The sovereign debt time bomb: why fiscal prudence outweighs deficit size

Welcome to Capital markets: strategy and risk, a new series where our leaders and experts help you navigate the complexities of today's capital markets and make informed and strategic decisions.

When deficits stop telling the full story

In the current financial climate, key risks being discussed have moved beyond lacklustre GDP growth and high inflation to the scale of sovereign debt and the fiscal response to deal with it.   Governments are failing to make sufficient inroads into reducing their deficits, pushing concerns over sovereign debt and the resulting impact on bond yields to the top of the priority list for institutional investors and borrowers.

Deficit size vs. fiscal intent

Recent actions by credit rating agencies have highlighted a critical nuance in assessing sovereign risk: it is not just the sheer size of the deficit, but the direction and commitment of the government’s fiscal policy that truly matters. During our recent semiannual market update virtual event,  Jackie Bowie, Chatham Financial’s Head of EMEA, pointed to the seemingly paradoxical downgrading of France while Italy's credit rating was increased, despite both countries having significant budget deficits. The key differentiator, Jackie explains, is intent and action: "France and the UK, to some extent, are not showing any indications that they’re going to get that debt under control, whereas Italy have made some inroads into slightly more fiscal prudence." This shift in focus means that the general fiscal position, and indications of a commitment to debt management, should now rank "at the top of the worry list."

A shifting fiscal landscape in the United States

The United States enjoys strong economic dynamism but is not immune to fiscal concerns. On the same virtual event, Amol Dhargalkar, Chatham Financial’s Chairman, noted domestic challenges, including recent extensions of tax cuts. He pointed out that the argument—that these cuts will unlock sufficient growth to improve the U.S. fiscal position—is "certainly not a mainstream view" among most economists.

Don’t take our word for it. On our virtual event, we asked our audience which risk factor they view as most underappreciated in the market. Below are their responses showing “Increasing sovereign debt yields” having the most votes from those polled.

What does this mean for investors and borrowers?

Paying close attention to the sovereign bond yields offers a clearer picture than waiting for agency ratings. As Amol noted, bond yields "tend to move ahead of any agency's decisions". This reinforces the idea that the market is already pricing in a lack of fiscal prudence in certain jurisdictions. The takeaway is that the political will to manage debt has become a significant factor in assessing sovereign risk.  Policy credibility is one determinant of long-term asset performance and the cost of raising debt in those countries.