- Macro Strategist
Switzerland, Intermediary
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As we look to the second half of 2024 and beyond, we’re watching governments’ deficit spending and the potential for it to fuel higher rates. To prop up their economies during the height of the COVID pandemic, governments across the developed economies engaged in unprecedented fiscal stimulus campaigns. Four years on, that massive spending has yet to be reined in. The rationale may be justified, but failure to adopt fiscal discipline could eventually come back to haunt governments in the form of higher borrowing costs.
Governments have been slow to reduce deficits for two reasons:
- To protect the economic recovery from additional shocks (e.g., European government expenditure to shield consumers from a spike in gas prices).
- Climate change and defence represent new structural demands on government spending.
In addition, politicians tend to spend in election years, and the massive global election cycle this year across the developed world has worked against fiscal restraint. Data from LSEG Datastream (Figure 1) shows that the cyclically adjusted deficit of developed economies is at nearly 7% of estimated GDP; this is as large as it was in the depths of the global financial crisis, and only marginally better than the budget deficits throughout COVID.
Figure 1
Deterioration in deficit dynamics
Over the past two years, 85% of developed economies have seen fiscal slippage. On our calculation, there has been an average slippage of 4.5% of GDP during that timeframe. Fiscal slippage, in simple terms, refers to any deviation in a government’s fiscal consolidation plan beyond what was planned. Worryingly, these big deficits have occurred at a time when nominal growth is booming because of strong inflation dynamics. This strong nominal growth has boosted countries’ tax revenues but rather than saving that inflation dividend, governments have spent it — implying a significant deterioration in fiscal resilience.
Evidence of the market repricing fiscal risk
While UK inflation has remained elevated, it is also true that gilts have not entirely recovered from the mini-budget debacle in 2022. Also, there has been a clear repricing of French debt by investors, with spreads widening relative to Germany and the Netherlands and narrowing relative to countries like Spain, which has a similar debt level but stronger deficit dynamics.
On the whole, however, the market appears relatively calm about fiscal risk despite the mounting negative deficit headlines. That could be because the market is more focused on debt-to-GDP ratios. In Europe, there is strong evidence that country spreads are more correlated with the change in the debt-to-GDP ratio than the deficit data. The debt-to-GDP ratio has been a lot more benign than the deficit slippage would suggest because:
- Term premia remains relatively low, which has limited the rise in interest costs; and
- Strong nominal GDP growth has helped pull these ratios down (a denominator effect).
Implications for government borrowing costs
If term premia were to rise more significantly, or nominal GDP were to turn over, these robust debt-to-GDP dynamics would fade quickly and the market could take notice. A deterioration in nominal GDP is particularly powerful because it has an immediate impact, whereas rising term premia lift the average interest cost slowly given longer debt maturities. A hawkish shift in monetary policy would likely be necessary before a more significant rise in term premia or deterioration in nominal growth.
Developed market central banks have seen high inflation as largely a supply-driven phenomenon, and so something that should normalise over time — as long as there are no second-round effects on inflation expectations and wages. As a result, policymakers have been reluctant to tighten policy to levels that push growth below trend and create the large amounts of slack needed to bring inflation back in line with their targets. If that were to change — perhaps on a reappraisal of the risks around inflation — and policy were set at a much more restrictive level relative to growth and inflation data, that could be the catalyst for the market to worry more about these fiscal dynamics, especially in the US, UK and France, where levels look most susceptible.
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