There’s Big Trouble in Global Credit Markets

Government Debt

Back in August the ratings agency Fitch downgraded the USA from AAA to AA+. Janet Yellen, the US Treasury Secretary, was displeased, describing the decision as “entirely unwarranted”. The proximate cause of the decision was the game of chicken that Congress was playing over raising the Federal government’s debt ceiling. But the real significance was that the cost of servicing America’s gigantic national debt is now becoming crippling, even for the world’s largest economy.

Policymakers in the USA, the EU and the UK remain sanguine about the tail risk of a full-blown debt crisis, despite the alarming debt projections produced by the Congressional Budget Office in Washington and our very own Office for Budget Responsibility (OBR). Elite economists like Paul Krugman have argued that our debt-to-GDP levels have been much higher in past history and that the current levels in the USA (120 percent) and the UK (about 101 percent) are nothing to worry about.

But how bad does it have to get before even Professor Krugman starts to worry?

Britain has not run a primary surplus (tax revenues minus government spending less interest costs) since 2001-02. Our debt-to-GDP ratio has been on a continuous upward trend since the financial crisis of 2008-09. It was much exacerbated by the pandemic, when Mr Sunak, as Chancellor, paid people to stay at home. The bills for the state retirement pension, for the NHS and for social care continue to mount relentlessly, in line with our adverse demographics – the nation is getting older and therefore sicker.

(We learnt this week that even 50-somethings in this country have high levels of cholesterol and hypertension which some have attributed to the Deliveroo eating culture – so they will also require expensive healthcare soon. The idea there will be a health dividend from rising longevity is questionable).

In fact, the OBR calculates that if public expenditure continues to rise on autopilot, the UK will have a debt-to-GDP ratio of 300 percent in 50 years’ time. And that assumes that “there is no feedback between the level of debt and the interest rate” – a heroic assumption.

The real problem is that – as I have said many times before in these pages – government expenditure, and not just in the UK, has been rising faster than economic growth. From the end of the Second World War in 1945 until the mid-70s the average rate of economic growth in the UK was 2.8 percent. That was sustained by the adoption of new technology (consider that popular terrestrial television effectively began only at the late Queen’s coronation in 1953), a baby boom and by more women entering the labour force. Now, economic growth is likely to continue at a rhythm of about 1.5 percent per annum – unless productivity rises unexpectedly, and more people who are off sick return to work.

About one quarter of Britain’s national debt is index-linked. So, increasing rates and rising levels of borrowing and absolute levels of debt are driving an explosion in the cost of government debt service costs. This year, the UK government will spend about £100 billion in interest costs. That is much more than we spend on either education or defence – in fact it is higher than any departmental budget except for pensions and the NHS. At about 11 percent of the government’s total expenditure, that compares closely with France – although less than the USA. Bloomberg reckons that annualised interest payments on US government debt climbed past $1 trillion at the end of October. (Remember one trillion equals 1,000 billion). It has doubled in the past 19 months to the equivalent of 15.9 percent of the entire Federal budget for the fiscal year 2022-23.

In Europe, negative demographics make the problem worse. Germany will have 64 pensioners for every 100 workers by 2050. The only way to maintain an affordable level of expenditure on state-funded retirement pensions will be to raise the retirement age, to reduce pension entitlements, or to restrict eligibility for state pensions.

Readers will recall the riots in France that raged in March this year in protest at President Macron’s raising the state retirement age from 62 to 64 by 2030 and raising the number of “qualifying years” from 42 to 43 years (and to 44 by 2034). This is a hugely politically sensitive arena. Many people in countries which have extended entitlement programmes like Britain and France spend years looking forward to when they retire and “put their feet up”. When you adversely change their expectations, they can turn nasty.

Noel Quinn, CEO of HSBC Holdings, Britain’s largest bank by far, said in late October that “There are a number of economies in the world where there could be a tipping point and it will hit hard”. De-coded, this means he thinks that a number of governments will default or, at least, will have to take drastic action to avoid default.

Long before countries default, the cost of borrowing in those countries spikes. Just consider the massive bond yields that Greece had to endure during the European Sovereign Debt Crisis of 2011-15. (How Greece managed to recover from that trauma – essentially, by means of protracted austerity – is something I would like to consider here in due course). That means that the debt burden can become unsustainable relatively quickly. I have quoted Hemmingway in this context before: people go broke “gradually, then suddenly”.

Corporate Debt

Rising interest rates are causing “corporate distress”. In plain English that means that many firms are struggling to service their debt (where debt service is both interest costs and the repayment of loans, though the latter can normally, but not always, be re-financed, though often on less attractive terms). Statistically and anecdotally, default rates are increasing in the USA, the EU and the UK. This is reflected in the rising cost of credit default swaps – a form of insurance against default risk – in the London market.

When corporate borrowers default in increasing numbers, lending banks have to raise new provisions against anticipated future loan losses. That raises their cost of capital, and in response, banks have to raise their lending margins (the interest differential between their cost of funds and the interest income they generate on their loan portfolios).

The consulting firm Alvarez & Marshall (A&M) estimates that $500 billion of corporate debt will have to be refinanced next year. Virtually all these refinancings will be at higher rates.

But let’s just unpick that last sentence. If corporates refinance floating rate debt they will be paying higher base rates (LIBOR – whatever) plus they will be paying higher lending margins on top because the price of risk has gone up. If they re-finance fixed rate debt they will have to pay a coupon with reference to a higher benchmark (the yield on US Treasuries of equivalent maturity – whatever) plus a higher risk premium.

In some cases, the interest cost of mature companies which are financed largely by debt could rocket, thus impacting the bottom line and therefore prospective dividends payouts. As price-earnings ratios decline for large debt-laden companies, so we can expect their equity values to decline. There is always an interplay between the credit and the equity markets, though often it takes time to play out.

Central Banks

Eighteen months ago, they told us that inflation was “transitory” – just a hiccup caused by supply chain bottlenecks arising from pandemic lockdowns across the world. What they will never admit, because of their groupthink, is that they caused it.

I’m taking about the leading central banks, of which the Federal Reserve, the European Central Bank and – yes – the Bank of England. The thirteen years of near-zero interest rates accompanied by massive money printing – so-called quantitative easing or QE – created the conditions in which inflation could become, not transitory, but endemic.

As a result of successive QE programmes, the Bank of England purchased huge quantities of UK government gilts, most recently at Mr Sunak’s bidding during the pandemic. That means that the Old Lady is sitting on a portfolio of gilts that are declining in market value as interest rates rise. Under an agreement that goes back to the late Gordon Brown government, HM Treasury must reimburse the Bank of England for the decline in the market value of that portfolio. According to one estimate, the Treasury will have to pay the Bank of England in the region of £150 billion over the next ten years – in addition to paying the coupons on those gilts of course.

I don’t suppose the Red Wall voters have even contemplated that a sum nearly equal to running the National Health Service for a year will be dedicated to what was, essentially, an exercise in financial engineering. There will be a stink about this in time.

As QE transitions to quantitative tightening (QT) – that is, selling those portfolios of bonds into the open market – so bond and particularly gilt prices have been falling, thus pushing up yields. This means that governments will have to pay more for newly issued debt, going forward. Thus far, the European Central Bank is doing only “passive quantitative tightening” by not reinvesting the redemption value of bonds as they mature. But all this has potentially grave consequences for the balance sheets of the central banks, even if much of their bond portfolios losses are still unrealised.

Moreover, the interest paid on overnight commercial bank deposits placed with western central banks (all banks are required to “close out” overnight with the central bank of the country in which their branches are domiciled) now in many cases exceeds the coupon income received from their bond portfolios. In other words, many central banks are losing money – and their capital bases are therefore in decline.

In theory, a central bank could operate with negative capital because at any moment it can wave a magic wand and create the money to refinance itself. However, there are two reasons why that is undesirable. Firstly, printing money – as we have now come to understand – is inflationary, especially when you already have rampant inflation. Second, if a central bank looks like it might fail (even though it won’t, in theory) the FX traders will hammer its currency. That is why the economically conservative government of Sweden is now requiring the central bank, Sveriges Riksbank (the oldest central bank in the world, by the way), to undertake a SKR80 billion recapitalisation. That could be a model for the Bank of England too, in the not so distant future. And it would not redound to the glory of whichever government happens to be in power at the time.

Some City types have recently voiced the risk that if Labour is elected, banks such as the reputational risk catastrophe NatWest (formerly Royal Bank of Scotland – remember them) which is still 38 percent owned by the government 15 years after the financial crisis, could be ordered to lend to borrowers of questionable quality for political reasons. (Wind farm operators, solar arrays, and the rest). That could result in further huge loan losses. Since the Bank of England is the lender of last resort, that would have wider consequences on national solvency.

Pension Funds

Pension funds are highly exposed to the government and corporate bond markets. An ONS report out in September showed that the value of private sector defined benefit pension schemes (which pay a guaranteed pension based on a worker’s salary before retirement) fell from over £2 trillion at the beginning of 2022 to less than £1.4 trillion at the end of March this year. That means they have lost a staggering £626 billion in value. Some UK defined benefit pension schemes also offer an inflation-linked uplift – including, reportedly, the BBC which has had to find 1.7 billion to plug its pension black hole, equivalent to £70 per licence fee payer.

Final salary pension schemes have been closing in the private sector as most employers, who are required to make up any pension fund deficit, now regard them as unaffordable. Historically, UK corporate pension funds invested heavily in UK-quoted equities; but, over time, they have reduced their exposure to FTSE-100 and FTSE-250 stocks as these markets have not performed well since the millennium.

The proportion of pension fund assets invested in UK listed companies has fallen from 53 percent in 1997 to just six percent in 2021, according to the Capital Markets Industry Taskforce. The Universities Superannuation Scheme, which invests on behalf of 528,000 lecturers and academics, has just 4.4 percent of its assets in UK equities – although it does allocate 17 percent to private UK assets such as wind farms and real estate. The British Airways pension fund holds just 1.7 percent in UK-listed stocks, while 59.6 percent is allocated to overseas equities. The Barclays Bank UK Retirement Fund, with £27.2 billion of assets, has a nil exposure to UK equities.

Many of the large pension fund managers such as Legal and General have confessed that they only allocate about five percent of total assets to UK equities. PensionBee claims that British pension funds have 17 times more money invested in US stocks than in UK ones. And yet many overseas pension funds invest in UK assets, and notoriously foreign private equity funds have invested in British utilities. For example, China Investment Corporation (CIC) has an 8.7 percent stake in Thames Water, worth about £1.4 billion.

This has prompted calls for the UK government to incentivise pension funds to buy UK equities, and there are rumours that something might be forthcoming in Jeremy Hunt’s Autumn Statement on 22 November. Gordon Brown’s infamous tax on dividend payments made to pension fund investors made holding British shares less attractive. Last July, Mr Hunt announced a voluntary agreement between some of Britain’s largest pension fund managers, including Aviva, Legal & General, and Phoenix Group, to commit to maintain five percent of their assets under management to private equity and venture capital flowing into early-stage businesses.

More recently, many pension schemes have invested in liability-driven investment (LDI) strategies which principally allocate to gilts. These structures were considered to be low risk – until the bond market wobble which followed the Truss-Kwarteng “kamikaze” mini-budget of September last year. This engendered a doom-loop whereby LDI funds were obliged to sell gilts as their market price fell, thus pushing down gilt prices still further, and correspondingly pushing gilt yields higher. (I discussed the technical aspect of what happened in my recent piece on Trussonomics).

The fall in value of UK pension funds does not necessarily mean that they are likely to be in deficit. While the value of their assets has fallen, the value of their liabilities (technically, the net present value of future pension payouts) has also declined as interest rates (and thus the applicable discount rate) have risen. Hopefully, your pension is secure for now.

The lack of capital flowing into UK stocks is one reason why the London market looks so cheap. And if new growth stocks look cheap they will tend to be snapped up by foreign buyers, which, as we know, is not uncommon.

Whither Rates?

The markets seem to have concluded that rates will not spike much higher than current levels – but that they will remain around current levels for a while longer. Huw Pill, the Bank of England’s Chief Economist, opined this week that it was “not unreasonable” to expect interest rates to start to decline by next summer. Fidelity’s Tom Stevenson believes that we are already post-peak – even if the market is not entirely convinced.

And yet, in the UK, the real interest rates (the base rate minus inflation) is still negative. In fact, in Britain, we have not had positive real interest rates for 15 years (which might just be why our inflation rate is stubbornly higher than in the eurozone or the USA). Once inflation is finally subdued – by which I mean it declines to the official Federal Reserve and Bank of England target of two percent or just above – it will be necessary to maintain rates at positive real levels.

Therefore, we are probably never going back to near-zero rates; rather, I suspect that rates will remain in the 3-6 percent range for the rest of my lifetime. And a good thing too. Near-zero interest rates, as I have propounded in these pages, lead to gravely sub-optimal investment decisions. If the discount rate is zero, then the net present value of all available investment opportunities is infinitely beneficial. (Although you would have to be a financial economist to believe that).

Since December 2021 the Bank of England has raised rates 21 times from 0.1 percent (that already seems like a completely different world) to 5.25 percent. And yet inflation persists at well over six percent.

What will it be this time next year? That is the question.

Afterword

I’m sorry if I upset some of my readers last week by concluding with a “party political” point. I’m not partisan: I think all the main political parties are deluded. They think that the role of government is to be a social worker; when what the masses really need is the agency to direct their own affairs.

I don’t understand why there has to be a minister for loneliness (or for equality, for that matter) or a “Fatness Czar” or a “Drug Czar”. These issues should better be the concern of community groups such as churches, mosques, trades unions, the British Legion, golf clubs, Alcoholics Anonymous, readers’ groups, knitting circles and indeed the most fundamental social grouping of all – families. Sociologists used to call this associative life. But this is being crowded out by Nanny knows best.

More people go to the gym, jog or do Pilates or yoga than ever before, entirely off their own bat. And how many millions of TV viewers does Jamie get for his healthy meals? This has absolutely nothing to do with government “nudge” policy.

True, there is a left-behind population who are unfit and poor – but is that really the fault of the state? It’s part of what the Labour peer Roy Hattersley (a national treasure still with us, aged 90) once called “the poverty of aspiration”. It’s cultural.

I have almost given up on the Tories. But apologies to my Labour friends, I can’t foresee Labour making the case for individual responsibility. There are things governments must do; and there are things governments shouldn’t even attempt to do. None of them seem to get that.