18 November 2022 |
Fixed Income Macro Views
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Talk to UsGROWING RISKS IN SOVEREIGN CREDIT
CIO Macro and Market Observations from Multi-Asset Solutions
December 01, 2022 | 9 Minute Read
Maria Vassalou, PhD
Co-Chief Investment Officer, Multi-Asset Solutions
Maria Vassalou, PhD
Amy Yifan Zhou, PhD
Multi-Asset Solutions
Amy Yifan Zhou, PhD
Credit dynamics have long been recognized as important drivers of economic cycles and useful indicators of financial stress. In recent years, sovereign debt growth has outpaced that of the household and corporate varieties and is today the main driver of global credit growth. But debt sustainability may face challenges as monetary policy gets tighter and liquidity declines. The good news is that spillover risks from the banking sector are less acute than they have been in previous crises and the investor base for sovereign credit has also changed in some important ways. Overall, the current environment, in our view, suggests investors should embrace a cautious and selective approach when reallocating capital toward credit.
Sovereigns Driving Global Credit Growth
In recent years, the global economy experienced rapid growth in the total amount of credit outstanding as well as notable shifts in the sector profile across household, corporate, and government debt. In 2022 Q1, global debt reached a record level of above $305 trillion, or 348% of global GDP, compared to about $208 trillion a decade ago. Across sectors, global government debt has grown broadly both in developed and emerging economies and meaningfully outpaced household and corporate debt, up sharply from less than 60% in 2009 and hitting a peak of nearly 110% of GDP in 2021. It is notable, too, that household debt has declined slightly since the Global Financial Crisis (GFC) and stayed largely unchanged until the pandemic. In the last few quarters, governments have tightened fiscal policies and the relative size of credit to GDP have declined slightly. This was driven primarily by increases in GDP rather than decreases in debt, with the overall amount of credit outstanding remaining quite elevated relative to historical levels. Arguably, the expansion of government credit may have been necessary to battle consecutive negative external shocks, including a global pandemic that put economic activities on pause and disrupted global supply chains followed by an energy shortage tied to war in Ukraine that raised the cost of living and the cost of production globally. Eventually, elevated government debt levels are likely to become a challenge to public finance and debt sustainability. In fact, many countries, expecting global growth to slow, have already reduced their growth outlooks and raised projected deficit levels for the upcoming fiscal year.
Exhibit 1: Government Debt Has Been the Fastest Growing Sector in Global Credit
Source: International Institute of Finance, Goldman Sachs Asset Management. As of 2Q 2022.
Weighing The Balance Of Risks
There are additional challenges today that may amplify the vulnerabilities in sovereign credit. First, tighter global monetary conditions have sharply raised the cost of borrowing. In the US, for example, the Federal Reserve has raised interest rates by a cumulative of 375 basis points (bps) in less than a year. This makes the cost of rolling over maturing debt much higher for countries that face a front-loaded debt maturity schedule. Case in point is Italy which will have to refinance a significant amount of debt from 2023 onwards, as we pointed out in last month’s observations (link, Exhibit 3). Recued liquidity in fixed income markets is another problem for market participants. The reduction is due in part to ongoing monetary tightening by most major central banks and the gradual reduction of the size of their balance sheets, a process known as quantitative tightening. However, increased market volatility tied to high inflation, weaker growth and tighter monetary and fiscal policy, has also contributed. As shown in Exhibit 2, liquidity in US, German, and UK government bond markets has been worsening for much of 2022 and is nearing some of the highest stress levels since the European debt crisis a decade ago. In the event of a global liquidity shock, the sudden surge of interest rates may put further pressure on sovereign debt levels, challenging their sustainability.
Exhibit 2: Liquidity Conditions Are Challenging in Global Government Bond Markets
Source: Bloomberg, Goldman Sachs Asset Management. As of November 21, 2022.
US dollar appreciation puts more pressure on governments around the world, especially in emerging markets where issuance of USD-denominated debt is often used to signal their commitment to price stability. Since 2021, the Bloomberg Dollar Spot Index has risen by nearly 20% from its trough. That makes servicing USD-denominated debt issued by foreign countries a challenge. The question for these countries is whether the strength of the dollar is likely to be sustained. This will depend largely on the relative real interest rates and growth rates between the US and those foreign countries. While geopolitical and macro conditions are supportive of the US dollar, demand for the currency may also be driven by other factors, such as the availability of safe assets in the world economy and their currencies of denomination. The biggest provider of safe assets globally remains the United States.
Exhibit 3: Dollar Strength Can Make Debt Servicing a Challenge
Source: International Institute of Finance, Goldman Sachs Asset Management. As of 2Q 2022.
Questions about debt sustainability may take center stage again in some European economies as a higher interest rate environment amplifies the divergent levels of fiscal health among euro-area member-states. In addition, as we have pointed out previously, the ongoing energy crisis is widening Europe’s internal economic divergence and has the potential to challenge the region’s unity because the resulting economic pain is not likely to be uniformly distributed. Unlike the US or Japan where central banks are expected to absorb the excess supply of government bonds, European countries would need to achieve fiscal coordination across members states for the European Central Bank (ECB) or individual states to step in as the lender of last resort. Therefore, depending on the political cohesion within the Eurozone, sustainability concerns may be triggered at much lower debt levels in Europe than in other parts of the world.
Exhibit 4: Government Debt and Public Balances in European Economies
Source: Eurostat, Goldman Sachs Asset Management. As of 2021
The investor base for sovereign debt also has important implications for government borrowing and refinancing costs. Countries with a higher share of domestic ownership of their debt can typically withstand higher debt-to-GDP ratios. A good example is Japan, where the majority of government debt is held domestically. Sustainability is more problematic where a significant portion of debt is held by foreign private investors. As shown in Exhibit 4, over the past decade, and as a consequence of its debt restructuring the vast majority of Greek debt is due 20 to 30 years from now and is in the hands of the foreign official sector, making the country’s debt less vulnerable to the current rise in interest rates and likely economic downturn. As a comparison, Italy has an average debt maturity of about seven years, and its share and composition of foreign investors have stayed relatively constant over the past decade.
Exhibit 5: Shifts in the Investor Base of Sovereign Debt
Source: IMF1 , Goldman Sachs Asset Management. As of 4Q 2021.
Can Distress in European Sovereign Debt Lead to Banking Distress Again?
During the European debt crisis, rise in sovereign yields led to several bank failures. This time around, the relationship between sovereign crises and banking crises is likely weaker. Following years of post-GFC regulatory changes, European banks are reasonably well capitalized compared to the twin crisis in the early 2010’s. Since 2015, EU banks have grown their balance sheets at a 3% compounded annual rate while also increasing their capital levels to incorporate higher capital requirements. Today, euro area banks’ common equity tier 1 capital ratios (CET1%), a measure of a bank’s equity capital relative to risk-weighted asset exposure, are in line with those at their US counterparts at ~15% as at 1Q22. That’s about 200 bps higher than where they stood in 2015.EU banks today hold about 450 bps of excess common equity capital against their total risk exposure, a healthy cushion by historical standards, and are also well capitalized from a liquidity perspective with 170% Liquidity Coverage ratio (LCR), a measure of highly liquid assets relative to short term obligations (30 days) under stressed conditions. Although capital levels remain on the lower side for peripheral countries relative to the broader EU, they continue to operate at a minimum of 200 bps of excess capital, and an above-median liquidity coverage ratio while continuing to reduce their non-performing loans ratios, lowering loan loss reserves and building more capital, creating additional cushion that would come in handy in the event of a more pronounced slowdown. According to the latest ECB survey, banks have continued to tighten their lending standards amid today’s economic uncertainty and less accommodative monetary policy, especially those in Spain and Italy. They are expected to continue doing so in 3Q22, largely in mortgage and corporate credit where demand is expected to remain subdued. This is why we believe that EU banks should be able to withstand a slowdown or a recession in Europe without posing systemic risks, even without major intervention by the ECB. The benefits of higher rates should be an offset higher credit costs, particularly if credit demand disappears. Repricing of the existing loan book over multiple years should support interest income growth and thus the bottom-line.
Exhibit 6: Bank CET1 Ratios in European Economies
Source: ECB, Federal Reserve, Goldman Sachs Asset Management. As of 1Q 2022.
Investment Implications
Governments increased borrowing so sharply in recent years in the belief that interest rates would stay low amid low inflation. When that changed suddenly when the pandemic ended and the energy crisis began, central banks were forced to reverse course—an about-face that set government debt levels on a troubling path. While US government debt appears likely to remain safe given the seiniorage benefits enjoyed by the US dollar and the use of US Treasuries as global safe-haven assets, that is not the case for government debt issued by many other countries with less dominant roles in the global financial system and less favorable fiscal and debt dynamics. If global growthlurches lower in the quarters ahead, it will be important that investors stay selective about the fixed income issuers and sectors they invest in. As long as monetary policy remains on a tightening track, correlations between equities and bonds may remain positive, reducing the diversification benefits of fixed income in traditional portfolios. In that sense, more emphasis on issuer default risk and the income that select fixed-income securities may generate will be critically important.
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