Sovereign stress and its impact on bond portfolios

The chief economist at Independent Strategy, Bob McKee, explains why a repricing of sovereign debt and defaults of advanced economies would be “logical” outcomes in the next stage of the financial crisis

The early weeks of summer may have brought a period of calm to the financial markets after a turbulent first half of the year, but by mid-August there were signs the global economic recovery may yet hit further stumbling blocks. After surprising economists and investors with 4.4% GDP growth year-on-year in the first quarter, Japan brought a dose of reality back to the markets when it reported a measly 0.4% growth rate in Q2, well below forecasts.

Perhaps of greater significance was the message that came out from the August meeting of the US Federal Open Market Committee. Following the announcement of weaker than expected economic performance data, Fed chairman Ben Bernanke made mention of the threshold for further easing if the recovery is “faltering” or the outlook worsens “appreciably”. Add his remarks to those made by the likes of Pimco’s chief executive Mohamed El-Erian, where he put a (not inconsiderable) 25% probability on the risk of US deflation, and it amounts to an uncertain outlook.

It is in this context that a recent book published by economics research firm Independent Strategy, Sovereign Discredit! Why Sovereign Debt Risk Is the Next Stage of New Monetarism, is well worth reading for bond investors. The book was written by veteran economists David Roche, the firm’s Hong Kong-based president and chief global strategist, and Bob McKee, London-based chief economist. Sovereign Discredit! follows their 2007 work, New Monetarism, which explained why the credit bubble would burst several months prior to the crisis that took hold in the second half of that year.

As the title suggests, the central concept of the pair’s latest work is that excessive levels of public debt in many advanced economies are unsustainable, and could lead to a repricing of sovereign debt. Such an event would be “an earthquake for financial markets. It would blow a hole in the balance sheets of previously safe financial institutions. That would be a new chapter in the crisis”.

The sentiment may appear sensationalist, but is based on hard, empirical evidence. In the US, UK, eurozone and Japan, public debt is already above the 90% threshold, beyond which fiscal stimulus has a negative impact on growth, which forms the basis of research by US economists Ken Rogoff and Carmen Reinhart.

“That means rich countries will lack a dynamic core to help them grow their way out of their debt spiral by boosting GDP. Indeed, if growth falls below the yields on their bonds, those countries will become sovereign black holes in the universe of credit, with uncontrollably upwardly spiralling debt levels,” wrote Roche and McKee.

Lacking domestic investor bases either big enough, or willing, to support governments running high deficits, rich countries “will have to sate their appetite for funding at the same trough of international savings, which will reprice them to reflect their true nature as risky assets”.

At best, heavily indebted nations would suffer a sharp rise in the cost of debt and weak growth; at worst, say McKee and Roche, there could be a series of debt crises and defaults, only this time they could affect larger, advanced economies. “Such an event would risk plunging the world back into recession or worse.”

The pair are also prepared to put a probability on this. The most likely outcome, to which a 40% probability is attached, is what McKee and Roche refer to as a “dead duck scenario”, involving a long, painful workout of debts spanning five to six years. They assign a 35% probability to a boom and bust scenario, whereby near-term rapid growth is replaced by recession in the next three to five years as global imbalances worsen. The third, even bleaker scenario, to which a 25% probability is assigned, is an outright economic collapse. Under this scenario, with no tools left to deal with problems, the cost of government debt in major economies could spike by up to 200 basis points within two years.

McKee explained further why the current situation is more precarious than most people appreciate. In particular, he disputes the idea that leverage – a major cause of the financial crisis – has been reduced or simply transferred from the private to public sector.

“Household leverage or debts have come down a little in the US and the UK, but they are still higher than in 2007. It’s the same with corporate sector debt, which has continued to rise. That sector is in a better position in relation to assets and cashflows, but the debt hasn’t fallen. What we have is an explosion of sovereign debt on top of existing leverage rather than a switch,” he says.

According to McKee, the size and speed of the increase in sovereign debt has only been matched in wartime. But in those instances it was usually specific to the countries engaged in the conflict, and subsequently they could deleverage over a number of years. In peacetime, and across such a range of Organisation for Economic Co-operation and Development (OECD) economies, this situation is unprecedented, making it more difficult to address.

“The course of reducing debt is either going to entail a series of defaults, which could be deflationary, or at best it will produce a much lower rate of growth for the major economies because it will cause a crowding out effect on the private sector,” he says.

“In our figures, 25% of world savings are being absorbed just by government debt; in the case of the OECD it is 50%. The savings that will be sucked up and sustained over the next decade are going to be extremely high, making it difficult for the private sector – particularly the production sectors – to get the funds they need. So leverage hasn’t gone away, it’s just been added to.”

In the past, a favoured option of governments to tackle high debts was to open up the printing presses and inflate their way out of trouble. But given the prevailing trend towards fiscal austerity, particularly in Europe, McKee views the inflation option as unlikely. And while he concedes that austerity is painful and by no means a cure for all ills, it will have benefits over the long term.

“If you delay dealing with debts and deficits, you will create higher interest rates, lower growth and productivity, while investment and unemployment won’t come down,” he says. “If you dealt with fiscal policy properly, I’m not convinced there would be a double dip. The empirical evidence such as it is shows that countries that adopt fiscal austerity measures early achieve better growth afterwards.

“At the levels of debt we are talking about now, the option of continuing with a Keynesian stimulus programme is probably the worst option. It would be better to cut the deficits and debts, even if it is painful for a year or two, if you want longer-term sustainable growth,” adds McKee.

Default setting

But what of the possibility, suggested in the book, that a series of advanced economies could default? McKee reiterates that, while unlikely, there is still a chance of countries such as the UK, Japan and even the US finding defaulting investors may lose confidence in their ability to refinance.

Of the three countries above, the UK benefits from having the longest debt maturity profile in the OECD, giving it flexibility in terms of timing its visits to the market. “But the US and Japan have quite short maturity profiles – less than six years. Spain is an even more extreme case: it has to virtually refinance its debt annually. Spain is a big risk for default and even the bigger economies down the road could be under threat,” says McKee.

“We are not saying it is likely, only that the risk has increased. If you’ve got some kind of ricochet effect and investors lose confidence in sovereign debt, you could get into that picture. That is a frightening thought because it will mean global recession,” he adds.

The more optimistic economists and investors would suggest advanced countries could be dragged out of their current malaise by emerging economies such as Brazil, Russia, India and China – the Bric nations. Pessimists, pointing to the fact the combined output of Brics constitutes around 15% of GDP, believe it is unrealistic to expect these economies to trigger a recovery. On this issue, McKee is more in agreement with the pessimists, even though he thinks in the long term the Brics have “tremendous potential”.

“Experience has shown that when there has been any downturn in the OECD, this has generally affected even the Brics. Obviously their economies haven’t collapsed, but China’s growth last year fell, forcing it to introduce its own stimulus package to boost growth. India’s rate of growth also fell, but none of these collapsed. That means they clearly have a dynamism of their own,” he says.

“But if we had a major debt default crisis in the advanced capitalist world, I can’t see how Brics would avoid being damaged by that.”

Regulatory reform

Given that the current woes of governments can be traced back to the financial crisis and the bursting of the credit bubble, which Roche and McKee predicted in New Monetarism, it is worth asking whether the current process of regulatory reform will help prevent similar future crises. Regardless of what industry 
lobbyists may say about higher capital requirements having negative effects on growth, McKee says tough measures are essential.

“It is not the responsibility of governments and central banks who regulate them to bail banks out. There are a few real issues at stake – capital requirements and the mismatch of assets and liabilities, the level of leverage involved, and making these institutions transparent so that central banks know what they should be regulating,” he says.

“We need to have some benchmarks to gauge when a bubble is materialising, and I think it is possible to do that. When leverage reaches a certain level relative to GDP growth, and bank leverage reaches a certain level, you can reasonably ask whether a bubble is building up. There are some specific anti-cyclical measures that should be introduced: specifically, banks need to be building up capital reserves during the good times.

Nevertheless, while McKee says such measures will prevent major crises for a period, experience tells him that, longer term, there is a force more powerful than regulation.

“We may have a regime for a decade or so where banking institutions have traditional restrictions and regulations and are separated from investment; and leverage will be kept under control. But I suspect that, human behaviour being what it is, the power of markets will at some point override the regulators. Rules and regulations get taken away when people decide they are no longer necessary,” says McKee.