Markets still risk underestimating debt and inflation
The elephant in the room for investors is the extent to which rising bond yields are now signalling a higher inflationary outlook and possible debt crisis. In recent years, central banks have downplayed the structural forces that are making for higher inflation, instead suggesting stubborn inflation has resulted from a series of ‘one-off’ inflationary shocks which will ease with time. It is no coincidence they have missed their 2% inflation target for over five years now – which has further dented their credibility.
Having been nervous for a while, the bond markets are now calling them out. The penny is finally dropping with recent interest rate rises pointing to heightened central bank concern. Yet I continue to suggest the strength and enduring nature of these structural inflationary forces risk being understated. If right, higher inflation and bond yields will continue over time – a scenario which will, once again, present challenges and opportunities for investors.
Economic and social drivers
The recent rise in bond yields across countries, some reaching levels last seen at the turn of the century, has surprised the authorities. The Federal Reserve doing away with forward guidance is a sign of the times. Yet the Fed has a point. Short-term economic forecasts shift with the sand – with the profession undergoing a crisis of confidence given its poor track record. Over the last decade, 80% of the IMF’s forecasts for UK GDP growth have turned out to be too pessimistic within a year – sometimes significantly so.
It is very difficult to predict human behaviour and patterns, let alone geopolitical shocks. This helps to explain why forecasting tends to focus on the short term. Yet this in turn underplays the importance of longer-term, structural factors which are usually the more important in identifying the long sweeps of inflation. My column in the spring of 2021 tried to focus on some of these and suggested inflation was set to rise and remain higher over time than the consensus expected. If anything, some of these factors have grown stronger.
The increasing level of government debt has worried bond markets for some time. The US figure is now topping $40 trillion. The interest cost of the UK Government’s debt has risen to £110 billion – a sum that could pay for some departments’ entire annual budgets. Again, it is similar elsewhere. This cannot persist. Increased government spending, and the concurrent crowding out of the wealth-creating and more efficient private sector, makes for increased inflation and higher bond yields.
Economic uncertainty is also becoming increasingly evident. Tariffs and trade friction add costs, as can shortened supply lines, as the cheapest option is having to give way to one that provides better security in an increasingly uncertain world. Globalisation is giving way to mercantilism, and the resulting additional costs are being passed on to the consumer and to governments.
Increasingly volatile weather conditions are making for more natural disasters, a huge cost in human life, and disrupted supply chains. Add in water shortages and farmers are set to grow fewer wheat crops and opt instead for either crops which are less weather-reliant, including those to produce energy, or government-funded nature schemes. This intent has been reinforced by the coming El Nino together with increases in fertiliser and diesel costs, courtesy in part of the US-Iran conflict. Food prices are set to rise further.
Climate change is also adding to costs given the required huge investment in the energy transition including across the full spectrum of our infrastructure – otherwise, some estimates suggest a $4 trillion funding gap by 2040. Whether this is paid for by governments and/or by regulatory authorities encouraging more private investment, costs will need to be passed on.
Meanwhile, other long-term drivers of inflation are coming into view – difficult to forecast accurately, but real all the same. The changing balance between capital and labour, in favour of the latter, makes for more business regulation, bureaucracy and cost rather than less. The West’s ageing population is gradually reducing the labour supply and its ability to support societies’ wider financial needs – it remains uncertain as to the extent artificial intelligence (AI) can compensate.
Societies are increasingly bypassing political protocols to become more vocal on matters that affect them – such as opposition to AI data centres. There is a notable decline in public trust and the dependability of good government. A poster behind Honest Tom’s tea counter suggesting customers ‘Don’t steal – the government doesn’t want competition’ seems to sum up the mood. A more questioning public, while understandable, does not make government easier.
More (geopolitical) shocks
Two other long-term drivers of higher inflation are becoming increasingly evident. In recent years, these monthly columns have highlighted a more volatile, if not hostile, geopolitical environment. Politics up to this point has largely been ignored by business. Shocks involving wars, oil, etc have usually seen markets recover and make ground over the following 18 months or so. But something more fundamental is happening.
Markets continue to underestimate the impact of Washington’s pursuit of America First – as espoused in the Pentagon’s recent ‘National Defence Strategy’ doctrine. The need to rebuild the US’ industrial base, which for many in the administration was found wanting by disrupted supply lines during Covid and the West’s poor response to Russia’s invasion of Ukraine, is paramount even if tariffs increase inflation and a weaker $ questions the world’s $-based financial system.
As a result, the rules-based international order will continue to be challenged in the search for economic gain and security. Higher tariffs and trade stand-offs, if not outright threats to cut off trade, are increasingly being used as a weapon to assist with wider political objectives. The rise in ‘geoeconomics’ can be seen by Iran pressurising the US to end the war by closing the Straits of Hormuz, and China’s positioning on its exports of rare earth minerals. This weaponisation of trade can only add to costs.
And imperfect though they are, the traditional safeguards founded after WW2 including the United Nations, NATO and WTO are being questioned, sidelined or even dismantled. The mutual respect needed in the conduct of international relations is giving way to a harder world of strategic alliances. Why is this important when talking of inflation? Because defence spending and wars, hot or cold, are inflationary. And a new international order characterised even more by ‘might is right’ will make for more shocks.
The invasion of Ukraine, Gaza and Israel and the US-Iran war not only add to the lot of human misery but to inflation. Having suggested when the US-Iran war started that it would last longer than markets believed, the upward pressure on prices is now being seen across a swathe of commodities. The Covid pandemic and climate change ‘one-offs’ further reinforce the bond markets need to compensate for such shocks becoming more common – a recurring theme, if you like, which needs to be priced as such.
Capital spending boom
At a time markets are already nervous about the extent of government borrowing, the extent of investment going into AI and data centres is giving focus to another factor which is now more clearly coming into view – the coming boom in capital expenditure. Whether it’s AI data centres, infrastructure investment or the energy transition, the corporate sector is looking to borrow significantly more from the bond markets – with corporate bond issuance already approaching $5 trillion so far this year.
With government defence spending set to rise meaningfully, for the first time in decades both government and business are competing in size for credit. Next year, recent estimates suggest the AI ‘hyper-scalers’ will be adding around $315 billion of bond market issuance (in addition to $280 billion in 2026). At least for the moment, this looks set to continue – as such, given the other factors at play, the price of credit can only remain elevated.
Of course, there is an element of circularity to this scenario. High yields perhaps also reflect market concerns about the corrective policy choices – austerity, default or inflation. The first two are unlikely for various reasons. Inflation can reduce the debt burden over time. Despite interest rate increases, the markets may be sensing a return to the era of ‘financial repression’ when interest rates were held artificially low after the financial crash. This would facilitate the issuance of more short-term debt but would be high-risk.
Portfolio composition
Of course, the spike in bond yields will not be a one-way street, but investors should not mistake reprieve for redemption. Higher inflation looks set to stay. Markets have contended with previous cycles of sustained high inflation (and low growth), for challenges usually beget opportunities. In my column later this month (this column being delayed a week courtesy of a travel bug), I will revisit the composition of our portfolios, with the above in mind.
Return to News