Article by Edward Harrison of Bloomberg

The article below is by Edward Harrison, senior Editor at Bloomberg. The article puts into context deficit spending and high interest rates. I have added a few explanatory words in parentheses. His main points are:
  • Government spending around the world will remain high because of security issues (wars), infrastructure, and imperative needs (climate change).
  • Governments are spending more money than they receive in taxes, therefore increasing deficits.
  • Higher interest rates are needed to attract investors to buy the government bonds needed to support the spending.  
  • Globally, 88 countries will hold elections this year and it is unlikely that candidates will announce they will raise taxes to reduce deficits. They would lose the election if they did.
  • Increasing and high interest rates will be bad for bond investors.
  • The economic stimulus created by deficit spending on the part of governments accelerates economic growth and can be good for risky investments, such as stocks. Stocks benefit from economic growth because the growing economy boosts profits. Recall from my recent note that companies can pass along the higher costs of doing business to their customers (https://marketresilience.blogspot.com/2024/04/weekly-note-april-10-2024.html).

Global Deficits Will Keep Interest Rates High

By Edward Harrison

(Bloomberg) -- For the first time in nearly 60 years, the US government is attempting to effect fiscal stimulus to both increase social well-being and stave off geopolitical threats. That (1970s) episode ended in high inflation. This time the guns-and-butter policy is global. And so, it makes sense to think inflation, and therefore interest rates, will remain somewhat elevated. How that will affect asset prices is not yet clear.  

Deficit spending is here to stay

I was scrolling through Bloomberg’s website this morning to catch up on the news when I saw a piece that put everything into perspective for me. The headline? Climate change to cause $38 Trillion a year in damages by 2049. Don’t get me wrong; this newsletter article is not going to be about climate change per se. Instead, I am thinking about the pressing and sundry reasons that will fuel persistent fiscal deficits globally for years to come.

In a world in which those deficits act as stimulus for the private sector, the only logical conclusion is that monetary policy is likely to be tighter to offset those deficits. The combination means higher near-term economic growth, persistently higher inflation and higher interest rates. For investors in government bonds, that’s going to be bad news, at least until long-term interest rates stabilize at a higher plateau and then decline. But then bond investors can join savers in reaping the benefits of higher rates while equity investors will have to judge whether discount rates or (profit) growth end up mattering more.

Secular trends pushing up inflation will also push up deficits

Let’s start this piece, not with climate-directed deficits but, with the secular forces I mentioned last week as keeping inflation higher. The three big ones are increased defense spending, de-globalization and a relative dearth of seasoned workers as Baby Boomers are replaced by the Baby Bust generation. Of those tectonic shifts, only the demographic trends won’t be driven by government directive. Add climate- and infrastructure-led spending to the mix and you have a triumvirate of secular trends — security spending, re-shoring, and infrastructure investment — that governments around the world will take an active role in fostering. To use a phrase from the Cold War days, we’re talking about guns-and-butter (the government spending money to fight battles AND keep people fed) fiscal spending.

The pandemic started this. We hadn’t had a global pandemic of such horrifying magnitude for 100 years. And so, all the rulebooks on government spending, debt and deficits were torn up as countries struggled to keep people from dying while also keeping the economy afloat. Having just left that period with climate-related disasters and geopolitical tensions front and center, governments are alert to taking the same tack to the aforementioned almost existential problems. And that has relaxed deficit taboos everywhere.

Take Italy, for example. The country expects a deficit of 4.3% this year and 3.7% for 2025. That’s certainly down from the still pandemic-influenced level 7.2% in 2023 but it’s well above the now defunct Maastricht criteria on debt and deficits in the EU. And the 2025 level is higher than previous government projections…

The world’s two biggest economies, the US and China, are very much leading the charge on this level. In recently published remarks, the IMF says, “in both economies, public debt is projected under current policies to nearly double by 2053.”

Deficits are money in your pocket

Here’s the thing. Unlike monetary policy, which acts with long and variable lags because its transmission to the economy is uncertain, fiscal policy works straight away. Deficit spending is basically money in your pocket. The government spends money into the economy and then claws back some percentage of that through taxes. If it taxes us less than it initially spent, it has basically created a windfall for the private sector.

For every dollar of deficit, advanced economies issue government securities with interest that cover those deficits to the penny. And so deficits translate penny for penny into a net increase in non-government financial assets as this government debt is the usually considered the safest benchmark financial asset in any currency area (though the eurozone complicates that concept). This is exactly why people talk about deficit spending needing to increase during recessions as fiscal stabilizers like unemployment insurance kick in to prevent economic freefall.

Think of how this worked in the pandemic during lockdowns. Governments around the world told you to stop working in order to prevent the spread of Covid-19 killing millions more. Many people were thrown out of work due to that shutdown of the economy. But knowing that the loss of income from large swathes of the population would cause a Great Depression, governments simply created money by fiat and credited people’s bank accounts so they could live as if they were receiving a constant paycheck from work.

Having spent that money into existence by keystroke, they then issued government debt to cover most of the spending. Governments didn’t increase taxes to cover the additional spending because doing so would collapse the economy. They simply let deficits balloon. And the result was a massive net transfer of assets into the private sector. We ended with an economy that saw a temporary collapse in output from being idle but that had the financial assets to make up that loss over time, preventing the short, sharp recession from having a measurably negative impact on financial assets and home prices.

How much money are we talking about

If we want to get a sense of how much governments are adding to demand today, the IMF’s recently-published figures are a good place to start. They estimate that the primary deficit, that is the percentage of government spending not covered by tax receipts not including interest expense, was 5.5% in 2023. In 2024, a year not affected significantly by Covid-19, they think that percentage only goes down to 4.9%.

What’s more, the IMF notes that “88 economies representing more than half of the world’s population “ will hold elections this year. The reality is you are not going to see incumbent politicians raising taxes in an election year to bring a deficit in check — unless they want to lose the election…

So 5% seems like a pretty good baseline to think of in terms of net transfer from the public sector. And since governments spend 30% or more of total output in advanced economies, we’re talking about 1-2% of GDP added by those deficits. That’s a big change in the baseline rate of growth.

I have nothing to say here about the need for increased defense, infrastructure or government-aided investment spending — nor about how whether that additional spending should be matched by increased taxes. That’s a political question. The reality, however, is that governments across the globe have decided to spend more without taxing more. That policy mix increases overall demand for goods, services and employment in the economy, likely raising the baseline level of inflation.

The Fed gets it now

So after months of inflation coming down as our post-pandemic economy normalized, we’ve stalled. With those added deficits, who says the baseline level of inflation isn’t 3% instead of the Fed’s 2% target. If it is — and I believe it is certainly higher than 2% — the Fed and other central banks have a decision to make. Do they try and get back to 2% by making monetary so restrictive it sends us into a recession or do they accept a higher level of inflation?

It’s a tricky question, in the 1970s in the US, for example, inflation declined after the first Oil Shock for months after the recession ended. Eventually it stalled at 5% though. And then it rose. That’s the outcome central banks are looking to avoid…

But how restrictive do they make policy? And what will be the impact on inflation? We don’t know and neither do they.

At a minimum, the Fed gets it. Just this week Fed Chair Jerome Powell said we will see the Fed’s target fed funds rate at these levels for longer than he had anticipated. He’s not making a judgment on whether inflation is permanently higher or whether the Fed will tolerate 3% inflation, mind you. He’s just stating the obvious that, with core consumer price inflation (CPI) close to 4%, more work needs to be done before the Fed cuts rates.

What that means — with the Fed’s target fed funds rate stuck at 5.33% and 10-year yields more than three-quarters percentage-points lower — is that long-term interest rates have to rise over time. After all, why would I buy your debt and pay you less money for taking on interest rate risk for longer unless I thought rates were going to come down? I wouldn’t. So the longer rates stay elevated, the less I and other investors are likely to think rates come down. That means the government must pay higher long-term rates. And all interest rates across the economy rise as a result.

The lesson for (bond) investors is mostly about downside risk

The lesson for holders of Treasury securities is clear then. Hold your assets and prepare for them to be worth less. Now you could hold to maturity and not lose any money. But the opportunity cost means you lose anyway. So holders of Treasury bonds are worse off. And I assume the same is true globally because the secular increase in deficit spending is a secular phenomenon. And what the Fed does has global implications because of the importance of the US dollar.

Beyond that, things get a bit murkier. For fixed income, whether we mean investment-grade bonds, high yield bonds, leveraged loans, private credit or mortgage-backed securities, higher yields on longer-term safe government assets mean higher yields on these other fixed income products too. But higher rates generally mean more financial distress too. So we should expect the spread in yield between government bonds and other fixed income products to go up.

Spreads are pretty low now because the economy has been so good. And for lower-grade bonds, there is always the potential for a credit rating upgrade as the economy holds. So it’s not a hard and fast rule that higher yields mean wider spreads. Nevertheless, on the whole, between higher government yields and spreads, I would expect fixed income products to suffer somewhat in an indefinitely higher for longer period.

Of course, eventually long-term yields peak, either because all of the eventual higher-for-longer impetus gets priced in or because the economy deteriorates and it becomes clear rates will go lower. So the period of pain for Treasury holders is limited. And since, the prospect of higher fed funds rates isn’t on the table yet, many will simply ride it out. When the economy turns down, that’s when lower-rated fixed income products will feel it most.

What about equities? If government deficits are boosting inflation because they’re also boosting growth, I would think the growth side outweighs the inflation side. A better economy makes it easier to discount (higher growth rates) well into the future…

Deficit spending helps risk assets (e.g. stocks)

On the whole, I tend to think the prospect of higher deficit spending is good for the economy in the medium-term and therefore buoys risk assets (such as stocks). Two years ago I wrote about how equities fared during the 1970s. My conclusion was that, equities did really well during the mid-1970s upturn. From the October 1974 bottom to the November 1980 for the S&P 500 you saw a 15% annualized (stock market) return during the worst inflation we’ve seen in a century.

But equities got savaged during the two oil shocks and the two other recessions after guns and butter was adopted before nosebleed interest rates crashed inflation with the economy. So overall, the 1970s was a lost decade as a result.

In the near-term then, geopolitical risks and climate change are likely to add to deficit spending in a way that buoys risk assets. The real question is what happens with monetary policy. Right now, central banks are telegraphing their desire to stick a soft landing. But if inflation remains sticky for longer, that calculus could change, and the probability of a soft landing with it.