What are the investment implications of mounting government debt post-Covid?

The Covid-19 crisis has had a seismic impact, necessitating yet another substantial policy response from governments and central banks to limit economic damage. This has brought to the fore a myriad of policy questions about public healthcare provision, economics and inequality.

The question of how to pay for the large amount of debt incurred as a result of the essential support packages across the globe is highly complex. It will be a crucial factor in considering both economic and market outcomes in the short, medium and long-term. We believe it could result in long-lasting fundamental shifts in the overall financial policy framework.

Ultimately, we see a likely rebalancing of the policy mix, with fiscal measures becoming more prominent, and monetary policy less dominant. Effectively we think this amounts to the gradual and unofficial introduction of ideas and concepts associated with modern monetary theory (MMT), particularly in developed markets. Although political obstacles remain significant, we think inflationary concerns, rather than budgetary considerations, will be the key constraint on policy.

The (relatively) good news is that there is an element of political choice, allowing societal preferences to influence eventual outcomes. The bad news is that these competing choices will most probably involve trade-offs and “loss allocation” between different stakeholders. 

What is Modern Monetary Theory and what role will it have?

Modern monetary theory (MMT) essentially goes against the idea that a country’s finances need to be managed like a household budget or corporate balance sheet. A government, the theory asserts, doesn’t need to “balance its books”. Its ability to effectively create money (provided it controls its currency) means it can never become insolvent. Instead, it is inflationary consequences that will act as the binding constraint on a government’s ability to raise spending or cut taxes.  

Given the disregard for budget deficits, this appears too politically toxic to become official policy at this stage, but continued substantial fiscal support looks all but essential to sustain the current fragile recovery. We would welcome that support extending well into 2021 though budget deficits will be extremely high. Reducing support too soon could ultimately end up worsening debt profiles due to the permanent loss of economic output.  

Could increased productivity offset mounting public debt?

Assuming the Covid crisis is brought under control, the focus will turn to dealing with the vast public debt.

The optimistic scenario over the medium term relies on “growing our way out of it” through increased productivity. The fall in productivity and the narrowing of its distribution in recent years is a significant concern. It has contributed to lower growth and rising inequality.

Boosting productivity could help to address both problems and would therefore be a desirable solution, but it is not easy. There are a number of longer-term global factors to contend with. Increased industry concentration seems to have resulted in lower investment and innovation, and thus weighed on productivity. This partly reflects positive factors, such as successful businesses establishing dominant positions, but also increased spending on lobbying to retain dominance and weakening of competition enforcement.

The other danger is that addressing issues such as inequality can be an opening to populist or simplistic “slogan politics”. Structural reforms are politically challenging, but the debates around a post-Covid landscape could allow some of these challenges to be addressed. Ultimately, it would be beneficial for fiscal policy to be formulated with a view to improving productivity and not just boosting short-run demand.

If not increased productivity, then what?

Our base case is that any productivity gains will be relatively small and overall growth will remain low relative to history.

Dealing with higher indebtedness will then come down to four possible options-

• outright debt cancellation
• inflation
• financial repression
• fiscal consolidation.

Debt cancellation is highly unlikely, so political choices will largely determine which combination of the three remaining alternative strategies will be deployed.

Inflation

The inflation path relies on the “miracle of compounding”, whereby rising prices erode the real value of debt over time. With 2% annual inflation the price level rises by around 22% over a decade, with 3% and 4% those numbers jump to 34% and 48% respectively.

The notion of a significant rise in inflation looks potentially challenging. Policymakers have struggled to generate consistent 2% inflation over the past decade, even amid historically low unemployment and ultra-low interest rates. Is it then plausible to expect to be able to achieve it amid even more challenging economic conditions?

Inflation expectations are low and seem to have been reinforced by central bank efforts to target specific inflation levels. Rising expectations could then start to play a role. We would be amazed if there were no financial market or real economy implications of policymakers announcing an intention to target 3-4% inflation instead of 2%.

We are seeing movement to at least shore up existing targets. The US Federal Reserve (Fed) moving to average inflation targeting for instance is a step, albeit small, in the direction of higher targets.

Financial repression

This can come in many guises, but it is certainly consistent with keeping real interest rates (interest rate minus inflation) negative for a sustained period of time, and ever-greater central bank intervention in financial markets.

The US Fed is lukewarm on policies such as explicit yield curve control (YCC) at this juncture. This is where a central bank purchases bonds to keep yields at a particular level, as the Bank of Japan (BoJ) has done. But it is likely to remain part of the policy discussion.

Financial repression is not new. Rates were kept low in the immediate post-war years to help alleviate debt burdens, and the 2007/8 global financial crisis (GFC) was followed by several years of negative real policy rates.

What seems different this time, however, is the degree of inventiveness of central banks. Markets have moved a long way to discount this recently – the real yield on ten-year US government debt has fallen roughly 50bps to -1% in the past three months – it is not obvious why this should reverse substantially anytime soon.

Fiscal consolidation

This will be needed or considered depending on the success of the aforementioned policies, and also political decisions. Some degree of fiscal tightening will be needed, as the present level of support measures is unsustainable, but the magnitude and pace of the tightening will be driven as much by political as economic considerations.

Austerity is highly unpopular, while there are ever greater demands on public spending due to demographics and the renewed importance of healthcare. Higher taxes will surely account for a larger proportion of the fiscal consolidation than was the case post-GFC.

The degree to which fiscal consolidation is required will be a key debate over the coming years. We find MMT a useful framework with which to analyse the policy choices faced by both politicians and electorates. MMT is widely interpreted, wrongly in our view, as offering a “free lunch”, whereby governments continue to increase spending, even beyond their means, with few or no trade-offs.

We see it differently. MMT does not suggest government deficits can rise indefinitely as rising inflationary pressures will ultimately be a check on policy. Currently, we have central banks concerned about inflation expectations becoming permanently lower, and monetary policy stimulus proving fairly ineffective for real economy activity. MMT suggests that a combination of continued fiscal stimulus and low interest rates is not just possible, but advisable.

At some stage this twin policy, if maintained long enough, will see inflation expectations rise to a level that delivers a socially undesirable outcome, and thus policy tightening will be required. Inflation, rather than ability to finance debt, must be our key yardstick. 

What are the implications of all this for markets?

We believe these political choices will generate differences in fiscal policy that will become more apparent. They will create volatility and opportunity, especially in foreign exchange markets, and cross-market opportunities in interest rates, particularly in longer-dated maturities.

We think it is still unlikely that overall financial policy will become fully dominated by fiscal measures, but they will become more important within the policy “mix”. Differences in bond market or currency performance between countries is likely to become more dependent on fiscal policies. Countries with well targeted, growth-enhancing policy will likely be rewarded relative to others. 

With this in mind, we remain very positive on the recent developments in the eurozone. Although the market has clearly become more encouraged on the cyclical dynamics, we believe there is still scepticism around the long-run efficacy of the recovery fund and its impact on trend growth. We appreciate where these concerns arise from, but we do not agree. We believe this well designed package could be a template for other fiscal authorities to follow, and thus retain our positive long-term view on the euro currency.

Historically, monetary policy meetings have received greater focus, while fiscal policy developments have often taken a backseat when thinking about macroeconomics. In the period to come, we think it will be vital to devote just as much time to thinking through the evolution of budgetary decisions as interest rate decisions.