A combination of large sovereign debt and lower rates for longer could see the eurozone emerge as another Japan, according to Columbia Threadneedle’s Mark Burgess, who warned that a low growth, low inflation environment could take years to escape from.
Sovereign debt levels have continued to rise in recent years as governments continue to deal with the aftermath of the global financial crisis and deliver sustainable growth.
“Barring glaring historical exceptions sovereign debt levels in many economies are close to all-time highs,” said Burgess, deputy global chief investment officer and chief investment officer for Europe, Middle East & Africa at Columbia Threadneedle. “They are certainly much higher than they were just two or three decades ago.
“In the US, the net debt to GDP ratio is 106 per cent and rising, compared to less than 40 per cent in the early 1980s. UK net debt to GDP is at almost 86 per cent but between 1975 and 2018 it averaged below 45 per cent.”
Source: IMF
However, Burgess (pictured) said the question remains whether central banks are can stomach spiralling debt should another crisis or recession occur? 
In normal times, central banks can lower interest to encourage borrowing but this has not occurred due to the private sector preferring to pay down debt rather than borrow more despite the cheap rates on offer.
“This is where governments stepped in, emerging as the sole remaining borrowers and spending the private sector savings,” he said.
“Government intervention certainly staved off a deeper financial crisis, but there was a huge cost to bailing out the banks and stimulating the economy in this way.”
The sharp rise in government debt has had negative consequences for future growth having effectively brought tomorrow’s consumption forward, noted Burgess.
As a result of quantitative easing (QE) central banks are also significant owners of their own debt, which they remain unable to write-off to prevent undermining their currencies.
Two scenarios could emerge for developed markets – and the eurozone in particular – according to the Columbia Threadneedle global deputy chief investment officer: a credit crisis or a Japan-style scenario.
“Neither is a particularly appealing scenario, but a credit crunch, inflicting perhaps a prolonged period of negative growth, would be by far the worst,” said Burgess.
“Debt to GDP would conceivably rise even further and this would likely result in the déjà vu effect of governments once again having to step in, but this time from a weakened position, having not had time to repair their balance sheets.
“This is clearly an unpleasant prospect, but it would result in interest rates remaining necessarily low, which would be one positive.”
While low interest rates may provide some comfort for developed markets, any sharp hikes could pose significant challenges for some over-indebted countries.
“In particular, a sharp rise in rates in Italy – where debt servicing costs are only just about manageable – would have severe negative knock-on effects for its financial sector and the wider eurozone economy,” he said.
However, rising rates in the eurozone are unlikely in the near future because of the absence of major inflationary pressures and accelerating economic growth.
Eurozone harmonised indices of consumer prices year-on-year
Source: Eurostat
Indeed, outgoing European Central Bank (ECB) president Mario Draghi announced a 10 basis points cut in deposit rates last week in a bid to kick-start a faltering eurozone economy.
Columbia Threadneedle’s Burgess said the eurozone economy “bears some striking similarities to Japan’s” and therefore makes a prolonged period of low growth and low inflation likely.
“Firstly, both economies have sizeable banking systems, which account for roughly 70 per cent of the funding of the corporate sector – dominated by small- and medium-sized enterprises [SMEs],” he explained.
“Lower interest rates are still not creating sustained loan growth to this sector across the entire eurozone.”
Burgess added: “In the periphery, growth is only just returning now, 10 years on from the crisis. And in Italy, it has not yet returned.
“Similarly, in Japan it took well over a decade from their crisis for sustained credit growth to return despite ultra-low rates. In the absence of borrowers from the corporate sector, both banking systems have also loaded up on government bonds, facilitating the growth in government debt to GDP.”
Even if there are further rate cuts by the ECB, Columbia Threadneedle’s Burgess said, the mechanism will not work properly if SMEs are not borrowing. With deficit caps set at 3 per cent under the Maastricht treaty, eurozone governments will be unable to step in and support the economy.
“The result will be continued deflationary pressures, increasing the need for sustained low interest rates,” he said.
He said this backdrop will be further supported by weak wage growth – traditionally a key driver of rising prices.
Source: International Labour Organization
“A myriad of factors, ranging from globalisation, technology and automation, to a rise in part-time and flexible contracts and falling unionisation numbers, are so far keeping salary rises to a minimum,” he said.
“Where there have been rises in wages, they haven’t sneaked their way into inflation figures. We see there being little change to this in the medium term.”
In addition, Burgess said that it can be very hard to escape a low growth and low inflation environment if Japan’s experience is anything to go by, even if productivity is rising and governments are running fiscal deficits.
“Increased corporate and personal borrowing would counter this but potential solutions to fix problems in the banking sector – such as bank consolidation, relaxing fiscal rules or changing ECB inflation targets – look unlikely,” he said.
“We therefore believe the eurozone is entering a prolonged period of low inflation, combined with low growth, which will keep interest rates low for the next 10 to 20 years.
“In this lower for longer environment, elevated debt levels are here to stay.”
Burgess concluded: “It’s going to be a multi-year, perhaps even multi-decade workout, with a dearth of growth and income opportunities persisting for savers and investors.
“High levels of leverage would also suggest a heightened level of volatility. Time to buckle up for what is likely to be a bumpy ride.”