Financial markets are once again becoming unsettled due to the substantial debts accumulated by the world's largest economies, particularly as elections introduce uncertainties into fiscal policies. French government bonds suffered significant losses following an unexpected election result and ambitious spending proposals, which sparked concerns. The focus is also on the U.S. debt situation, with the upcoming November presidential election likely to influence debt dynamics. Although a debt crisis is not currently anticipated, investors are vigilant about the potential for increased spending leading to market instability. "Attention is shifting back to deficits," noted Guy Miller, chief market strategist at Zurich Insurance Group. He emphasized the need to focus not only on reducing debt but also on fostering economic growth, especially in Europe.
Here are insights into five major developed economies that are causing concern: 1/ FRANCE: The surprise election outcome served as a wake-up call for investors, who had previously overlooked France's strained public finances. With a budget deficit reaching 5.5% of GDP last year, France is subject to EU disciplinary actions. The risk premium on French bonds over German bonds soared to its highest level since the 2012 debt crisis due to the strong performance of far-right candidates in the election. Although a leftist alliance eventually won, a hung parliament could constrain their spending plans and hinder efforts to improve France's financial health. The head of France's national audit office declared that there is no flexibility in the budget, and debt reduction is imperative. Despite the recent easing of France's risk premium, it remains relatively high. "A permanent fiscal premium will be reflected in bond prices," commented David Arnaud, fund manager at Canada Life Asset Management.
2/ UNITED STATES: The U.S. is also facing significant debt challenges. The Congressional Budget Office projects that public debt will increase from 97% to 122% of GDP by 2034, more than double the average since 1994. Rising expectations of a Donald Trump victory in the November election have recently pushed up Treasury yields, as investors anticipate larger budget deficits and higher inflation. Some investors believe that a Trump presidency combined with a Republican-controlled Congress could lead to another round of fiscal stimulus, starting from a deficit of 6% of GDP. Despite the safe-haven status of U.S. Treasuries, the yield curve has widened to near its highest level since January, indicating increasing pressure on long-term borrowing costs.
3/ ITALY: Despite being led by a nationalist Prime Minister who is considered market-friendly, Italy's budget deficit reached 7.4% last year, the highest in the EU, leading to potential EU disciplinary measures. Italian bonds have performed well compared to other European bonds, but the risk premium on Italian bonds briefly hit a four-month high in June, reflecting the rapid spread of market jitters. Italy aims to reduce its deficit to 4.3% this year, but its recent track record in meeting fiscal targets is poor. The government's home renovation incentives, which cost over 200 billion euros since 2020, will continue to exert upward pressure on Italian debt. The EU forecasts that Italian debt will rise to 168% of GDP by 2034 from the current 137%. "Investors are not adequately compensated for the risks they take in Italy," stated Christian Kopf, head of fixed income and FX at Union Investment.
4/ UK: The UK's financial situation has become a concern since 2022, when unfunded tax cuts by the previous Conservative government led to a sell-off in government bonds and the pound, necessitating intervention by the central bank to stabilize markets and a reversal of the policy. A new Labour government, committed to economic growth while maintaining tight spending, faces significant challenges with public debt close to 100% of GDP. The UK's budget forecasters predict that debt could surge to over 300% of GDP by the 2070s, due to an aging population, climate change, and geopolitical tensions. Stronger economic growth is crucial for stabilizing debt, according to S&P Global.
5/ JAPAN: Japan's public debt is more than twice the size of its economy, the highest among industrialized nations. However, this is not an immediate concern because most of the debt is held domestically, reducing the risk of a sudden sell-off by foreign investors. Fitch Ratings suggests that rising prices and higher interest rates could improve Japan's credit profile by effectively reducing the real value of debt. Nonetheless, there are reasons for caution. Government estimates indicate that Japan's annual interest payments on government debt could more than double to 24.8 trillion yen over the next decade. Therefore, any abrupt increase in Japanese bond yields as monetary policy normalizes is worth monitoring. Currently, 10-year yields are just over 1%, near their highest level since 2011.