Barclays released the latest edition of their classic tome the Barclays Equity Gilt study last week.
I thought I would highlight two key sections.
The first is focused on the massive US fiscal and monetary expansion. For the record, I think Biden’s programme is astute politically and also astute economically in the short term. I have my real doubts about it long-term, unless the Biden administration gets very serious about raising taxes. In my view, he needs to raise taxes at some point to prove to the markets that his big welfare state push can be financed without an ever-larger mountain of debt ( a concern that also applies to previous Republican stimulus). If he doesn’t and the economy tips over into sustained inflation, then we are due a nasty bout of austerity.
The Barclays report is also concerned about this eventual reckoning. It believes that the “risk of disorder seems meaningful in the US, where policy responses have been especially forceful. The key variable is long-term inflation expectations: if they prove highly responsive to shorter-term price pressures, the prospect of a messy unwind could emerge for the Federal Reserve. Such a scenario would likely involve painful trade-offs between prolonged unemployment and longer-term inflation, testing the Fed’s resolve to achieve its 2% inflation target… A shift in the political backdrop could force austerity, prompting a rapid fiscal consolidation that would disrupt the economy”.
I’d be willing to put a date on that – quarter 4 2022 after the next House of Representative elections when there’s a good chance that the Republicans wrestle back control of the House. That’s why I think what Biden is doing is smart politically. Push all the buttons now to show during that election you can make a meaningful difference to voters’ lives. The risk though is that inflation wrecks that particular benefit.
The Barclays report does map out a few scenarios about how the US might pay for this fiscal and monetary bonanza. I suspect a consensus view is a balanced approach in which the Fed “slows the tightening cycle in order to forestall a deeper recession, but at the cost of much higher inflation expectations and permanently higher inflation. Indeed, with this model calibration, inflation runs well above 2.5% for a prolonged period. In our view, a balanced scenario along these lines might reflect multiple potential realities: the Fed might lack the will to create a large downturn once the spiral is triggered, or it might not see 2.5-3% inflation rates as much of an adverse outcome. Either way, there is long-term damage to its credibility.
The picture looks quite different in the “inflation focused” approach where the Fed is determined to bring inflation and inflation expectations under control (the dark blue lines in chart). As can be seen, doing so requires a much tighter policy, at least initially, which causes a deeper recession. The benefit of this aggressive action is that inflation and inflation expectations eventually revert to 2% , leading to better longer-term outcomes as the economy returns to full employment. Hence, even though this reaction leads to more adverse outcomes in the near-to-medium term, the overall outcome is more desirable, in our view. Indeed, this type of approach would help fortify the Fed’s credibility, providing it with policy space to respond to future downturns in a manner more similar to the orderly scenario depicted above.”
The other area from the report worth focusing on is also related to debt again – this time for emerging markets. The chart below – from the Equity Gilt study – nicely sums up the various scenarios based on key metrics such as private debt, domestic vs foreign debt and external debt.
Each axis on this chart poses different challenges for investors
Here’s the Barclays narrative for each corner of the chart above:
- “For those countries in the upper left-hand corner, private sector debt (households and corporates) seems dominant, but given that these countries also exhibit low external indebtedness, any debt sustainability challenges likely would be primarily a domestic issue… For those countries with weaker banking sectors, private sector debt challenges could naturally translate into higher risks of bank recapitalisation with public funds, and/or direct debt support via transfers, subsidies, tax breaks or similar to mitigate the private sector debt burden. Among the ‘debt-challenged’ countries flagged earlier, Russia and Peru fall into this category. Peru’s banking sector appears to be generally healthy, while Russia’s banking sector screens as weaker
- LatAm countries dominate the lower left-hand corner, ie, those countries for which public rather than private debt seems the dominant concern, but whose debt is mostly owed to domestic creditors. Brazil is certainly the most prominent example in this group. Potentially unsustainable debt situations in this group would appear to be primarily a local-currency government debt challenge, which if not remedied could lead to fiscal dominance, threatening monetary policy effectiveness. Questions about the capacity of the local market to absorb ever-increasing amounts of government debt, for example through financial repression, are likely to be at the centre of any debt challenge and financing discussions in this group of countries.
- Countries in the upper right and lower-right hand corner face the challenge of a high share of external creditors. Those countries with well-developed private sectors, for which corporate and household debt dominates public debt, are in the upper part, including rather advanced EM economies such as Chile and Poland. The group also includes Turkey, for which private sector external indebtedness has long been a focus in investors’ risk assessment, making Turkey vulnerable to sudden stops in capital flows. Relatively low reserve levels and concerns about Turkey’s policy credibility and governance have contributed to repeated bouts of volatility in Turkey assets over the past few years. From a government debt perspective, the relatively low public indebtedness and a generally well-capitalised and liquid banking sector have been an important anchor. However, they have not arrested the market’s concerns that private sector debt in Turkey may ultimately migrate onto the sovereign balance sheet, as reflected in recent swings in sovereign risk premia.
- Lastly, although the lower right-hand corner seems sparsely populated among our group of countries, many less-developed countries that have issued in international debt/eurobond markets would fall into this category, as do Argentina and Ukraine which have both gone through external debt restructuring in recent years (Ukraine in 2015, Argentina in 2020). Those countries would generally be categorised with public sector dominance in debt aggregates, but contrary to the second group, the debt is owed to external creditors. While this is by no means a homogeneous group, with the focus on public external debt, recent initiatives such as the G20 framework for debt restructurings of low-income countries are geared towards this group. South Africa is not a low-income country, but it straddles this group, as subdued growth, fiscal slippage and the overhang from SOE contingent liabilities has shifted the focus to public debt sustainability. While, similar to Brazil, South Africa has a deep local government debt market, the share of local-currency debt owed to foreigners is much higher, while reserve adequacy is lower. The choice of debt issuance over time will determine if South Africa moves more into group four (which would be the case if South Africa were to increase its financing in international markets) or closer to group one (if the focus remains on local market debt issuance and locals, rather than foreigners, were to absorb it). “