Government indebtedness – we ain’t seen nothing yet

Longevity risk and pension fund deficits aren’t exactly new topics – one of the first ever comments on this blog was on precisely this subject (see here).  But it’s going to become a bigger and bigger issue over the coming years, and this has huge implications for both bond investors and for the global economy as a whole.  Last week the IMF made an important contribution to the debate with this paper.  For a decent synopsis, the Economist reported on it in their most recent edition here.

Probably the most startling part of the IMF’s paper was this slightly understated passage – the “major threat to long-term fiscal solvency is still represented, at least in advanced countries, by unfavourable demographic trends. Net present value calculations illustrate the differential impact of the [current] crisis vis-à-vis ageing: in particular, for advanced countries, the fiscal burden of the crisis is about 11 percent of the aging-related costs”.  In other words, the long term cost to governments of an ageing population (eg government pensions, healthcare) is ten times larger than the amount that governments around the world have thrown at the current banking crisis.  TEN TIMES.

Yesterday I attended S&P’s European sovereign roadshow, and they referred to the IMF study above in conjunction with one of their own studies.  Their study was released in September 2007, which was a long time before the worst effects of this financial crisis were felt, and countries’ fiscal positions have obviously deteriorated rapidly in the past two years.  In 2007, S&P estimated that if governments didn’t do anything about the huge demographic time bomb (eg don’t sort out pension deficits, don’t raise retirement ages) then of the 32 countries sampled in their study (25 EU and 7 larger non-EU countries), spiralling debts and deficits would mean that half of the world’s richest countries would be junked within the next 20 years.  80% will be sub-investment grade in the next thirty years.  As S&P pointed out, the assumption that governments don’t do anything about the demographic time bomb is (hopefully) unrealistic because countries would be forced to eventually address these problems, not least by the electorate.  But if they didn’t take action, then Japan would be junked by 2020, and the US, UK, France would be rated sub-investment grade by 2040.

One of the long term implications of this is that investors will likely prefer lending to the world’s strongest corporates than to the world’s strongest governments.  Stefan mentioned in February here how 5 year euro denominated Greek government bonds had about the same yield as 5 year bonds issued by Vodafone, Carrefour, BHP Billiton, Deutsche Telekom and Diageo.  These corporates actually all now yield quite a bit less than Greek government bonds, which is a combination of a significant credit rally since February and continued deterioration in Greece’s finances (S&P mentioned yesterday that they see Ireland as a much stronger credit than Greece, which doesn’t say much about Greece), but it’s still relatively unusual for corporates to trade inside government bonds. In 2020, maybe it will be very common for a large number of investment grade corporates to yield less than government bonds, and people will get used to talking about negative credit spreads.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Mike Riddell

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