Will Government Debt be the Next Big Thing for Bond Markets?

The Greek poet Archilochus wrote, "The fox knows many things, but the hedgehog knows one big thing." Global bond markets are typically more hedgehog than fox: they focus on “the one big thing.” Since 2022, that big thing has been the COVID-19 pandemic-driven inflation surge and the efforts of the G-20 central banks to bring it down. Interest rate hikes have done their job; inflation is falling nearly everywhere, and (ex-Japan) the global rate cycle has turned towards ease. Unfortunately, a host of fiscal challenges has left G-20 governments in a worse fiscal place than before COVID, and many of these governments have, or can expect, new leadership. In many countries, fiscal policy and its multiple knock-on effects may replace monetary policy as the new challenge to fixed income valuation, in our view. We believe developed market (DM) bond investors may have to consider more than one big thing at a time.

Debt and the developed markets

As a rule, deficits do not matter until they suddenly do. Post the global financial crisis and pre-COVID, debts and deficits often did not matter, as real global interest rates were zero or negative (euro crisis excepted!). This is no longer true: debt once more has a real cost. Across DM economies, a broad pattern of structural and cyclical debt and deficit deterioration may point to a future of slower growth, higher taxes, and steeper and more volatile yield curves. Going forward, a narrow focus on central bank interest rate cuts may be an inadequate guide to the performance of longer-duration securities. Here’s a look at debt burden factors by country.

• New president unlikely to be able to reverse deteriorating US debt-to-GDP ratio.

If Vice President Harris wins, we would expect a divided Congress with a Democratic House and Republican Senate, and limited ability to pass major new legislation. Policy continuity points to a federal deficit of about 6% of GDP, split evenly between primary deficits and debt service.[1] COVID spending sent the federal debt stock from 79% of GDP in 2019 to 99% currently. Current policies look set to increase the debt to GDP ratio by 2% per year continuously.[2] If former President Trump wins, we would expect a Republican Congress and more policy changes. This might be a combination of deregulation, tariff hikes and other tax cuts, whose net effects might well widen the deficit further, while boosting goods inflation somewhat. A continuous deterioration in the US debt-to-GDP ratio implies a bond investor protest, but the timing is hard to pinpoint, in our view.

• In contrast to the US, the growth rate is the problem.

The debt-to-GDP ratio jumped from 60% to only 69% during COVID, then fell back to 63% currently. The federal deficit is under 2% of GDP.[3] Real GDP has been flat for two years, and forecasts for 2025 anticipate only a 1.0% growth rate.[4] We believe this is too low to meet the structural challenges of reviving the national export engine, rearmament in a hostile world, and the green energy transition, let alone reviving voter incomes. Centrist parties have lost voters to the fringes, especially in eastern states. The federal election will be in autumn 2025. In our view, the federal debt brake may not survive, as a future coalition may well favor growth over fiscal rectitude.

• Higher debt than the US and weaker growth.

The debt stock, already 100% of GDP in 2019, jumped to 117% during COVID before falling back to its current 111%. Unfortunately, deficits of 5% are too high to permit further debt consolidation. Real growth is running at 1.1%.[5] A three-way split in parliament between right, left and center makes any policy change unpredictable. But both right and left want to spend money—something France arguably does not have.

• Just outside the 100% club, net government debt at 98%, up from 80% pre-COVID.

Public sector net borrowing is forecast to fall to 3.1% of GDP in fiscal year 2024/2025 from about 4% in 2023.[6] GDP growth is 1.1%, expected to be little changed next year at 1.4%. The new Labour government hopes to continue fiscal consolidation, mostly via selectively higher taxes and hopes that higher growth can be sustained.

Emerging markets: the fox unseats the hedgehog

This year, adverse fiscal surprises in emerging market sovereigns have produced losses for currency and bond investors, while positive fiscal surprises have generated gains. In our view, DM bond investors should take note of these examples.

• A cautionary tale of government deficit surprising markets.

The current gross debt-to-GDP ratio of 77% is barely up from 74% in 2019 pre-COVID. But the recent deficit story is alarming. On a trailing 12-month basis, the nominal deficit jumped from 3% of GDP in 2022 to 10% of GDP this summer as spending surged and primary surpluses turned into deficits.[7] Brazil has some of the highest inflation-adjusted real interest rates in the world. Investors were unnerved by projections for future debt levels implied by current policy. The real lost 15% of its year-end 2023 value.[8] The 10-year bond yield jumped from 10.37% at the start of the year to 12.16%,[9] even though CPI inflation was only 4.5%.[10] Capital loss wiped out the coupon income for a zero return in local terms. A difficult fiscal tightening now looms.

• Questioning country’s reputation for fiscal sobriety.

Claudia Sheinbaum and her Morena party won massive victories for the Presidency and Congress. This may permit constitutional changes, including changes in the autonomy of regulatory agencies and the election of Supreme Court judges, which we believe may unsettle some market participants. The government deficit jumped from 3.2% of GDP in 2022 to 5.7% this year.[11] Compared to Brazil, this is a rounding error, but the deficit jump to over 5% is a sharp contrast from Mexico’s longstanding habits of fiscal sobriety. In most years, deficits have been below 2% of GDP, which enabled Mexico to cut its debt-to-GDP ratio over time to 41% in 2019. The COVID debt jump was about 5%. It remains a low 49%.

• Market-moving positive fiscal surprise.

Newly elected President Prabowo campaigned as a populist, featuring a new school lunch program to combat widespread malnutrition in poorer villages. Government savings elsewhere will now fund this, and the forthcoming fiscal deficit should be about 2.5% of GDP. Both the currency and the local bonds have rallied on the news as foreign investment in local markets has jumped. COVID and its aftermath increased the government’s debt-to-GDP ratio from 30.6% to 39% between 2019 and 2024.

Caveats and cautions

First, the caveat: we have not discussed Japan, China, or India in this note because these three important government bond markets have dominant local investor bases, and are relatively more isolated from foreign investor sentiment. They deserve separate examination.

And finally, the caution: bond vigilantes—in the form of market sentiment—appear to be back in the saddle in the emerging markets bond sector. We suspect that they may well be riding toward the developed markets shortly. DM investors take heed—fiscal developments may overtake monetary developments as key drivers of longer-duration performance soon.

Written By:

David Rolley, CFA, Portfolio Manager

Scott Service, CFA, Portfolio Manager, Co-Head of Global Fixed Income

Lynda Schweitzer, CFA, Portfolio Manager, Co-Head of Global Fixed Income

[1] Congressional Budget Office, as of 18 June 2024.

[2] Bloomberg, as of 18 September 2024.

[3] Bloomberg, as of 18 September 2024.

[4] Bloomberg, as of 18 September 2024.

[5] Bloomberg, as of 18 September 2024.

[6] House of Commons Library, D2, Public Finances, Net Debt, % GDP, Economic Indicators #02812, data as of 21 August 2024.

[7] Bloomberg, 2022 as of 31 March 2022; 2024 as of 30 September 2024.

[8] Bloomberg, as of 1 August 2024.

[9] Bloomberg, as of 18 September 2024.

[10] Bloomberg, as of 31 July 2024.

[11] Bloomberg, as of 18 September 2024.

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