Policy

EUR/USD is trying to breach above 1.10. What is the balance of positive versus negative factors that would allow the euro to breakout?

Yen bulls need patience. The near-term narrative remains bearish on the back of interest-rate differentials. Longer term, it is the most attractive currency the G10, on valuation grounds.

Yen bulls need patience. The near-term narrative remains bearish on the back of interest-rate differentials. Longer term, it is the most attractive currency the G10, on valuation grounds.

Cyclically-speaking, the risk of global indebtedness does not appear to be acute. There are several pockets of sizeable private sector debt risk, and it is possible that the next US/global recession will cause a more pronounced economic downturn in some of these countries. Over the next one-to-three years, these risks are likely to be idiosyncratic. With the possible exception of France’s corporate sector, private sector debt risks appear to be manageable in the US, euro area, and China, the main drivers of global economic activity. However, over the longer-term, there are several problems with global indebtedness that will eventually “come home to roost.” US government debt is now excessive, and we expect meaningful net interest pressure for the US government in three-to-four years, even if the US does not experience elevated structural inflation. In China, the government’s strong desire to avoid aggravating structural imbalances will lead to the limited and finely balanced use of fiscal and monetary policy to boost growth, which is not good news for China-related financial assets. On balance, our conclusions are generally consistent with a structural bear market in the US dollar that is likely to begin after the next US recession. It also speaks to the possible structural outperformance of euro area stocks within a global equity portfolio, and possibly a continuation of the structural bull market in gold – which would benefit mightily from the development of any fiscal risk premia in US assets. The global financial crisis of 2008-2009, as well as the subpar economic recovery that followed, demonstrated to global investors the threat posed by elevated private sector and government debt. There has been a substantial improvement in the risk of indebtedness in some sectors of some countries over the past 15 years, but the risks of excessive indebtedness have increased in other areas of the global economy. In this special report, we check in on the indebtedness risk of a list of major economies using the BIS’ credit to the nonfinancial sector database and examine whether these risks exist primarily in the household, non-financial corporate, or government sectors. We contextualize the indebtedness data from the BIS into a risk score using several risk factors (by sector and by country), based on how elevated a given sector’s risk factor is relative not only to its own history but also the history of other countries. The sector risk scores are presented on pages 24 to 29, and we present a synthesis of our analysis below.1 We conclude that, while there are limited cyclical implications of recent trends in global indebtedness, there are several problems that will eventually “come home to roost” – particularly in the US and China. This would be consistent with a structural bear market in the dollar and a long-term uptrend in the price of gold, and could point to structural euro area outperformance within a global equity portfolio. A Global Indebtedness Report Card Table II-1 presents the aggregate risk score for each country by sector that we examined in our report. Several themes are evident from Table II-1 and the tables shown on pages 24 to 29. Table II-1A Summary Of Our Debt Risk Scores By Country/Region And Sector May 2023 May 2023 Shifting Household Sector Indebtedness Risk Chart II-1Shifting Household Sector Indebtedness Shifting Household Sector Indebtedness Shifting Household Sector Indebtedness The risk of household sector indebtedness has rotated from countries like the US and Spain to several other countries/regions, including Hong Kong SAR, Australia, Canada, and Sweden (Chart II-1). These are relatively smaller countries/regions and thus theoretically pose less of a risk to global financial stability than excessive household sector debt in the US and select euro area economies did in 2008. Mainland China remains one important wildcard for investors to watch. Ostensibly, the risk of China’s household sector indebtedness is only moderate according to our risk score methodology, given that its household debt-to-GDP ratio is lower than in many other countries. However, it has grown at a very significant rate over the past decade. In addition, household disposable income is lower as a share of GDP in China than in most advanced economies, and China’s housing sector has experienced a significant shock over the past two years. The fact that interest rates in China are likely to remain comparatively low versus the pace of economic growth, and that China’s property market is stabilizing, suggest that a major debt crisis in China’s household sector is unlikely over the coming year. The recent property market crisis, however, serves as a reminder of the potential structural vulnerability posed by Chinese household sector debt, which would almost certainly cause a global recession were a major deleveraging event to occur. Chart II-2Elevated Corporate Sector Indebtedness In Hong Kong SAR, China, Sweden, And France Elevated Corporate Sector Indebtedness In Hong Kong SAR, China, Sweden, And France Elevated Corporate Sector Indebtedness In Hong Kong SAR, China, Sweden, And France Some Surprises From The Trend In Corporate Debt Some countries with elevated nonfinancial corporate sector debt risk scores will not be surprising to investors. Chart II-2 highlights that Hong Kong's corporate sector indebtedness is massive and that mainland China's nonfinancial corporate sector debt risk is also very elevated. Mainland China's corporate sector debt risk is concentrated in state-owned enterprises, reflecting the significant quasi-fiscal spending (mainly in the form of infrastructure investment) that has occurred over the past decade in support of economic stability. However, Sweden and France also have very elevated nonfinancial corporate sector debt risk, whose corporate sector scores closely mirror their risk scores from the shadow banking sector. “Shadow credit” references credit that is not provided by domestic banks. A rise in shadow credit appears to be the source of the increase in nonfinancial corporate sector indebtedness in both Sweden and France. Shadow credit poses a risk to financial stability because credit availability from nonbank entities could tighten rapidly in a crisis; it thus points to potentially outsized economic weakness in Sweden and France in a bad economic scenario. Based on the IMF’s stress test results, we continue to regard Sweden’s nonfinancial private sector as one of the riskiest in the developed world. Real Long-Term Risks From US Government Indebtedness Investor concerns about the rise in US government debt have prevailed for over a decade following the surge in the debt-to-GDP ratio that occurred following the global financial crisis. However, with interest rates having fallen to extremely low levels during the last economic expansion, the debt servicing burden of US government debt was minimal. The COVID-19 pandemic changed that reality in two ways. First, the fiscal response to the pandemic resulted in another surge in the debt-to-GDP ratio. Second, the surge in inflation that occurred in the latter half of the pandemic has caused both short-term interest rates and expectations for future interest rates to rise. We expect interest rates to fall meaningfully during the next US recession, so a US government debt crisis is not imminent. However, we doubt that the fed funds rate over the coming decade will be as low as it has been over the past ten years. Higher average interest rates point to net interest costs exceeding their early-1990s levels later this decade (Chart II-3), which could cause financial market participants to force fiscal adjustment via a crisis. Chart II-3The US Will Likely Face A Fiscal Reckoning By The End Of The Decade The US Will Likely Face A Fiscal Reckoning By The End Of The Decade The US Will Likely Face A Fiscal Reckoning By The End Of The Decade The US is not the only country with elevated government debt risks. China, the euro area (excluding Germany) and the UK also rank highly according to our aggregate risk score methodology, as does Canada – although this reflects our use of gross rather than net debt to facilitate international comparability (see page 27 for details). The recent mini fiscal crisis in the UK is a preview of what may occur in the US and other countries on a grander scale in three-to-four years, given our view that the next US recession is likely to be mild and that the neutral rate of interest in the US and euro area is not as low as many investors believed prior to the pandemic. China’s relatively elevated government debt risk score reflects a significant rise in local rather than central government debt over the past decade, but that too carries risks for China’s economy given the way Chinese economic policy is carried out. Admittedly, these risks are much more likely to pertain to the risk of economic stagnation rather than an acute crisis. The Presence of Fiscal Space As A Buffer Against Private Sector Indebtedness In several of the countries identified with excessive indebtedness, the debt is concentrated in either the private nonfinancial or the government sector. For example, in the case of Sweden, its very concerning private sector debt load is somewhat offset by a very low government debt risk score, suggesting the presence of fiscal space in Sweden that could allow its government to respond to any private sector deleveraging event. However, in a few countries/regions, debt appears to be elevated in both the private and public sector: chiefly in Hong Kong, mainland China, and France (Chart II-4). France is a core member of the euro area; a corporate sector debt crisis in France would have a meaningful impact on European economic activity, but China’s very sizeable debt load is obviously more concerning given the importance of China as one of the three pillars of the global economy. Chart II-4Less Fiscal Space In Hong Kong SAR And Mainland China Than Before Less Fiscal Space In Hong Kong SAR And Mainland China Than Before Less Fiscal Space In Hong Kong SAR And Mainland China Than Before Investment Conclusions There are no real cyclical investment conclusions to be drawn from our analysis of global indebtedness. There are several pockets of sizeable private sector debt risk, and it is possible that the next US/global recession will cause a more pronounced economic downturn in some of these countries. However, with the possible exception of France’s corporate sector, private sector debt risks appear to be manageable in the US, euro area, and China, the main drivers of global economic activity. China’s nonfinancial corporate sector is indeed extremely leveraged, but much of this debt resides on the balance sheet of state-owned enterprises and thus is unlikely to pose a cyclical economic risk due to government support – especially given recent incremental easing in China. Tight monetary policy in the US and euro area is a much more proximate risk to the business cycle and, as described in Section I of our report, we expect a recession in the US to begin at some point over the coming six-to-twelve months. However, our analysis of global indebtedness highlights several problems that will eventually “come home to roost”. US government debt is now excessive. The likely future path for interest rates implies meaningful net interest pressure on the government in three-to-four years, even if the US does not experience elevated structural inflation. And in China, the government’s strong desire to avoid aggravating structural imbalances will lead to the limited and finely balanced use of fiscal and monetary policy to boost growth. As we noted in last month’s report,2 that is not good news for China-related financial assets, as it implies that Chinese policymakers will remain reactive and that China will become a more insular economy with even broader state influence or control. The Xi administration’s paradigm shift implies a very different China than many investors became accustomed to between 2008 and 2014, and one that is far less likely to stimulate global economic growth. In short, this is not, and likely will not be, the China that you have been hoping for. On balance, these conclusions are generally consistent with a structural bear market in the US dollar that is likely to begin following the next US recession. It also speaks to the possible structural outperformance of euro area stocks within a global equity portfolio, and possibly a continuation of a structural bull market in gold – which would benefit mightily from the development of any fiscal risk premia in US assets. Finally, once the next US administration is in place and a new high in the servicing costs of US government debt is within sight, investors should structurally monitor the spread between 10- and 30-year US Treasury yields for signs of an abnormally steep curve. An aggressive shift into short-duration positions will be warranted in response to any true signs of a budding fiscal crisis in the US. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Private Nonfinancial Sector The countries/regions most at risk from elevated private non-financial sector debt are Hong Kong SAR, Sweden, mainland China, France, Canada, and the Netherlands (Table II-2). Across all of the metrics shown in Table II-2 that measure the risk of indebtedness, Hong Kong consistently ranks as the riskiest market. This is particularly true based on debt service measures, which show an extremely large amount of income “lost” to repaying debt. Unlike the case of mainland China, Hong Kong’s sharp rise in private sector indebtedness over the past two decades (and especially since 2009) has not occurred due to government efforts to stabilize economic activity. Hong Kong’s pegged exchange rate effectively imports US monetary policy, which has been extraordinarily easy since the global financial crisis – particularly for an economy that did not suffer the same shock to household balance sheets that occurred in the US. The source of the risk from Sweden’s indebtedness is somewhat different than is the case in Hong Kong. Sweden’s private sector debt-to-GDP level is meaningfully below Hong Kong’s, although that is mainly indicative of how extreme the latter is. More importantly, the pace of leveraging in Sweden’s private sector indebtedness has been somewhat slower than in Hong Kong and indeed a few other countries/regions (such as Japan, France, and mainland China); it ranks third after Canada based on the first of our two debt service proxies. However, based on our second DSR that uses a measure of equilibrium interest rates, Sweden appears to be much riskier. Table II-2High Private Nonfinancial Sector Debt Risk In Hong Kong SAR, Sweden, China, France, And Canada May 2023 May 2023 The Household Sector The countries/regions most at risk from elevated household sector debt are Hong Kong SAR, Australia, Canada, Sweden, and the Netherlands (Table II-3). Relative to Hong Kong’s total private sector debt, the household sector is not the dominant contributor. When compared across countries/regions, however, Hong Kong’s household sector debt-to-GDP ratio is among the most extreme. Australia, Canada, and the Netherlands rank worse than Hong Kong in terms of household sector debt-to-GDP, but both economies have recently seen meaningfully slower household debt growth than has occurred in Hong Kong. Aside from the Netherlands, euro area economies rank quite low on the list of household sector indebtedness risk and nontrivially lower than in the UK. The risk of indebtedness posed by the household sector in mainland China may be understated in Table II-3. This is because China’s household disposable income is smaller as a share of GDP than most of the other countries/regions shown in the table, which causes artificially lower debt ratios when scaled relative to GDP. Relative to developed market economies, Chinese interest rates are meaningfully below the prevailing pace of income or GDP growth, so we still suspect that China’s household sector debt service ratio is not extremely high. Investors should acknowledge, however, that the risk posed by China’s household sector leverage is probably larger than conventional debt-to-GDP measures would indicate. Table II-3High Household Debt Risk In Hong Kong SAR, Australia, Canada, Sweden, And The Netherlands May 2023 May 2023 The Nonfinancial Corporate Sector The countries/regions most at risk from elevated nonfinancial corporate sector debt are Hong Kong SAR, Sweden, France, mainland China, and Canada (Table II-4). Unlike in mainland China, where most nonfinancial corporate sector debt is held on the balance sheets of state-owned enterprises, Hong Kong’s corporate debt does not have the same defacto state backing and is enormously concentrated in the real estate and financial sectors. Hong Kong’s real estate sector does enjoy significant structural policy support from the government. It is also true that the region has been highly indebted for some time. But Table II-4 highlights that Hong Kong’s nonfinancial corporate sector is massively leveraged and is thus vulnerable to a permanent rise in US policy rates and/or a property market crisis in the region. Commercial Real Estate (CRE) debt constitutes a large portion of Sweden’s corporate debt. IMF stress tests of Sweden’s CRE sector show that the median interest rate coverage would drop below one in a severe scenario, resulting in 75% of firms with debt-at-risk.3 We continue to regard Sweden’s nonfinancial private sector as one of the riskiest in the developed world. France ranks surprisingly high on the list of nonfinancial corporate sector indebtedness, the result of an M&A boom in the years prior to the COVID-19 pandemic. Our debt service ratio calculations suggest that the servicing burden of this debt may be lower than the BIS’ DSR would suggest, but it is still elevated even based on our measures. This suggests that the French nonfinancial corporate sector should be closely watched over the coming year, especially if the ECB were to keep its policy rate in restrictive territory. Table II-4High Corporate Sector Debt Risk In Hong Kong SAR, Sweden, France, China, And Canada May 2023 May 2023 The Government Sector The countries/regions most at risk from elevated government sector debt based on the BIS’ gross government debt data are Italy, the US, Canada, the UK, and Spain (Table II-5). If Canada were removed from the list, China would be the fifth most vulnerable country according to our methodology. We show gross debt-to-GDP in Table II-5 because of the lack of reliable net debt measures for China, but gross debt measures have many drawbacks. Canada is an example, as its gross debt-to-GDP ratio suffers from two international comparability problems. First, Canadian general government debt statistics include sizeable accounts payable (20% of GDP). In addition, the Canadian government holds significant financial assets; Canada’s net debt is very low compared to other developed economies. The gross/net debt issue also impacts the government indebtedness risk score for Japan, although Japan’s net government debt is still extremely elevated (160% of GDP). Very elevated debt levels in Italy, especially in net debt terms, underscore why the effective neutral rate of interest is likely lower in the euro area than would be the case if the euro area was one political and economic entity. The extraordinary US fiscal response to the COVID-19 pandemic underscores that the US will likely face a fiscal reckoning in the latter half of the decade as net interest costs eventually exceed their early-1990 levels. It is impossible to come up with a precise estimate of when the US will face market pressure for fiscal reform, but our best guess is that it will occur at the tail end of the next US administration. Table II-5High Government Debt Risk In Italy, The US, The UK, And Spain May 2023 May 2023 The Total Nonfinancial Sector (Private Plus Government) The countries/regions most at risk from total nonfinancial sector debt (private plus government) are Hong Kong SAR, mainland China, Sweden, Canada, and France (Table II-6). As noted above, Canada’s rank in Table II-6 is likely overstated due to the country’s much lower net debt ratio, although it would still rank relatively high given very elevated private nonfinancial sector debt. We agree that private sector debt is typically more of an economic risk than public sector debt. It is important to examine total debt, however, as it reflects the combined risk of a private sector deleveraging event that the government of that country will struggle to respond to because of a lack of fiscal space. The fact that Hong Kong and mainland China top this list underscores the risk of long-term economic stagnation in the region, and partially explains why the Xi administration is focused on improving China’s financial resiliency. Sweden’s government debt risk score is extremely low, but the country’s very elevated private nonfinancial sector debt is large enough for total nonfinancial sector debt to show up at an elevated level (similar to Canada). France’s comparatively high levels of government debt, even when measured in net debt terms, underscore the economic risks to the country were its highly leveraged nonfinancial corporate sector to experience a crisis following a period of meaningfully tight euro area monetary policy. Table II-6High Total Debt Risk In Hong Kong SAR, China, Sweden, Canada, And France May 2023 May 2023 Non-Domestic Bank Credit To The Private Nonfinancial Sector The countries/regions most at risk from excessive non-domestic bank credit (“shadow banking”) are Sweden, Hong Kong SAR, France, Japan, and Canada (Table II-7). The risk posed by shadow credit is that debt provided by non-bank entities is very rarely amortized, meaning that it needs to be periodically rolled over. The other risk is that lending standards or credit availability from these entities is more discretionary than is the case for banks and thus could tighten rapidly during a crisis. Combined with non-amortized loans/bonds that need to be rolled over, high levels of credit provided by the “shadow banking” sector could result in larger or more frequent credit “crunches.” Generally speaking, the list of countries with high shadow banking risk matches those that show up as high risk for the private nonfinancial sector. Japan is an exception. Global investors should be attuned to any potential credit availability issues that arise in Japan should JGB yields eventually rise, potentially in response to the end of the BOJ’s yield curve control policy. Table II-7High Shadow Bank Risk In Sweden, Hong Kong SAR, France, Japan, And Canada May 2023 May 2023 Appendix: Debt Risk Measures Our debt risk score tables present five measures of debt risk for three individual sectors and two aggregate sectors over fourteen countries/regions. The five sectors include: Households Nonfinancial corporations Government The private nonfinancial sector (aggregate of households and nonfinancial corporations) The total nonfinancial sector (aggregate of households, nonfinancial corporations, and the government) We also examine the private nonfinancial sector focusing on debt that is not provided by domestic banks (“shadow banking”). Our methodology scales each measure of debt vulnerability for each country across the matrix of histories of all fourteen[1] countries/regions for that debt vulnerability measure using a percentile rank. In that way, we compare each country’s measure to a range of country histories, rather than only its own history. We scale these measures as scores from 0 (best / lest vulnerable) to 10 (worst / most vulnerable) and present the most recent observations in the tables included in this report. Our five measures include: The BIS[2] Credit-to-GDP Ratio: Ratio of total credit provided to the sector to GDP The BIS Debt Service Ratio: Ratio of debt payment estimate to gross disposable income (GDI). This measure is not available for the government sector, the overall nonfinancial sector, as well as for nonfinancial corporations for China and Hong Kong SAR. The BCA Credit-to-GDP Gap: Measure of Credit-to-GDP relative to its 10-year moving average The BCA Debt Service Ratio (Proxy 1): Ratio of debt payment estimate 1 to gross domestic product (GDP) The BCA Debt Service Ratio (Proxy 2): Ratio of debt payment estimate 2 to gross domestic product (GDP) We also include an Aggregate Debt Risk Score, which aggregates the scores of all debt vulnerability measures available by sector for each country using an equal weight approach. Our BCA Debt Service Ratios are calculated in the following manner: We estimate principal payment schedules of 18 years for households and of 10 years for nonfinancial corporations. We then estimate a principal payment component of the total debt payment by dividing the stock of debt by the debt maturity. We do not consider a principal payment in cases where debt is exclusively not amortized, such as government debt. We then compute the measure of debt interest payment by multiplying the overall stock of debt by an interest rate proxy. For our DSR proxy 1, we use the 10-year government bond yield as a measure of effective interest rate plus a spread of 1.75% for household sector debt and 1% for nonfinancial corporate sector debt. One exception applies to Hong Kong SAR, where we use US 10-year Treasury yields given Hong Kong’s pegged exchange rate. For our DSR proxy 2, we use an estimate of the equilibrium interest rate instead of 10-year government bond yields with the same household/corporate sector spread estimates. Our estimate considers the median 10-year nominal GDP growth rate as the equilibrium interest rate, with exceptions for euro area members, Hong Kong SAR, and mainland China. For euro area economies, we use euro area GDP rather than the individual country GDPs due to the commonality of monetary policy. For Hong Kong SAR we use US GDP rather than Hong Kong GDP given its pegged exchange rate and its importation of US monetary policy. For mainland China we use half of the estimated equilibrium interest rate, given that China has consistently maintained a large gap between domestic interest rates and the prevailing rate of nominal GDP growth. We then add the interest payment estimate to the principal payment estimate (when applicable) to obtain total debt payment. We then express these debt payments as a percent of GDP. Gabriel Di Lullo Research Analyst   Footnotes 1 Please see the appendix on pages 30 and 31 for a description of our debt score methodology. 2 Please see The Bank Credit Analyst "April 2023," dated March 30, 2023, available at bca.bcaresearch.com 3 Sweden’s Corporate Vulnerabilities: A Focus on Commercial Real Estate, IMF Working Paper, Selected Issues Paper No. 2023/024, March 21, 2023

In Section I, we discuss why the rally in stock prices over the past month reflects the soft-landing view, and why that is not a likely economic outcome. US inflation is slowing, but target inflation remains elusive. Meanwhile, cracks in the US labor market are already apparent, and there is strong evidence against the view that US stocks are appropriately priced for an eventual US recession. This underscores that conservative investment positioning is still warranted. In Section II, we check in on the indebtedness risk of several major economies, and examine whether these risks exist primarily in the household, nonfinancial corporate, or government sectors. While there are limited cyclical implications of recent trends in global indebtedness, there are several problems that will eventually “come home to roost” – particularly in the US and China.

First Republic Bank’s earnings report showed how its struggles have exaggerated the perception of other banks’ distress. Ex-FRC, the banking system appears to be coping with the post-Silicon Valley Bank turmoil pretty well.

Inflation is hot, but inflation expectations are not. We explain the answer to this apparent puzzle and discuss the investment implications. Plus we identify two commodities that are at imminent risk of reversal.

Government financing vehicles (LGFVs) are a key component of China’s credit system. LGFV bonds make up a 40% share of the onshore corporate bond market, and loans to LGFVs make up 20% of total loans. LGFV debt-servicing capacity is very weak. What are the ramifications of all of these for Chinese economic growth and financial markets?

This Special Report discusses why there is a non-negligible risk that the US Congress will not reach a timely agreement to lift the debt ceiling this summer. It also discusses what will happen in bond markets in the lead up to the debt limit and in the case where a deal is not reached in time.

The latest round of earnings calls from the systemically important banks was encouraging on balance. Households are still flush and still spending and consumer and business delinquencies remain remarkably low. Though a recession is surely coming, it doesn’t seem to be lurking just around the corner.