Tuesday digest
Posted 30 May 2023
Overview: debt ceiling angst, or simply a lack of good news
Last week brought another bout of equity market volatility, with much of the blame for the market wobble attributed to the US government debt ceiling negotiations. The deadline after which the US government runs out of money – and technically defaults on its financial obligations – is now likely only 5-10 business days away, so market nervousness ahead of such an impending – and portentous – deadline is wholly understandable. Over the weekend an agreement between Democratic and Republican party leadership was reached, although the House of Representatives must vote on Wednesday before sending the bill to the Senate. It could therefore still go right down to the wire.
The other big – and to our mind more important – move of last week took place in the bond market, with a sell-off moving yields higher again, in some instances, like the UK, reaching levels not seen since last autumn, after the Truss government’s ill-fated mini-budget. Indeed, last week’s step up in bond yields came at the same time as inflation reports (such as in the UK) showed that inflation – while trending downwards – is nevertheless proving sticky and persistent. At the same time, Germany was reported to have been in recession over the winter quarters and China’s COVID recovery has disappointed this far against the high expectations earlier in the year. Against this backdrop, expectations of central banks reversing their rates policies have been further pushed out towards the end of this year and even the first quarter of next year, while expectations of resurging economic growth over the second half of this year have been dampened.
It is unsurprising then, to find the investment community increasingly polarised on the outlook. There are many strong arguments pointing towards an eventual downturn – even if that only takes place next year – and equally good reasonings why the global economy might just muddle its way through the downdraft forces of 2023, and keep going forward for longer than conventional economic theory would otherwise suggest. For those already looking beyond the likely resolution of the debt ceiling cliff, the next market threat will likely be the impending liquidity drain caused by the US government which must replenish its empty coffers by issuing $1 trillion of new bonds into markets. But there may be some reassurance that most of the $2.4 trillion of cash currently deposited by US money market funds in the US Federal Reserve’s Reverse Repo facility is expected to be attracted by the higher rates the US government will have on offer than the US central bank. Perhaps this insight better explains some of upbeat market sentiment on Friday than the positive vibes from the debt ceiling negotiators.
New EU fiscal rule changes loom large
While last week’s sobering announcement that Germany was officially in recession through the winter was worrisome, Europe’s problems could undoubtedly have been much worse. Given Germany’s (and Europe’s in general) previous dependence on Russian energy, a bleak winter would likely have resulted in widespread production shutdowns. In the end, a combination of milder weather which supported construction spending, the faster establishment of liquified natural gas (LNG) supplies from North America and better-than-expected energy storage meant the eurozone emerged without an overall contraction of growth. At least so far, although the recent German numbers are likely to weigh on revised eurozone growth performance – nevertheless, a decent result all things considered.
Even Greece – the epicentre of past euro crises – is on course to regain its investment-grade credit rating this year. It is already the fastest-growing economy in the bloc, and the unexpectedly big election win for Greece’s centre-right government recently pushed bond yields down dramatically, in a further sign that markets are regaining confidence. But before too much credit is claimed by Europe’s technocrats, in truth, the Greek story is far from a success of European policy. Strict budgetary rules have hindered growth and after a decade of public spending cuts, tax rises and reforms – much of it at the behest of the troika (the European Commission (EC), European Central Bank (ECB) and International Monetary Fund (IMF) combined) – Greece’s debt-to-GDP ratio remains worse than in 2012. Its economy, meanwhile, is still smaller than it was in 2008.
The EC is currently drafting proposals for reforming the bloc’s fiscal rules, which it argues even more urgently must be updated in light of the pandemic and Europe’s energy supply crisis. It wants to reappraise debt-to-GDP targets which prohibit national debt from exceeding 60% of GDP and the annual fiscal deficit from going above 3% of GDP. Its original proposals were for bespoke plans for each nation, similar to the IMF’s national lending agreements (of course without disbursing any money).
Germany and the Netherlands have opposed such tailor-made plans, arguing there must be minimum targets for indebted countries. They suggest numerical targets are the only way to ensure tangible progress on debt reduction, and point out that the existing rules are full of exceptions for economic hardships anyway – as evidenced by historical adherence to the rules. Proponents of the tailor-made approach, though, argue countries would be much more likely to stick to the rules if they were bilaterally agreed, instead of imposed by central diktat. This could also avoid pro-cyclical policies which demand austerity through tough economic periods and spending in times of growth. That could be a big help for nations that might need more time to implement budget adjustments. Fiscal transitions, and especially structural reforms, can be very costly at the beginning, as some industries might need to be closed or reformed, while productive infrastructure is put in place.
Something policymakers will not openly discuss, but are very likely worried about, is that a lack of common rules might lead to preferential treatment for certain countries. However, even under the new framework, bespoke repayment plans have to be approved by the EC, meaning national governments have the final say. If some such budget can be established by the end of June (when negotiations heat up) that would be a transformative, though unlikely, step. Whatever formal framework is agreed, it is most likely going to be through a typical European compromise – enforcement and genuine progress will (as usual) come down to goodwill and political engagement.