Markets Weekly podcast

Julien Lafargue (JL): Welcome to a new edition of Markets Weekly podcast. My name is Julien Lafargue, Chief Market Strategist here at Barclays Private Bank, and I will be your host today.

The first part of this podcast is usually dedicated to offering some insights on the recent developments in financial markets. However, today, these feel somewhat irrelevant. Indeed, as many of you may know by now, Henk Potts, the original host of this podcast, passed away a week ago today.

Henk was much more than a colleague. For many of us he was a friend, and I’m sure he was too for many listeners of this podcast. That’s why, today, I wanted to pay tribute to Henk. To be honest, I’m not sure I’m the best placed to do so. After all, I only crossed his path for the first time five years ago. 

Not only that, but it is probably the hardest thing that one can do. How do you come up with and deliver a speech for someone who was one of the best presenters and speakers in this industry?

So, maybe I should simply reiterate what everyone says about him: a gentleman, larger than life, an exceptional human being, caring, kind, incredibly professional, talented, fun, precious, intelligent, cheerful, thoughtful, smiling. I could continue like this for a while but, let’s face it, I will never be able to say as many things as Henk in five minutes.

I will just add that I have never in my career met anyone who was so passionate about his work. Throughout his 26-year career, Henk took us thousands of times on a million whistlestop tours through the turmoil of the financial markets, and I would pay a lot of money for another ride right now.

You left too early, my friend. Even if I translate your time on this Earth into Henk’s time, where 10 minutes is really 15 or 17. May you rest in peace, assured that you’ve changed this world for the better. Henk has kept the show going for as long as he could, even when his body was failing him. And the least we can do is to do the same.

So, with that, let’s move on to the guest segment of this podcast. And, today, Lukas Gehrig, Quantitative Strategist here at Barclays Private Bank, is joining me and has the very difficult to task to follow up on that message.

But we’re going to cover a topic that is top of mind for many investors, sovereign debt. Lukas, again, thank you so much for being here today. We’ve just published the latest edition of Market Perspectives, our monthly report, and this particular edition delved into the issue of government debt, its sustainability and its potential impact.

So, let me start by asking you a direct question. Should we be worried about government debt levels?

Lukas Gehrig (LG): Well, thank you for having me today, Julien. I believe that the loss of our host Henk will also be felt by our listeners. You know, for me, Henk was kind of the musician of macro news and financial markets. Whether it was boom or bust, a pandemic, or the occasional debt crisis, Henk could play all the tunes and turn them into a catchy melody. 

And, on that debt sustainability melody that you just mentioned, I don’t think we should be worried right now, but we shouldn’t be complacent either. The constant debt ceiling debate in the US, those events might have encouraged some complacency because nothing really bad ever happened.

But think back a bit further to the euro debt crisis in ’13, ’14 and ’16, or closer to home in 2022, the Liz Truss mini-Budget moment, where the gilt market went on the brakes, those events reminded everybody that financial markets do take debt sustainability seriously.

Now, as you said, debt levels currently they are very high. In the UK, we’re at 100% of GDP. In the US, it’s 120%. And, if you look to Japan, well, Japan’s government debt is even above 250% of GDP. This sounds unheard of, but it’s not actually if you’re willing to look back 200 years.

Because at the end of the Napoleonic wars, that’s about where UK government debt was at. And while it came down again, World Wars I and II brought it back up to 250% of GDP. So the level itself, as astronomic as it may be, is not the biggest issue. 

The biggest concern right now is that these higher debt levels they leave less room for the unforeseeable global pandemic, and they may constrain productive spending that the government may want to engage in.

JL: So you mentioned Japan, which I think currently leads the debt statistic among developed markets, i.e. the country with the largest debt pile. Is that level of debt still sustainable?

LG: Well, Japan is a bit of a special case, but generally sustainability is all about what we economists would say G minus R, or in plain English, how much the economy grows minus how much the government pays to service debt.

The problem, or the difficulty, is that these variables are not static and they have a lot to do with trust, which itself is very hard to measure. 

So, to give you some examples, the cost of debt service could be lowered in many ways, a) you could build trust in the ability to repay. That’s the path that the European Union is taking. Greek and Italian government debt, even with two days’ G minus R difference, should be on an explosive path so never to come back to a contained level again. 

But as the EU as a whole and the indirect link via these ECB programmes that create something like an EU budget shield, those stabilised the interest rates that these countries paid.

The other approach you could take to lower the debt service cost is to make your debt more attractive. That’s the path that the US is taking. US debt is not only the debt of the US sovereign, it’s also the largest and most liquid store of value that an investor can find around the globe. For there’s a huge demand for safe dollar assets, and this demand is further supported by legislation like, for example, the Dodd-Frank Act or Basel III, which all encouraged the use of debt as collateral.

But, coming back to your original question on Japan, the recent events were all about R going up quite quickly in investors’ minds, so the cost that the government is paying, because the Bank of Japan not only raised rates out of negative territory, but they also suggested further hikes down the road.

Now, this got investors worried and very much so before the BoJ had to backpedal to reassure markets that they wouldn’t be hiking into a volatile market environment. So I think the takeaway is that, yes, the levels, even for Japan, are still sustainable but we’re nearing the verge in many developed markets, and some may have more agency than others to reduce their debt burden.

JL: OK. And I guess if we think about how to reduce this debt burden, we have to think about this difference between how much a country grows and how much it costs to fund that growth, i.e. how high interest rates are. But maybe you have more examples of ways how governments can actually reduce that burden?

LG: One option has just closed its window of opportunity, and that is using extended periods of low interest rates. That allows governments, a) to pay lower interest itself and b) to extend the average debt maturity making that more plannable. That’s the path that European governments have taken between the global financial crisis and the COVID-19 pandemic.

But if we look into research on the topic, there was an interesting study by the International Monetary Fund who found that for developed economies, they reduced their debt piles most effectively by real economic growth and positive primary balances, while for emerging economies, inflation has been the most prominent debt reducer historically.

But if we stick to developed markets, this outgrowing debt is actually how US government debt has become more manageable after the second oil shock in the ‘80s. So when interest rates peaked after the Fed’s rigid hiking cycle back then, 11% of government outlays were spent on debt service. Or, in other words, more than $1 in every $10 that the US Government spent was spent to service debt, and this ratio continued to increase for eight more years and rose to a whopping 16%.

It was only then through the prosperity of the ‘90s and, again, real economic growth that debt service has been brought back down again to a manageable 5%. 

JL: So, maybe a last question for you. Do you expect a repeat of that whereby growth would come to the rescue of government, or should we think about US debt service increasing for a while before we get to that point?

LG: Well, let’s look at what the Congressional Budget Office is telling us. According to their projection, yes, US debt service as a percentage of what total outlays are, is going to increase for another eight years before growth should eventually turn it around.

And, actually, the starting point today is very similar to the end of the oil shocks in the ‘80s. Today, the US Government is again spending 11% of their outlays on debt service, but even though the numbers that the CBO bases their calculations on look very reasonable to me, I don’t want to risk a prediction for eight years here. But what I will say is that debt is accumulated very quickly, but debt reduction can be very painful. 

And, as we have just witnessed in the case of Japan, even if debt is held by your own central bank it can be very tricky to unwind. The global interlinkages have to be respected, therefore, kicking the can down the road to the next government is the most likely course of action in developed markets.

But what should investors do with all this now? Well, sovereign debt ratings and the outcomes of Treasury auctions can be very informative. Debt ratings, because they aggregate a lot of information so these agencies, they collect information on demographics, growth potential, inflation, political stability, willingness for reforms, and even the debt structure. They aggregate it all into one symbol, which has been shown in empirical studies that a downward notch in the rating actually continues to affect financial markets for more than a week.

The other thing with Treasury auctions, it’s interesting because they gauge the market’s appetite for more debt. And with green Bills being passed and rising military expenses, especially in Europe, more debt is a guarantee.

JL: Well, I guess we’re done speaking about debt levels. We have a few more years of that ahead of us it looks. Well, thanks a lot, Lukas, and again, listen, we can find all that and more our Market Perspectives report, which is available on Barclays Private Bank’s website.

Now, before I conclude, a few important datapoints this week with the ECB expected to cut interest rates by 25 basis points on Thursday, and before that we’re going to get US inflation figures on Wednesday.

Finally, if you can, I encourage you to watch the Trump/Harris debate on Tuesday night. It should be interesting and possibly entertaining.

With that, let me close as Henk used to do by wishing you all the very best in the trading week ahead.