Merlin Weekly Macro: Fiscal folly, global tensions drive debt costs up

If global equities remain almost impervious to underlying economic conditions, the same cannot be said for government bonds. It has been another arduous week of rising yields (more accurately steepening yield curves) and falling prices as fixed income investors weigh up the changing financial and geopolitical risks.

A familiar old chestnut: deficits and debt

While there are national idiosyncrasies, the common theme is an old one. It’s the “Double D”: Deficits and Debt. It is entirely familiar territory to our regular readers; goodness knows we’ve discussed it often enough in these columns, not only over weeks and months but years. Indeed, back in 2020 and the peak infusion of liquidity to stop the world economy grinding to a halt while whole populations were confined to barracks during Covid, and governments and their central banks were almost literally hosing money at the situation to keep the system alive, we described the “socialisation of a crisis”, writing that “we are all in this together” and concluded that eventually, “we will all be made to pay”. Half a decade later we are facing the financial reckoning.

Some like Germany have managed to keep their deficits and debt reasonably under control. In Germany’s case such were the political tensions involved in maintaining fiscal conservatism that it cost former Chancellor Scholz his premiership. His ill-starred government collapsed in November 2024. Still, in the welfare vs warfare competition for funding, ground has had to be given. By a whisker in the Bundestag vote on the subject earlier this year the debt brake law was relaxed under the new Merz-led coalition to accommodate Germany’s commitment to rearmament. Markets now have one eye on whether in the face of a stagnant German economy, the relaxation of fiscal frugality becomes the thin end of the wedge prefacing higher debt levels becoming politically more expedient.

Others such as the UK and France have found it difficult to the point of impossibility to kick the deficit habit. Debt has proved to be an expensive but dangerously addictive drug. Politicians are seduced into thinking it is victimless. However, the reality is that it can become so pernicious and embedded that in the end it overwhelms the system as the associated interest costs rack up. Today, the UK spends just over 4% of GDP on debt interest; by 2075, the Office for Budget Responsibility estimates that the debt interest burden could amount to 12% of GDP, nearly six times what we currently spend on defence and close to what we already spend on health. What governments in both London and Paris are finding to their political cost is that when welfare payments such as benefits are doled out with abandon and without reciprocal responsibilities required from the beneficiaries, what essentially become rights and entitlements are almost impossible to take away again without severe consequences. As fiscal pressures mount elsewhere, such governments rapidly start running out of room for manoeuvre.

Downing Street turns sharply left

The 2025 UK Budget is now scheduled for 26 November. Intense focus is on Keir Starmer’s new group of economic experts appointed to give advice directly to No 10. Needing to try and wrest back control over the economic agenda after a disastrous first year in office, a marked lurch leftwards presages a new and gloomy fiscal chapter. With a shared background in the overtly socialist, redistributive ideology of the Resolution Foundation think tank, those involved including Baroness Shafik advising the Prime Minister, and Torsten Bell and Dan Tomlinson doing the same for Rachel Reeves in No 11,  all have actively championed the taxation of wealth and assets as being at least as important if not more so than taxing income.

With government borrowings out of control and Labour backbenchers determined to inhibit spending cuts on health and welfare (if they allow any cuts or reform of these systems at all), the Budget’s main emphasis will be on taxation as the principal means of trying to balance the books. Given an assault on wealth is completely incompatible with trying to stimulate investment and to inject enduring growth into the economy, it is not surprising that investors are sceptical, pushing long-term yields to their highest in nearly three decades.

Given the size of Labour’s majority, however incompetent the government and economically illiterate or careless are many of its backbenchers, this path of economic recidivism and fiscal regression appears to be one we are stuck with at least until 2029. Unless, as some predict, the market appetite for UK bonds finally cracks and the IMF has to step in, takes control and sets about a draconian series of remedial actions from which to rebuild the economic and social fabric. If the geostrategic tensions discussed later are adding generally to the risk premium on bonds, the UK’s seemingly intractable economic problems are only adding to the awareness that risk needs pricing upwards.

The Bank’s magic money unwinds in every sense

Even the Old Lady of Threadneedle Street is in a fangle of her own making. Bank of England base rates have been falling for a year. August delivered the fifth quarter point cut, albeit voted by the narrowest of margins. It is therefore ironic that the Bank of England has itself been contributing to the upward pressure on government funding costs.

Counterintuitively in the context of its policy of reducing interest rates, in simultaneously actively reducing the stock of bonds held on the Bank’s balance sheet by selling them to the market (“quantitative tightening”, the opposite of its previous policy of “quantitative easing”, buying them from the market), the oversupply of bonds coming from both the Bank and the Treasury at the same time has had the effect of putting downward pressure on bond prices. The corollary of falling prices is rising yields. Rising yields add to government borrowing costs and Rachel Reeves’s financial headache.

But there is a second technical aspect adding to the Treasury’s cash outflows: under a rebate system the Bank earns no interest on the gilts it owns; but as soon as those gilts are sold to the market, the rebate ceases and the coupons (interest payments) resume as normal cash liabilities. Further, the losses incurred by the Bank on the sales (the gilts are being sold at prices significantly below those at which they were purchased) are effectively covered by the Treasury; in September 2024, the New Economic Foundation calculated that the Bank maintaining its then pace of QT would cost the Treasury £96 billion over four years, or £24.9 billion annually. £24.9 billion is almost exactly half the estimated value of the “black hole” in the government’s finances that has appeared since March.

Governor Bailey is “reconsidering” this approach.

France: political dysfunction in action

The UK is not alone making heavy weather of squaring the fiscal circle. France is giving significant cause for concern too. Again.

If the UK’s financial situation is bad, France’s is much worse. Here, debt/GDP currently stands at 104%, in France it is 114%; our deficit/GDP 4.8%, theirs 5.8% and widening; UK government spending on public services is 47% while in France it is 57%; the UK tax burden is currently 37.7%  of GDP and growing while in France (which already has wealth taxes) the burden is 45.6%.

Francois Bayrou, President Macron’s 6th prime minister, is determined to confront a deeply divided French parliament over the unsustainable budget deficit. Bayrou has neither a popular mandate nor a secure parliamentary platform; his is not a winning hand. Aiming to reduce the fiscal imbalance by €44 billion through €35 billion of cost savings and €9 billion of tax rises, in a heavily polarised legislature with no middle ground centre of gravity, he risks losing a vote of confidence.

By any measure, France is one of the most indebted nations in the G7 group of leading economies. However, since President Macron’s ill-considered snap election in June 2024, there has been no political consensus in Paris to grip French budget deficits and to control its debt. With Macron’s Ensemble party trailing Marine Le Pen’s National Rally by 15 points in the polls (despite her being barred as a candidate having been found guilty of fraud), Macron will move heaven and earth to stay in the Elysee until the next Presidential election in 2027. Unless Macron is ousted or capitulates, France remains politically paralysed, economically rudderless and virtually ungovernable for the next year-and-a-half.

Despite that, the spread between French 10-year bond yields (3.49%) and German 10-year Bunds (2.72%) is a remarkably constant 0.77 of a percentage point, only slightly more than 6 months ago when it was 0.7 percentage points; given France’s position as the second largest economy in the Eurozone, markets are confident that even if the wheels drop off yet another French government, the European authorities including the central bank will do anything and everything to prevent a systemic risk to the euro currency and European national bond markets. In the early 2010s, Greece (a mere minnow in comparison) came within a cat’s whisker of causing a bond market melt-down and had to be rescued by a Troika comprising the European Commission, the IMF and the ECB. France falls into the category of “too big to fail”: the consequences of the disintegration of the euro for the global financial system, let alone Europe’s, would be massive. Nobody in their right mind wants to go there.

Across The Pond it’s business as usual

America, on the other hand, acts simply as if it does not care. With the dollar being the world’s strategic reserve currency and the pitprop of the global financial system, Washington always assumes there will be an appetite for dollars and US treasury bonds. Successive US administrations have spent with abandon and allowed yawning deficits to proliferate. US debt has spiralled to unimaginably large figures, now 124% of GDP fed by a deficit of 6.4%. When measured in not only trillions of dollars but tens of trillions i.e. the substantive number with twelve zeros on the end, such figures are so large and unrelatable that they become incomprehensible to the point they are not worth worrying about.

Consider this: if the current US debt of $36 trillion were to be fully paid off at the rate of one dollar per second, it would take 1,141,552 years and 6 months to clear; by 2029 when Trump has left office and the US debt ceiling is projected to be $41 trillion, that will add another 158,549 years to the dollar-per-second payback period; in context Homo Sapiens has only wandered the Earth for around 300,000 years.

Donald The Disruptor

But bond markets do worry about Trump and his unpredictability. As we discussed in our most recent issue, he is waging a personal war with the Federal Reserve in his belief the central bank is not acting in America’s best interests. But markets worry also about the real effects of his America First strategy and the geostrategic implications.

Take Russia as a case in point. What is it with Trump and Putin? Churchill memorably said in October 1939, after the Soviet Union and Nazi Germany signed their mutual non-aggression pact, “I cannot forecast to you the action of Russia. It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key. That key is Russian national interest.” Today, such might be an appropriate description of President Trump’s enigmatic relationship with President Putin: whether Trump is bewitched, bewildered or bemused is a moot point. Perhaps all three. Whichever, his promise before taking office to bring peace to Ukraine “in a day” and his boast that he personally has “the power to bring the war to an end” have both proved hollow. Given the US obligation as the guarantor of Ukrainian sovereignty and its borders as of 1994, all the indications remain that his inclination is an appeasing deal with Putin that in principle borders on moral bankruptcy.

August concluded the bulk of Trump’s new tariff “agreements”. After talking tough about super sanctions on those knowingly funding Russia’s war machine, in the event he took no action at all against the Kremlin, punished India with a 50% fine on all its imports into the US for buying Russian oil and gas, and extended trade negotiations with China for another 90 days. To misquote Edmund Blackadder, if there is a “cunning plan, it is so cunning you can stick a tail on it and call it a weasel”.

As it is, deliberately cocking a snook at Trump, NATO and the UN, General Secretary Xi Jinping’s New World Order accomplices including Russia, North Korea and Iran met in Beijing to consolidate their Axis and to show off China’s new military might with the explicit warning to be prepared for war. While absent from the march-past, at the prior economic conference of the Global South countries in Shanghai, India’s prime minister Modi made great public play of walking animatedly and excitedly hand-in-hand with Putin, a bit like Pooh and Christopher Robin (with apologies to AA Milne).

As the geopolitical and geostrategic tectonic plates shift perceptibly, investors register the increasing tension in longer-term bond yields where higher returns are required for the greater perceived risk.

The investment perspective

How are the Merlin portfolios positioned against this complex backdrop? Those which do not need to own bonds have none. Those which have an equity cap and therefore need to own other asset classes do have bond exposures compatible with their risk profiles and specific fund mandates. However, while having diversified bond exposures, we have tried as far as possible to keep the tactical focus towards corporate bonds where the risk is concentrated on company fortunes and is less at the mercy of the big macro-economic and geostrategic headwinds. Should the situation change, as active managers we reserve the right to change our minds. As you would expect!

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each.  With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.