What do high levels of government debt mean for equities and bonds?

SPONSORED CONTENT - The situation may not be as bad as it looks.

Unless you’ve been living in a cave, you can’t help but have noticed that the government is spending a lot of money. In turn, that means that government debt is increasing rapidly. At the end of February 2020, the amount of money owed by the public sector to the private sector in the UK – the national debt – stood at roughly £1.8 trillion, which equates to 79.1% of gross domestic product (GDP).

But as the weeks and months roll by that number will surely grow. The budget deficit (the gap between government spending and the tax take) came in at £61.36bn in April, compared to £10.2bn for the same month last year. Quite where the level of national debt will end up by the end of 2020 is anyone’s guess – but it seems a racing certainty that it will rise above £2 trillion. Should investors be worried?

The UK’s debt pile isn’t as bad as it looks

The first thing to point out is that the recent uptick in debt is slightly out of character. The UK’s fiscal deficit has largely been falling over the last decade, amid what some commentators have called “austerity”. Back in 2009/10, the annual deficit came in at nearly £160bn, as Britain (and the rest of the world) struggled to cope with the fallout from the global financial crisis. But the deficit has fallen steadily in almost every year since.

Secondly, if we look at one key measure – government debt measured against GDP – we’ve experienced far higher levels in the more distant past. For instance, in each year between 1918 and 1963, the stock of national debt was larger than annual GDP, due largely to rapidly escalating military expenditure during the two World Wars. Debt peaked at 252% of GDP in 1946. It is also worth throwing in some international perspective. Japan, for instance, recorded a government debt equivalent to 238% of GDP in 2018. Even if our level of public debt smashes through the 100% level, we’ll still be well below the Japanese level.

Finally, note that with many, if not most government bonds yielding under 1%, all of this extra debt isn’t costing the Treasury much. According to the most recent forecast from the UK’s fiscal watchdog, the Office for Budget Responsibility (OBR), interest on public sector debt for the 2019/20 fiscal year is expected to total £41.6bn, which would represent just 4.9% of total public spending.

Indeed, because interest costs are so low, some economists – disciples of a school of thinking called Modern Monetary Theory (MMT) – reckon that the government can in fact borrow and spend pretty much whatever it wants to. (This sweeping assertion is subject to a few assumptions – notably that a nation has its own currency, and that the government is willing and able to raise taxes if inflation rates jump due to the overactive money printing presses.)

The big worry for equities and bonds

But mention of that word “inflation” brings us nicely to the worriers, who fear that if inflation starts creeping up again, interest rates will be forced higher. At that point, the interest charges on those debt piles will start costing governments a great deal more. The truth is that many central bankers would be very happy to see inflation rates rise somewhat above their current 1% to 3% target range, thus eating away into the “real” (after-inflation) value of that debt. But if inflation rates grow out of control, and lunge above the 5% level, the danger is that interest rates could follow suit.

What would that mean for investors? By and large, equities tend to do well in an environment where inflation is increasing gently, in the 2% to 5% range or so. But a proper inflation shock – where we get a sudden surge past 5% or 6% – could produce a nasty stockmarket sell off. As for bonds, inflation is often called “the invisible thief”, as few investors think in real returns – they don’t quite appreciate just how much damage can be done when the payouts from a fixed-income portfolio fall behind the inflation rate.

A recent analysis by Nicolas Rabener of research group FactorResearch pointed out that this “inflation thief” can become quite destructive to a portfolio of bonds. When inflation shot up in the 1970s, for example, many bond funds experienced a 60% drawdown in real returns. That said, real returns were positive on average in all other, less dramatic inflation regimes.

The key insight from Rabener’s analysis is that what really mattered was the impact of expected versus unexpected inflation. If inflation unexpectedly rises, the impact can be disastrous for both bonds and equities. A gentler rise by contrast – one which investors have time to anticipate and adjust to – can actually be highly beneficial, and help reduce the value of current debt without overly damaging returns. Smart investors should worry less about the absolute level of government debt – and worry more about how that mountain of debt will impact on inflation expectations.

Discover more of the latest investment views and ideas from Liontrust’s experienced fund managers.

Recommended

I wish I knew what negative interest rates were, but I’m too embarrassed to ask
Too embarrassed to ask

I wish I knew what negative interest rates were, but I’m too embarrassed to ask

There’s been a lot of talk from the Bank of England recently about introducing “negative interest rates”. So what on earth are they, and what would th…
20 Oct 2020
Shaniel Ramjee: tech stocks, China and Japan – where to find the best returns
Investment strategy

Shaniel Ramjee: tech stocks, China and Japan – where to find the best returns

Merryn talks to Shaniel Ramjee of Pictet about where to find the best returns in global markets right now – the continued growth of technology; why Ch…
20 Oct 2020
What’s the world’s most hated market? I hate to say it, but you probably live there
UK stockmarkets

What’s the world’s most hated market? I hate to say it, but you probably live there

UK stocks are among the most hated in the world – almost nobody is buying. John Stepek explains why, and wonders if that presents an opportunity for c…
20 Oct 2020
Cash rich and bored? Be careful what you do with your money
Investment strategy

Cash rich and bored? Be careful what you do with your money

As the pandemic has left many people with more time on their hands but little opportunity to spend, they have been speculating in the markets. But don…
19 Oct 2020

Most Popular

The Bank of England should create a "Bitpound" digital currency and take the world by storm
Bitcoin

The Bank of England should create a "Bitpound" digital currency and take the world by storm

The Bank of England could win the race to create a respectable digital currency if it moves quickly, says Matthew Lynn.
18 Oct 2020
Negative interest rates and the end of free bank accounts
Bank accounts

Negative interest rates and the end of free bank accounts

Negative interest rates are likely to mean the introduction of fees for current accounts and other banking products. But that might make the UK bankin…
19 Oct 2020
What would negative interest rates mean for your money?
UK Economy

What would negative interest rates mean for your money?

There has been much talk of the Bank of England introducing negative interest rates. John Stepek explains why they might do that, and what it would me…
15 Oct 2020