Published on November 15, 2022 by David Bakkegaard Karsbøl, CIO at Selected Group

While private households around the world have wisely reduced their indebtedness relative to their assets and incomes in the wake of the financial crisis, sovereign debt has grown explosively. The IMF already concluded at the beginning of this year that total debt as a share of gross domestic product (GDP) in 2020 has seen the largest annual increase since the Second World War. Although 2020 was a crisis year, developments have been worrying for several years.

Total global debt (sovereign, corporate and household) at the end of 2021 amounted to a total of USD 226 trillion, equivalent to 256% of global GDP. This in itself is a major concern, as it puts pressure on public budgets and removes the room for manoeuvre for future crisis responses by governments. But in addition, the size of the debt has become significantly more problematic as a result of the dramatic interest rate rises we have seen over the past year.

In the short term, interest rate rises have little impact, as most of the payments by governments are already fixed in fixed-rate bonds (although these have fallen in value). The problem arises when these bonds mature and need to be refinanced at significantly higher interest rates in the coming years.

In just a few years, the US federal government has gone from paying less than 2% of GDP in interest payments on its outstanding debt to almost twice that amount. The federal debt alone has risen to about 140% of GDP, and judging by the bond market, this debt will have to be refinanced at significantly higher interest rates over the coming years. Americans can look forward to a future in which the federal government spends almost 10% of its revenues on interest payments alone. The same problem applies to several of the most indebted European countries.

How do we get out of this vice? If policy makers find it unattractive to be subject to the authority of the bond market, a much tighter fiscal discipline should be introduced so that the budget deficit as a share of GDP will always be lower than GDP growth. This would reduce the size of debt burdens relative to GDP over time. There is probably no political appetite for this anywhere. The desire for re-election buries any politician's long-term responsibility.

The most palatable - and thus most likely - solution to the problem for policymakers would be to allow inflation to be systematically higher than the normal 2 percent. This would increase both tax revenues and nominal (i.e. not adjusted for inflation) GDP, so that debt burdens would be reduced relative to these over time.

If my assessment is correct, government bonds will be one of the worst investments over the coming years because their yields are still quite low and do not reflect the risk of sustained, higher inflation.

Conversely, despite the current downturn, real estate investment may actually prove to shield investors from an investment environment with higher inflation. While real estate investments are likely to be hit by higher yield requirements (when the investment alternative is, for example, a 5% mortgage bond), sustained rent increases above 3% will generate quite high long-term returns for real estate investors.