Merlin Weekly Macro: Debt and deficits plague the West

The International Monetary Fund (IMF), the Delphic Oracle of global economics and financial lender-of-last-resort for broken countries, has spoken: in 2024/5, global growth will be stable at around 3.3%. With sharp divergence between developed and developing economies, the IMF heads its latest report ‘The Global Economy in a Sticky Spot’.

Among the major developed economies, the IMF predicts ‘convergence of growth’. What it sees is convergence from opposite directions. The United States economy is projected to slow to 1.9% from 2.6% this year (it has just put in a remarkably strong clip of 2.8% annualised economic growth in the second quarter, far higher than the consensus estimate of 2.0%); Germany, with virtually no economic growth at all in 2024, might get back to 1.3%; Italy will yet again fail to achieve 1%, and France may stagger to 1.3% from 0.9%; Japan is flat at around 1%. Here in the UK, the economic growth rate is projected nearly to double from 0.7% (underwhelming even when revised up from 0.5% since April) to 1.5%. For the markets, the good news is the western economies are likely to be going somewhere again; the bad news, it’s nowhere quickly. It is more pertinent to observe that competitively, this is convergence of the economically mediocre.

By the end of 2025, it will be almost exactly five years since the Pandemic broke out and the world went into lockdown; it will be almost four years since Putin invaded Ukraine. Restoring sustainable growth to rates above 2% is proving challenging in the western world. Quite why this is seen as a surprise is itself surprising. The whole point of the central banks’ monetary policy of raising interest rates to bring runaway inflation back under control was to cool the demand side of the economy and curb consumers’ enthusiasm to spend: it was designed precisely to reduce growth!

On the other hand, if the western economies are torpid, to achieve the 3.3% global rate the IMF predicts, the rest of the world must be performing considerably better. This is its case. The IMF sees Emerging and Developing markets growing at 4.3% in both years. China’s economy is forecast to grow at 5.0% this year, in line with the Chinese Communist Party (CCP) leadership’s target, slowing to 4.5% next year. India, with 7.0% economic growth in 2024 may ease to 6.5% in 2025. Among the Emerging group are two interesting cases: first, given the oil market weakness, Saudi Arabian growth has been revised down by 0.9 and 1.3 pts respectively in 2024 and 2025 but is still expected to accelerate from 1.7% this year to 4.7% next (reflecting the significant investment in diversification); second, Argentina, where the still novel rock-‘n-roll radical monetarist president Javier Milei has put a policy hand-grenade under the economic establishment: a deep 3.5% recession in 2024 may reverse sharply to a 5% recovery in 2025.

Is China really growing at 5%?

China sits in the foundry of the global economy. Producing 31% of total aggregate manufactured output, it is the world’s dominant supplier of components and goods; given China’s domestic consumption accounts for 13%, much of the demand for the balance is generated in the West. As we have seen above, western growth is weak, especially in Europe. Unsurprisingly there is doubt about the reliability of the Chinese GDP forecasts. There is only one version of the truth in the public data: that published by the Chinese Communist Party and what it wants you to believe. But independent economists constantly try to corroborate from supporting global data if China really can be growing as fast as indicated. The evidence is often contradictory.

Today, pointing to a weaker than officially reported economy include the following: policymakers at the People’s Bank of China unexpectedly cutting the short term lending rate this week as a stimulus; as a barometer of consumer activity, a string of weak sales figures from western companies active in China, including Burberry, Gucci and French luxury goods company LVMH; in the industrial sector, commodity prices, in particular copper, iron ore, steel, nickel etc for all of which China is not only a major but often the global swing consumer, have all weakened significantly in the past few months; structurally, China’s teetering property sector is financially challenged; this week the CCP has reinforced its intention in the next five years to raise the state retirement age from 60 to 65 for men and from 50 for women, saying that on the grounds of demographics and national productivity, the current system is unviable (the Chinese Academy of Social Sciences predicts the state pension fund will be insolvent by 2035 without substantial reform); finally, its stock market is down 10% year-to-date.

Pointing to strength, last week the International Energy Agency issued a report suggesting China’s electricity consumption, another barometer of economic activity, is likely to rise 6.5% this year. Heavily subsidised by the state, China’s automotive sector is operating flat out delivering a tsunami of cheap electric vehicles to flood western markets with the strategic intent of undermining German, French and American manufacturers.

On balance, a growth rate north of 5% appears a stretch. When considering global growth, accurately predicting China is important: at close to a fifth of the global economy, any error in estimating its actual growth potentially throws the global calculation significantly (the old rule-of-thumb used to be that for every point of marginal global growth, a third of that was driven directly by Chinese economic activity).

The never-ending story: debt and deficits

If the IMF is reasonably sanguine about global economic activity (note global, not western), it has raised concerns again about the state of many key governments’ finances. In particular it focuses on a theme entirely familiar to regular readers of these musings: sky-high government debt and enduring deficits.

First up for criticism is the US. With government debt to GDP ratio at 125%¹, the IMF projects the ratio rising to 145% by 2033. To keep the ratio where it is today (not even reducing it) would need a sharp reversal in government spending and a significant increase in tax revenues: the IMF estimates that a current budget deficit of 6.3% needs to be turned into a budget surplus of 1%. ‘Making the case for a substantive fiscal adjustment is difficult given the current weak societal support for taking action on debt and deficits and the complex political economy dynamics around fiscal policy more broadly.’ That is the IMF’s laboured way of saying Hell will freeze over before a surplus is achieved (the US has an unbroken record of deficits this century, the last surplus was 2001). But that typically lily-livered ‘Making the case for a substantive fiscal adjustment is difficult’ abstract from the IMF’s assessment of US fiscal policy also betrays the organisation’s tacit acceptance of the status quo: it’s all too difficult to change, ‘tis what it is.

Poppycock! To economic conservatives and monetarists, those who understand the necessity for fiscal prudence and strong, sound financial foundations, there is every case to be made; it is merely that nobody is willing to break the lazy consensus to make it, even less so today as we in the West risk penury, facing potential financial shipwreck on the rocks of the binding commitment to carbon net-zero. The restoration of ‘sound money’ was the basis of Thatcherism and Reaganomics; it was the political challenge to which both leaders rose with vigour and with demonstrable success. That their economic legacy was squandered by their successors is beside the point.

Effecting change is certainly difficult but making the case for it is about principled thinking, conviction and leadership. What is evident in the US today is that the next administration, whether it be led by Trump or Harris, will have little explicit focus on debt management. Both candidates have a strong appetite to spend (even if Trump reverses America’s participation in the Paris Climate Accord), all that is likely to divide them is the order of magnitude. Deficits are likely to endure: Trump wants tax cuts, the debt will be cut by growth; Harris wants to push through tax rises but under Democrat plans expenditure will still rise faster than receipts.

What should focus the mind in terms of economic efficiency and financial productivity is both the nominal and the opportunity cost of that American debt: in 2023, the US Treasury reported that it spent $900 billion servicing its debt in interest charges; in 2024 it will exceed $1.0 trillion (by the end of June it was already $682 billion). At over 14% of annual US Federal expenditure, were it a department, interest would have the second highest budget behind social security (22%); it is greater than either the US defence budget or what is spent on public health. Surely in the forthcoming election, the question voters should be asking is how can it be that with near criminal profligacy, the government allows annual expenditure of over $3 trillion on two areas with little or no productive value (as distinct in the case of social security from social value). Reducing the debt and the cost of servicing it is painful in the short-term but opens opportunities and choices in the longer term.

We are at an inflection point in US interest rates: they are likely to begin falling in the second half of this year, possibly very soon, predicated on when the Federal Reserve feels more comfortable that inflation is less of a concern. A falling cost of debt will help relieve the burden. However, if interest rates rose from zero in 2021 to 5.5% today, there is little if any expectation they will return whence they came. As we have discussed on previous occasions, nominal interest rates may halve over the next couple of years from today’s level but the argument is against a return to negative real rates of interest (after adjusting for medium-term inflation predicted at 2% in line with the Federal Reserve mandate).

The second consideration is about financial resilience. With nominal debt and the debt/GDP ratio both heading the wrong way for the foreseeable future, what if there were another unexpected exogenous shock and further inflationary pressure? Because we have had two in quick succession does not preclude a third. Starting from a higher base than in 2022, would the system cope with interest rates possibly in high single figures? The best way of not finding out and to mitigate against the systemic financial risk is to get the debt down beforehand rather than being forced to pick up the pieces after.

The IMF on the UK: Rachel Reeves’ sums do not add up

In 2022, UK Shadow Chancellor Rachel Reeves enjoyed sticking the political boot into Liz Truss, ridiculing Kwasi Kwarteng’s own-goal budget and seeing the government squirm in embarrassment from the IMF’s censure. Now as Chancellor, Reeves also finds herself uncomfortably under the IMF’s spotlight. Just like the independent Institute for Fiscal Studies, the IMF cannot get Reeves’ sums to compute. That is even before the interim spending review due to be published next week with reports of the convenient discovery of a £20 billion unfunded ‘black hole’ in the schedule inherited from the Tories (odd, given in March the Office of Budget Responsibility declared Jeremy Hunt had no defined spending plans!).

With what is known so far about Labour spending plans, the IMF reckons that the UK economy will need to grow by a minimum of 2.6% per annum every year from 2024/5 to the end of the decade without the Chancellor needing to resort either to borrowing beyond her means or significantly raising new tax revenues (and the report was written before Reeves hinted at a 5.5% public sector pay award to nurses, teachers and potentially the police which will almost certainly precipitate another round of inflation-busting pay demands from the unions representing other trades and professions). In context, since the Global Financial Crisis of 2007-10, and excluding 2021 and 2022 in the post-Covid recovery period after the 10.1% crash in 2020, calendar year GDP growth of 2.6% or greater was achieved only on two occasions: 2014 (3.2%) and 2017 (2.7%); in six of those years it failed to exceed 2%. If the IMF is correct, Reeves risks being hoisted on her own petard: growth will be unlikely to bail out her spending plans. She cannot disappoint the unions; she has promised to obey the Office of Budget Responsibility; she dare not confront the bond markets. It isn’t difficult to join the dots here: for the rest of us, wearing size 11 hobnails and wielding a big stick, the taxman cometh.

If France were Greece, they’d be sending in the Troika

Although not directly nailed by the IMF, France is under the fiscal cosh.

It is little more than a decade ago that Greece had the ‘Troika’ of the European Central Bank (ECB), the European Commission and the International Monetary Fund imposed upon it to restore economic discipline. Today, France is demonstrating worrying signs of serious fiscal irresponsibility. In Paris, amid the political turmoil and horse trading to attempt to agree a new coalition government, those on the far left wishing to lead the new parliament have already laid down their political markers: reversing Macron’s hugely unpopular April 2023 increase in the national retirement age from 62 to 64, and significantly increasing the minimum wage. Reported in the FT, the Institut Montaigne think-tank believes the package could cost a total of €179 billion a year, taking the prospective French government deficit to a rule-busting 10% of GDP, three times the permitted maximum under the EU Stability Mechanism. Even without these measures, Brussels is insisting that the current deficit of 5.5% be addressed by annual spending cuts of €15.4 billion for each of the next seven years; the socialists and the communists under the firebrand Jean-Luc Melenchon have no intention of complying, indeed just the opposite. A titanic clash is in the offing, either in the French Parliament or with Brussels, or more probably, both.

France and Germany: compare, contrast and explain why investors remain sanguine?

France is one of the most heavily indebted nations on earth; it has significant and seemingly intractable structural difficulties, both economically and socially; its politics are not only divided but deeply polarised and viscerally rancorous; it has a lame duck president, his lameness being entirely of his own making (Macron did not need to hold an election at all).

Germany has its own difficulties too: a virtually stagnant economy but in contrast with France, a substantial trade surplus (it exports more than it imports; France is the reverse); its government is a fragile three-party coalition which just about holds together; a budget which was rejected by the courts as illegal and which enforced significant cost savings to be allowed to pass (the two most recent casualties of which are far less expenditure than promised both on defence and aid to Ukraine). But even if only through legal enforcement rather than political will, at least Germany is maintaining sound financial foundations: its debt/GDP ratio is 66% and relatively stable compared with that of France’s which is 110% and rising; its deficit in 2023 was 2.6% and is under the legal microscope to restore it to no more than 0.3%; France’s is 5.5% and potentially doubling.

It is therefore a moot point why the yield differential between German 10 Year government bonds (today at 2.43%) and those of France (3.13%) is only 70 basis points (or 0.7 of a percentage point); yes, the gap has widened since the French political crisis blew up in June after the EU elections, but only by a modest and remarkably constant 20 basis points which hardly seems adequate to reflect the significant change in landscape. One can only assume that markets are sanguine because they believe that there will be political paralysis in Paris, therefore no major change in policy will be effected which rocks the boat. Time will tell if that optimism is well-founded or significantly misplaced; if the latter and that difference in yield explodes towards the critical two percentage point gap, the ECB will be forced to step in with its anti-fragmentation measures (officially ‘Transmission Protection Instruments’) designed to prevent monetary union from melting.

Markets and central banks: the clash of heavy metal

Bringing all this to a conclusion, amid debt and deficits, disinflation, anaemic economic prospects and the IMF’s ‘sticky spot’, the emerging consensus is that the principal western central banks are simply wrong to maintain high nominal interest rates and to endorse rising real rates (if the nominal rate remains static while inflation falls, the real rate of interest rises) both of which risk choking their economies. The clamour is for the Federal Reserve and the Bank of England to capitulate on their ‘higher for longer’ strategy and get a shift on with loosening monetary policy before too much damage is done.

The European Central Bank introduced its first 0.25% cut in June but declined to follow with a second in July. The policy setting committees of both the Federal Reserve and the Bank of England meet soon. In this enduring power struggle between the markets who provide capital and the authorities who set the benchmark cost, are Chairman Powell and Governor Bailey likely to be swayed by the arguments, or do they remain obdurate that they are right and everyone else is wrong? We will know soon enough.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each.  With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.

¹A government’s debt to GDP ratio measures the total size of its outstanding debts against the size of its economy. A higher ratio means that the country has larger debts relative to its economic size.