debts and deficits for Member States, preferring a new flexibility to allow them to spend more (and borrow more!). the EU itself has embarked on expensive new policies of its own that entail EU-level borrowing on top of the Member states deficits. US President Joe Biden has set out additional policies to subsidies business, improve welfare entitlements and make health care cost assistance more generous. This has led to some speculation in markets and by ratings agencies over how state debt will fare in the years ahead as more of it becomes available.
The big increases in debt so far this decade financed large payments to people and companies to see them through suspicious pandemic-era lockdowns. This was followed by recovery money to boost restoration of lost output levels. Today, governments are settling into longer-term financial commitments to implement their ‘net-zero’ vision (of net zero fiction!). This will prove costly, as it is requiring large state subsidies to move from petrol and diesel to electric for transport and heating, to out in big increases in renewable power and grid capacity, and to accelerate development of new battery and hydrogen technologies and fabrication. There are also bigger bills for munitions for Ukraine and to promote more home production to cut Chinese imports. However, as the Germans have recently admitted in their quest to move away from reliance on Russia for their energy, – they have reopened their coal mines and increased their nuclear power stations output, – so much for net zero.
US DEBTS ARE COMPOUNDING
The White House’s own forecasts for the US budget see the country running a federal deficit of around 5% of GDP every year from now until 2033. Please digest this……the US forecast would see state debt as a percentage of GDP rise from 97% to 110% by 2033! The forecasts assume increased tax raising 66% more over the period 2023-33 and spending rises of 55% (and just to think that they fought the English in the US War of Independence in 1776 because they wanted to start a nation that paid no taxes and each free man could keep what he earned and be free from the yolk of the taxes of England. Yeah? – how did that work out then?).
The President claims deficit cuts of around US$3Trillion over the time period to achieve these figures, and yet the irony is, is that the only way the US can reasonably cut their real debt levels is by having inflation at the recent levels it has “enjoyed” which reduces the real value of the debt by the annual inflation rate – it is a necessary evil if you will no matter what the rhetoric. Despite this, they are suggesting the cuts are mainly increased taxes on the rich and companies which is bad enough for the economy by itself, – but of course it will not the ultra-rich as they seem to avoid such tax rises. The spending plans assume faster growth in mandatory spending, with a squeeze on discretionary expenditure. Mandatory is based around Social Security, Mideicaid and Medicare, whilst discretionary includes defence. Interest costs soar, doubling over the ten years as the substantial increases in borrowing compound with the higher interest rates. Fitch, the US Rating Agency recently downgraded the US from AAA to AA+ and so the US will be asked to pay more interest as investors money is seen to be less secure now than it was than even just one month ago. Moody’s have also downgraded some US Banks, which might see the US banking sector in trouble and that appears to have gone under the radar in favour of more attention to the LGBTQ and Woke agenda which continues to dominate the popular news. More on the US banking downgrades below.
The Congressional Office of the Budget Summary has produced some largely pessimistic forecasts of the future budget situation. It highlights how discretionary spending including defence is below historical averages in relation to GDP. It points out how state debt would grow more quickly if spending returned to the average.
The forecasts also show that tax revenues are already taking a higher proportion of GDP than the past average. Its base case suggests that state debt will rise from 98% of GDP today to 181% by 2053. That would be eve higher if productivity is weaker, should interest rates move higher over the period than the base case (which has them at 4% by 2053) – and if spending returned to the average of 1993-2022. It also runs scenarios where productivity is up more and where spending is cut more, but they still produce state debt as a higher proportion of GDP over the next 30 years, and this is a real concern.
A Republican president working with a Republican Congress could arrange this, but it would not necessarily lead to lower deficits. Republicans would probably wish to spend more on the military, seeing the current budgets as tight at a time of increasing international tensions. They would want a lower overall burden of taxation, but would probably say to the electorate they could not afford to follow their natural leaning on that one. They would find it difficult to persuade voters to support significant cuts to mandatory programmes in support of net zero ‘fiction’.
President Biden and any democrat successors to him (let’s hope that will not be ‘you know who’) over the next decade will want to relax some of the constraints on spending on supporting people with education and healthcare costs and with general living expenses. They will wish to spend more on promoting the transition to green energy and to electrical power.
BIGGER GOVERNMENT MANIPULATION ON BOTH SIDE OF THE ATALANTIC
It is likely on both sides of the Atlantic the vogue is for more government spending and borrowing, with governments grabbing a bigger role in determining the balance of outputs and incomes in the economy as a result. Both the US and EU have manipulated their capacity to borrow more, but they will find interest payments take up a sharply rising proportion of their spending from an already low base. Higher interest rates will add to the stresses from even higher levels of borrowing to come.
Markets may well want to charge a bit more for government borrowing in the years ahead as they discount the risks as the spiralling debt burden increases yet further out of control. Bond analysts must issue programmes to meet the rising cost of debt service and debt roll over, and start considering the fall-out of debt-defaults. There will be cynical gains to be made as the economy slows, inflation falls and rates hit, and pass their peak.
Equity analysts must determine how governments will spend their extra debt monies and how they will regulate the private sector. As governments spend to exert ever increasing views and constraints over how people should live their lives, plan their meals, and heat their homes in the fictional name of net zero, there will be impacts on sectors and shares that benefit and suffer. Defence shares have already done well from the spending on rearmament.
MORE TROUBLE AHEAD FOR THE BANKING SECTOR?
Following he collapse of Silicon valley Bank which went bust with US$210Billion of assets, and the failure of the Swiss giant Credit Suisse, Private Office Asset management has been keeping a close eye on the banking sector, and frankly it is not good news despite the lack of news-flow on the subject as the governments try to contain panic by suggesting that the banks are all well capitalised and tat there will be no more failures. We have lots of research in the subject, enough for 10 newsletters, and we will be writing again to describe the underlying issues once we have condensed it all into a readable mass1
In this newsletter, however, we will simply confirm the facts in relation to several downgrades of US banks that have not really hit the public domain to any meaningful degree as yet:
Moody’s Investors Service has downgraded the debt ratings of 10 banks by one notch earlier in the month, 5 of which are the biggest US banks, including:
- Bank of America
- Morgan Stanley
- Goldman Sachs; and
- JP Morgan Chase
The downgrades were due to the banks’ shrinking growth and poor profit forecasts. Moody’s also placed 6 other US banks on review for downgrade due to concerns over their reliance on uninsured deposit funding and unrealised losses in their asset portfolios. The US banks on review for a downgrade include the following:
- Bank of New York Mellon
- US Bancorp
- State Street
- Truist Financial
- First Republic Bank
Moody’s also downgraded the deposit ratings of 5 banks in Pakistan due to the country’s weakened creditworthiness and the high interlinkages between the sovereign’s creditworthiness and the banks’ balance sheets.
In conclusion, we are very cautious of the banking sector as a whole, and we remain particularly concerned about the astronomical levels of government debt, and the forecasts of these governments which will add enormous amounts of further debt to existing levels. In respect of the banks, whilst the higher interest rates provide banks with the opportunity to lend out at higher rates, there is an enormous amount of costs involves in adjusting to these monthly rising interest rates and it has a negative impact on the banks balance sheets and potentially their credit-worthiness.
This is why we as a firm are relentlessly working on ensuring that our clients investment portfolios are advised upon, with defence of capital and maintaining as low a volatility (inherent portfolio risk) as possible, – whilst trying to make and take short term gains as much as possible during these challenging times.
Assuring you of our best attention at all times.
Please note that the opinions expressed in this newsletter are those of the author, and they do not purport to reflect the opinions or views of Private Office Asset management and should not be construed as advice.
If you enjoy reading this weekly update, please feel free to share it with your friends and / or family who may also find the contents of interest, and do not hesitate to contact us if you need any help, information or advice yourself about any of the areas covered this week.
Philip A. Simmonds MBA, LL.B(Hons), FPFS, Chartered MCSI
Chartered Wealth Manager | Chartered Financial Planner
Solicitor (company in-house solicitor)
Chief Investment Officer