What begins as a lesson in learning to ride a bike becomes a way of thinking about today’s global economy: sometimes slowing down can make you less stable. With governments caught between mounting debt, stubborn spending, and the need for growth, this piece explores where the next economic waves could hit — and why investors may need to rethink what diversification really means.
I have always had a slightly complicated relationship with cycling. I travelled quite a bit by bicycle when I was younger, although never really considered it a sport – for that I preferred ice hockey, football or even chess. What I did discover was its beauty as a way of travelling: slow enough to see the world around you, but fast enough to cover surprisingly large distances.
Like many parents, I have spent quite a few nerve-racking hours running alongside a small bicycle, trying to decide whether to shout “brake!” or “keep going!”. The strange thing is that both pieces of advice can be right. Children first need to learn that braking prevents them from crashing. But they also have to discover something much less intuitive: going too slowly can make them less stable. If you actually want to get from A to B, stopping every time things feel uncertain is not much of a solution. At some point, you need enough forward momentum to stay upright.
There is a broader lesson in this. Our instinct when something feels uncertain is often to reduce speed. Sometimes that is exactly the right response. But there are situations where deceleration can make the underlying problem worse. If stopping is neither realistic nor desirable, continuing to forge ahead can become a necessity rather than a choice. I think developed economies have entered such a situation.
Governments have accumulated debt on a scale that makes hitting the brakes difficult. Austerity can reduce deficits, but it can also weaken the economy against which the existing debt has to be carried. Higher real interest rates can restrain demand, but they simultaneously increase the cost of servicing the debt. At some point, the question is no longer simply how to reduce the numerator. The denominator has to grow. In other words, growth itself becomes part of the stabilisation mechanism.
The growth imperative
The difficulty is that real growth cannot simply be engineered. Governments can invest to improve productivity over time, but they can support nominal demand, much more directly through fiscal policy. And in recent years, they have shown an increasing willingness to do so. The relentless rise in government debt and fiscal deficits across the developed world is no longer simply the result of one pandemic, one recession or one unusually generous fiscal package. Much of the strain on government spending is structural, and there is little political appetite for austerity.
Our modern societies have become pluralistic. More groups are competing for government support, while politicians face growing pressure to satisfy a wider range of interests. As populations age and demands on the state increase, reducing spending becomes more difficult. At the same time, fiscal policy has become less responsive to the economic cycle: large deficits are no longer reserved for recessions or periods of high unemployment.
Governments can try to stop this wave of debt. But most ways of doing this, risk creating another wave somewhere else.
Aggressive spending cuts or raising taxes can weaken economic growth. Keeping real interest rates high for too long can do the same, while also adding to governments’ own debt-servicing costs. Policymakers therefore face an uncomfortable trade-off: restoring fiscal discipline too quickly may create precisely the economic weakness they are trying to avoid.
The more politically acceptable path is likely to be one that favours growth – while tolerating, to some degree, the inflation that may come with it. If the stock of debt cannot easily be reduced, growing the economy against which that debt is measured becomes increasingly important. But there is an important distinction between growing out of debt and inflating out of debt.
The composition of fiscal spending matters
Fiscal support directed towards consumption can sustain demand today, but does little to increase the economy’s productive capacity tomorrow. Investment in infrastructure, energy, defence or technology can also support demand in the short term, but may additionally raise future supply and productivity. Both add to the debt stock, but only the latter has the potential to boost productive capacity and make that debt easier to carry over time.
This creates a second wave: a policy environment that is more supportive of nominal growth (growth including the effect of inflation), but potentially also more inflationary. For the economy and for many companies, that may not necessarily be bad news. For long-dated government and investment-grade corporate bonds with a maturity date far into the future, however, it is a much more difficult environment. Higher nominal growth, persistent inflation, greater bond supply and competition for capital can keep longer-term bond yields elevated even when corporate fundamentals remain healthy.
This distinction matters because sovereign solvency risk is not the same as asset-price risk.
A deterioration in government finances does not automatically imply falling equity or other risky-asset prices. In fact, policies used to make a large debt burden more manageable can also support nominal economic activity, corporate revenues and asset prices.
Who is the creditor?
A government can reduce the real value of its liabilities without formally defaulting on them. Inflation, financial repression or a gradual erosion in the purchasing power of the currency can all reduce the real burden of debt over time. But somebody owns those liabilities. For the holder of a long-dated nominal government bond, being repaid at par offers limited protection if that par buys materially less.
Companies sit in a different position. Their revenues, prices and earnings can adjust with the nominal economy. Fiscal deterioration can therefore coexist with healthy corporate fundamentals and rising nominal asset prices for much longer than conventional intuition might suggest. The fiscal problem may show up in the price of duration long before it shows up in the price of risk. This also has implications for the traditional role of government bonds in a portfolio.
Changing correlations
For much of the past few decades, government bonds provided a reliable counterweight to equities. When economic growth weakened, inflation typically fell, central banks could cut interest rates and bond prices rose. What was bad for equities was often good for bonds.
But this relationship depends on the nature of the shock.
Government bonds have traditionally been effective diversifiers when the shock comes from the economy. They can be much less effective when the shock comes from fiscal policy itself. If markets are worried about inflation, government borrowing or the sheer supply of bonds, yields can rise at the same time as equity valuations come under pressure. Bonds and equities can then move in the same direction.
This changes the way investors should think about diversification. Simply owning a basket of different assets does not necessarily mean that the underlying risks are different. If they ultimately depend on the same economic growth, liquidity or interest-rate environment, they may all be sitting in the same car when the next wave arrives.
What this means for investors
For investors, the implication is not simply that the world has become riskier, but that the nature and location of risk may be changing. Deteriorating government finances do not necessarily translate directly into weaker economies or asset prices, as the policies used to manage them can themselves support nominal growth. The more important question may therefore be where the consequences ultimately appear – and whether portfolios are genuinely diversified against them.
The answer is not to abandon fixed income. Far from it. But investors may need to look more carefully at where their income comes from. Shorter-duration and floating-rate assets (whose interest rates adjust periodically) reduce exposure to long-term interest-rate uncertainty, while alternative sources of income can introduce return drivers that are genuinely different from those of traditional bonds and equities.
Catastrophe bonds are one example. Their income ultimately comes from taking insurance risk linked primarily to natural catastrophes rather than corporate profits, central-bank policy or the economic cycle. That does not make them risk-free, but it makes the source of that risk fundamentally different. This distinction – between diversifying asset labels and diversifying sources of return – is becoming increasingly important. It is also why Cat Bonds have attracted greater attention from investors looking beyond mainstream fixed income. In fact, in a full-circle moment, I recently invited ex-colleague, Cape alumni and long-standing friend Florian Steiger, the CEO of Icosa Investments, to join me in a Cape Conversation on this subject. Icosa, which focuses on Cat Bonds, is a new partner for Cape, and integral to the way we’re re-thinking fixed income.
The waves building in the global economy will not all break at the same time, nor will they affect every asset in the same way. The challenge for investors is therefore not simply to predict the next wave or try to avoid it altogether. It is to understand what is driving it, which assets are exposed to it – and which sources of return may behave differently when it arrives.
Michael Lienhard
Head of Fixed Income