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Inflation is expected to progress towards 2% in both Europe and USA.

  • Thursday, November 23, 2023

Giorgia Meloni, Italy's prime ministerThe governments of the developed world are being held back by the crushing responsibility of repaying huge debt piles at elevated interest rates. This debt has been accelerated in the past 15 years through the buying out of banks in the financial crisis of 2008/9 and the recovery cost of the Covid pandemic in 2020/21. The impact of this heavy investment is now returning as inflation.

The Institute of International Finance (IIF) has calculated that total world debt including government, corporate and household, stands at US$307tn.

Global growth is slowing, countries are less able to rely on growing their economy to reduce real debt levels. Countries are facing reduced GDP growth rates meaning that the world will see lower rates of expansion and less resilience to future shocks.

Countries are getting used to a growth model that is based upon borrowing to stimulate. Over the longer term this will have negative consequences if growth is not then forthcoming. Higher interest rates have sent the cost of servicing debt to a new high, with counties now borrowing to plug the gap between revenue and public spending.

Within the G20, Russia and Saudi Arabia have the lowest government debt to GDP at 17.2% and 30% respectively. Singapore has 168% debt to GDP while Japan is the highest at 264%. Those over 100% debt to GDP include Canada at 107%, France at 112%, Italy at 145%, Spain at 113%, UK at 101% and USA at 129%.

These rates of indebtedness are concerning bankers and economists alike. JP Morgan’s Chief Executive Jamie Dimon has noted that ‘the financial situation and fiscal spending is more than it ever has been in peace time with the highest government debt levels we have ever had.’ Mr Dimon felt the situation can be managed but is concerned.

Allianz Chief Economist Mohammed El Erian feels that ‘some countries are well placed to handle the heavier debt loads, especially if they have medium term growth potential, strong economies, and respected currencies.’ It is the debt burdened developing countries that will suffer most. In some African countries over 50% of total tax revenue is spent on interest payments. Some countries have defaulted on debt. In 2022 more sovereign debt defaults occurred than in the past 40 years.

A factor that influences sovereign defaults is that US$ denominated debt remains an issue for countries with weaker currencies as the combination of rising interest rates and the value of the US$ has an impact.
HSBC Chief Executive Noel Quinn, also joined the voices of the IIF, World Bank and IMF when he warned that ‘the global economy is growing very slowly, too slowly to cope with the rate by which government debt is rising.’ Global GDP is expected to hit 3% this year but many countries have inflation and interest rates above this figure.

Borrowing comes at a price and for advanced economies the price is weaker growth and less money for public services as tax payers service debt repayments.

We started the 2020’s with a Covid inspired recession which we have recovered at the expense of massive borrowing. The Treasury issued gilts that the Bank of England bought. Both the UK and Europe are facing challenges from demographics, productivity, and sustainability.

Despite these concerns, the US economy has done a remarkable thing. It has grown GDP by 4.6% and reduced inflation to 3.2%. Despite the scares over the collapse of Silicon Valley Bank, Signature Bank and First Republic Bank earlier this year, US banks now look to be in a more resilient position. The fact that the Federal Reserve held US interest rates at 5.5% in the November FOMC meeting has helped.

A major concern in world markets has been the state of the Chinese residential property market. This sector is so significant to the country and its people. Many large companies have been on the brink of bankruptcy this year including the two largest Country Garden and Evergrande. The property market bubble in China is a major issue as almost three quarters of Chinese households have 70% of their overall wealth tied up in property, so fears of a Chinese property collapse have unnerved investors across the world. Policies have helped stem the concerns over a major Chinese property market collapse but analysts are viewing the worst of the crisis as now over. China has -0.2% inflation in its economy and interest rates of 3.45% so there is plenty of room for interest rate cuts to stimulate the property market.

The other great investment bubble that is of concern is the heavily indebted countries of Europe. Italy is trying under new Prime Minister Giorgia Meloni to spend its way to growth with debt to GDP rising from 120% to 145%. Italian government 10-year bonds are now trading at 4.23% having peaked at 5% in mid-October. This is relevant as Italy will need to refinance 24% of its GDP as bonds mature this year. If the ECB are called in to buy these new bonds a new buy out crisis could develop.

The UK is also not in a great position. In 2020, the Office for Budget Responsibility (OBR) forecasted that the UK debt interest spending was expected to be £23.5bn in 2023/24. Last March the OBR predicted a rise to £94bn. Britain is now likely to spend £110bn or 10.4% of GDP on debt interest in 2023. This has increased significantly due to the level of index linked gilts in circulation and the rate of inflation this year. This sum is greater than we spend each year on Education. Debt repayment now stands second only to the Health Service budget in cost to the country. UK policy makers must focus on growth if they are to escape the burden of debt.

The UK is an oil importer and now has limited gas storage facilities. Britain is therefore exposed to a costly cold winter and spikes in oil and gas prices.

All markets have been nervous this year with geopolitical conflict, high inflation, and high interest rates, slowing growth and consumer confidence falling. Despite these challenges the global economy is proving to be far more resilient than many expected. This is particularly true in the USA, where high interest rates have not affected many consumers and corporations yet. Most US homeowners hold 25-year fixed mortgages so interest rate rises have not had the impact one may have expected. However, excess savings built up during lock down are now falling and student loan repayments are restarting so we could see a fall in disposable income.

The longer-term themes of low carbon energy, infrastructure and technology innovation including AI are attractive sectors and will be the drivers of growth in the decades ahead. The traditional sectors that have been hurt by high interest rates such as property, fixed interest and growth stocks are now also looking more attractive as global interest rates look to have hit their peak.

We are now witnessing declining inflation in the US, Europe, and the UK but inflation is still high compared to central banks 2% target. Rising bond yields have been doing some of the tightening work for the central banks. It is increasingly likely that yields will fall as interest rate cuts are expected next year. The consensus amongst economists is that inflation will make continuous and uninterrupted progress towards the 2% target in both Europe and USA.

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Chris Davies

Chris Davies

Chartered Financial Adviser

Chris is a Chartered Independent Financial Adviser and leads the investment team.

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