This week our economist Bob Gay has been touring Europe, giving his latest presentation. Bob’s presentations are always well received and this one appears to have sparked particular interest. Titled, “Debt cycles don’t repeat, but this one rhymes”, Bob’s thesis is that central banks and regulators are offloading risk from the banking system onto financial markets. This leads to the conclusion that macro-prudential and monetary policies do not eliminate global risks but instead simply redistribute them across time and among countries and markets.
One of the headwinds identified by Dr Gay is demographics, and the problem of ageing populations, a topic we have referred to many time in the past. Although we always don’t always agree with the conclusions of rating agencies (did they seriously think Greece was single A in 2008?) but a recent Standard and Poor’s paper on “Global Ageing” highlights a number of risk implications, or potential opportunities, from the effects of ageing populations which are worth considering in relation to global bond investing. Notably, their forecasts on the rising public cost of pensions and healthcare that will come with global ageing (rising to 9% of GDP by 2050) and how this COULD affect sovereign debt levels, yields and long-term sovereign ratings distributions.
They note that although recently some reigning in of excessive pension spending has been observed, “we believe that nearly all countries will face a steep, demographically driven deterioration in public finances in the absence of adjustments in social safety net costs combined with policies that boost growth” otherwise “the median net general government debt in advanced economies will rise by 2050 to 131% of GDP, and for emerging markets sovereigns to 136%”; by which time demographers expect the old-age dependency ratio to have doubled for most sovereigns.
Such high debt levels countrywide highlight significant risks according to Stratton Street’s Net Foreign Asset Analysis (which combines for government, corporate and household debt) but is not necessarily a concern if such debt is owned (or covered) by other domestic savings. Thus an important distinction is between those countries able to finance such potential public deficits domestically (net creditors) and the comprehensively indebted who will need to solicit international creditors in order to fund care for their retirees et al..
The former will likely retain more fiscal credibility and thus lower (or more negative) yields as well as their higher (single-A-and-above) credit rating. The latter could see their ratings deteriorate along with a less benign environment for the yields demanded on their debt. Indeed Standard and Poor’s forecasts on long-term sovereign ratings distributions (assuming current policies!) show the percentage of sovereigns rated A-and-above declining from two thirds to under 30% by 2050.
Under such a scenario one could argue that downwards is the most likely direction for yields amongst the shrinking pool of high rated sovereigns even if they borrow heavily to lock in low rates and help fund their pension liabilities. That is, assuming they also run a primary surplus and the household and private sectors continue to save and invest (i.e. an insignificant trade deficit) which is quite likely with a population pyramid containing more retirees. Such fiscal requirements and funding for an ageing populations pose deflationary pressures as the persistent negative rates induce frugality for those attempting to live off interest income (and should governments attempt to counteract such deflation and raise short term rates there is also the potential for an inverted curve).
These are only distant scenarios extrapolating existing policies which will of course adapt to varying degrees of success and opposition. But it does highlight the mounting risks associated with indebted countries trying to attain primary surpluses in the face of many unfavourable factors including demographics. The major problem with adapting existing policies of course is that we already know the number of people who have been born and that life expectancy has been rising. Consequently, policies designed to allow for this should have been in place many years ago. Fortunately for us though, it is precisely because we know which countries are ageing (most of them) and which countries have taken the necessary steps to cope with this (virtually none of them) that we can identify the countries that will see an improving credit profile and those that are likely to deteriorate.
Dr Gay ends his presentation with a reproduction of a chart published by Princeton Economics which shows that economic cycles seem to exhibit 8.6 year cycles. This chart shows that the business cycle peaked in 2007, just before the crash, and again in late 2015. We all remember 2008 and the sell-off that occurred late last year and on first inspection the chart does not appear that interesting - until you realise the chart was first published in 1997!