Bonds Undone, Maybe


Recent rating agency analysis cites negative secular trends in place. Whether fiscal ends can meet will become more an open-ended question as the next decades unfold. Global risk takers should take heed as fiscal circumstances become straitened, presenting greater levels of event and duration risk for fixed income portfolios. At least that’s what’s implied. Developing circumstances will also evoke questions on and invite responses to the growing public policy challenges. What those responses will be will influence the outcomes that current trends entail. Ongoing due-diligence will remain necessary over time.

Just this past week, political compromise won the day and the White House fashioned an agreement with a Republican congress to make certain fiscal concessions and lift the federal debt ceiling for the next two years. Default on US Treasury debt was averted at about a few minutes before midnight.

In a timely way, the Financial Times had printed an article just before US President and Congress managed to cobble together an agreement; the article, “Aging populations ‘already hitting’ government credit ratings”, appeared in the paper’s May 16th edition. While the US fiscal impasse was immediate and particular, the trends the Financial Times reports on are more secular and baleful for fiscal solvency and the credit quality of sovereign issuers across all geographies. What to do?

To start, fundamentals are against us. Working age populations are declining, especially in the industrialized world. The Financial Times cites the findings of the European Commission which prognosticate that the EU’s population share of those over 65 will increase from 20 percent to 30 percent by 2050. Astounding, no other word for it. If not quite matching, similar trends are in store for other industrialized and emerging countries, according to European Commission assessments.

Rising pensions, greater health care expenditures due to aging populations and a long- term increase in interest rates will exert critical pressure on fiscal accounts. Rating agency Standard & Poor’s expects that a “typical government” will be running an annual fiscal deficit exceeding 9 percent of GDP by 2060.  The Financial Times reports, “S&P said in January that roughly half of the world’s largest economies will have been downgraded to junk by 2060, up from a current level of around a third, if measures are not taken to ease the cost of aging populations…”

On that note and given the apparent urgency of reform, the FT quotes Edward Parker, global head of research for sovereigns and supra-nationals at Fitch, who comments, “We are well into the adverse effects (of negative secular trends) in many countries, and they are only growing.” Parker adds, “The longer governments defer action, then the more painful that action (that is, government reform efforts) will be.”

Rising pension outlays, increasing healthcare expenditures, higher secular interest rates coupled with declining demographics together present an insoluble dilemma, so it seems.

But, before wholly ingesting the sober assessments cited in the FT, it’s useful to add some more context.

Total US federal debt is counted at USD31.36 trillion, corresponding to roughly 124 percent of US GDP. By contrast, as of year-end 2021, total US household net worth amounted to USD150.12 trillion, or about 643 percent of US GDP for that year. That net worth figure represents the total asset holdings of US households and non-profits. That sum is drawn from total holdings of corporate equity securities, debt securities, real estate and other assets. The magnitude of this number suggests two things: 1) the success of that economic system – at least insofar as it is able to generate asset value, and 2) the consequent ample availability of credit and “risk capital” necessary toward generating innovation, economic growth and ultimately the fiscal resources necessary to address current and prospective public policy initiatives.

What will be critical for the United States, for example, in the coming five years, ten years and beyond will be how well policy will allow for wealth creation  – that is, ease of business formation; administration of business failure; ensuring improving method, product and technical innovation, and incentives to initiate and innovate; and how well policy will also prune and temper public expenditure – imbuing more pragmatism, empirical analysis and vetting, and productivity enhancements to the delivery of public goods, services and benefits. It can be done. How well this transpires will influence trends, maybe “bending the curve”.

As opposed to just considering issues of demographics, health care costs, and pension expenses as they stand right now and as we extrapolate, the global risk taker will have to consider for any country how well its institutional endowment will allow for implementation of the rough equation noted just above: the dynamic behind generating more economic activity and wealth creation related to the dynamic toward more vetted and productive fiscal expenditure and public sector remit and delivery.

Countries poor at “implementing” this formula will present fresh sovereign crises involving balance of payment difficulties, foreign exchange illiquidity, sovereign default, declarations of incipient illegality which effect sovereign commitment, and perhaps civil crisis, to name a few. Countries good at priming this formula will experience smoother sailing, just maybe.

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