I had the pleasure of participating in an economic symposium organised by Axa in Paris last week (w/c 1 Feb). The subjects under discussion were of central importance to bond investors – inflation and sovereign risk.

In general the takeaways were all somewhat negative for bonds. We will see exit strategies over the next couple of years, there is less confidence in the inflation-targeting model of monetary policy, we face a severe fiscal problem as a result of the financial crisis and there are long-term concerns over the cost of ageing. An extremely thought-provoking paper was presented arguing that the cost of ageing - measured as the present value of the future costs of pension provision, health and care -  is a multiple of the fiscal cost of the current economic crisis and that to ensure long-term fiscal stability governments have to address this important issue. The key recommendation was to increase the retirement age such that taxes are paid over more years and benefits are paid over fewer years. Happy start to my note!
 

Sovereign risk

Given the current focus on sovereign risk in the bond market there is much debate about what needs to be done in the very near term to restore some confidence in government bonds. Sovereign debt really is the last domino. In the crisis debt has been passed from the household sector to the banks to governments. While the taxpayer has bailed out the banks, there is no-one left to bail out the tax payer. Or is there?

As yet, taxpayers have not really had to stump up. The cost of the crisis has been borne by increased debt. Taxpayers will start to pay soon – as we here in the UK know only too well. However, the whole real cost won’t be borne entirely by today’s taxpayers. Public liabilities can be spread out over many years, so not only today’s but tomorrow’s taxpayers will repay the debt. The ability of a sovereign borrower to extend the maturity of its debt and put some of the burden on the younger generation depends on how creditworthy the borrower is perceived by investors, the depth of its financial markets and the existing structure of its debt. It is on these issues that markets are currently focussed and a number of sovereign borrowers are under pressure because of the rapid increase in government deficits and debt levels in the past couple of years, the existing maturity profile of debt and the underlying strength of its economy and its financial markets.
 

Greece's debt

If we compare Greece and the UK we see some big differences. The maturity of Greece’s outstanding debt is much lower than for the UK. Just under 50% of all Greek debt is set to mature between now and the end of 2014. For the UK the comparable figure is 31.8%. In terms of the current level of debt and debt service, the UK is in a much better position than Greece. The OECD expects the UK’s debt to GDP ratio to stand at 83% in 2010 while the burden of debt interest payments is at just under 8% of government revenue. The equivalent numbers for Greece are 123% and 13.2%. Of course, no-one is suggesting that the UK is as poor a credit risk as Greece at this stage but there are concerns that the UK could lose its AAA status and that the UK is in danger of getting caught up in the current turmoil affecting European sovereign borrowers. The reality is that the UK economy is stronger and more diversified and has the flexibility to address its fiscal problems. Whether it does or not depends on politics.

Sovereign exit strategies

At the symposium there were lengthy discussions about exit strategies and how best to achieve fiscal consolidation. One area of discussion was inflation and the possibility that inflation might actually be a policy choice that would, to some extent, reduce the burden on future taxpayers of the debt incurred today. However, it was also shown that, historically, governments have not been able to use inflation as the primary source of debt reduction. Moreover, there is no guarantee that governments can actually choose to have higher inflation - as Japan has proved in recent years. The key driver of debt reduction in budgetary adjustment in the form of medium term fiscal plans to reduce government spending and increase government revenues. This has to be the initial kick-start to any debt reduction programme and, if welcomed by the markets, will allow long-term interest rates to decline thus boosting growth. Over the medium term the improvement in growth contributes to the reduction in debt:GDP ratios. If there is a little bit more inflation this will also help as nominal GDP growth will rise, thus reducing the real value of debt.

So for the UK and for Greece, and for all the other sovereigns that are currently in the spotlight, it is important for governments to present credible deficit reduction plans. The plans put forward by the Greek government are, on paper, credible and would deliver a reduced debt:GDP ratio over the medium term. The residual concerns are all around the ability of Greece to actually implement these plans, and the upturn in public unrest in Greece in the wake of the fiscal announcements is a concern. However, it does seem likely that EU support will be forthcoming – there has already been verbal support for Athens – as the risk of not supporting Greece is too high. For the UK we still need to wait for the election and the first budget of the new government. Recent opinion polls have shown a reduced lead for the Conservative Party and a hung parliament remains an undesirable possibility.

US fiscal indicators

The US is also interesting. Its fiscal indicators have deteriorated and there is little real evidence of medium-term fiscal tightening. On the simple basis of fiscal ratios, the US is just as likely to see its AAA status downgraded as the UK is. Over 60% of the US’s Federal debt matures before the end of 2014 so a sharp rise in interest rates by the Fed is going to create some pressures on the Federal budget in the next few years. The US has the advantage of having its debt in the global reserve currency (China will remain a buyer) and having a young and still growing population. However, there is also the suspicion that, amongst all the major economies, the US is the one most likely to tolerate a rise in inflation. Nothing too dramatic, but a CPI rate of 5-6% was seen as entirely possible.

Global inflation

An interesting point about inflation was that some studies have found that global factors explained a very high proportion of national inflation rates. Most countries were lucky in the last decade that China was flooding the global market with cheap manufactured goods so that imported inflation in Europe and the US was low and inflation targets were easily met. Going forward that may not be the case. China’s (and Asian) inflation rates are rising and the downward pressure on import prices is reversing. Central banks in the west can choose to fight against this (by raising interest rates) or allow some testing of the upper bounds of tolerable inflation. The ECB may not allow this but the Fed might. I have some sympathy with this analysis. In the UK, imported inflation was negative for much of the period after 1997 yet domestic inflation was higher than the inflation target. I’m not convinced that as the UK recovers inflation will necessarily be at 2%. Hence, inflation linked bonds in the UK remain a core investment.

All in all, considering the various and complex issues surrounding the outlook for inflation and sovereign risk, I came away with thoughts that support some investment strategies in the bond market. The first was to be underweight US Treasuries relative to German bunds because of the perceived greater tolerance for higher inflation in the US than in core Europe. For the same reasons an overweight position in US break-even inflation rates relative to Euro break-evens would be desirable. Having exposure to a global index linked asset is also attractive as, despite the obvious deflationary risks coming from spare capacity in the developed world, we might be underestimating the inflationary consequences of rapid emerging market growth and rigid exchange rate policies in Asia. Related to that, exposure to Asian currencies but not to Asian interest rates seems appropriate as pressure will build for Asian currencies to rise in the long-run.

In the short term, the sovereign crisis is dominating the bond market. Lucky for gilts. This week the Bank of England announced a pause (or possibly an end) to QE and between now and May we will see how the market deals with very heavy supply and no Bank of England bid. I suspect that once this phase of concern about the European peripherals passes – perhaps as a result of EU support for budget plans – gilt yields will rise above 4%.