INSIGHT. Juggling act QUARTERLY MARKET REVIEW Q ASIA SPECIAL FOCUS OVERVIEW. Brexit clouds clearing. Who holds the debt?

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1 INSIGHT QUARTERLY MARKET REVIEW Q 18 HIGHLIGHTED IN THIS PUBLICATION: GLOBAL STRATEGIC ASSET ALLOCATION REGIONAL ASSET ALLOCATION GLOBAL SECURITY SELECTION REGIONAL PORTFOLIO CONSTRUCTION Juggling act OVERVIEW UK ASIA SPECIAL FOCUS Government finances: a trilemma Brexit clouds clearing China-US trade Who holds the debt?

2 OVERVIEW Around the world, governments are performing a juggling act: trying to meet the demands for more government spending; keeping taxes competitive and yet avoiding public debts spiralling out of control. Rising government spending Pressures for more government spending are relentless in developed and emerging economies alike. In many cases, this increase is baked in because of commitments to social provision: state pension payments (many of which, in retrospect, now appear overly-generous) will rise as populations age; healthcare spending faces similar demographic problems, coupled with demand for the better services made available by technological improvements and the development of new medicines. Pressures on other government spending are also intense: to provide better policing, defence, environmental protection and aid to poorer countries; and in some economies to return to state control industries that were privatised in the 198s and 199s. These longer-term issues may be partly obscured in the short-term as a result of a stronger job market and consequently reduced pressure on unemployment benefits. But there is no escaping the longer-term pressures. is not a great surprise. Such pressures have long been recognised. Adolph Wagner, a nineteenth-century German economist, set out what proved to be a surprisingly prescient and still pertinent law of economics. 1 Wagner s Law states that as societies grow richer, government spending tends to take up a greater share of GDP. Germany itself became the first nation in the world to adopt an old-age social insurance programme in 1889, designed by Chancellor Bismarck. He argued that those who were unable to work due to age or disability had a well-grounded claim to receiving support from the state. Wagner saw state spending also growing because of the need to pay for defence, environmental protection, bank rescues and to finance scientific and technological advances. Wagner s prescience is demonstrated in Figure 1, which shows government spending in the major European economies, the US and Japan, between 187, when it was under 1 of GDP, rising to above now. Taxation rose as well, especially to finance wars, but there has been a persistent tendency, over time, for this to lag the rise in spending. Since the 197s, government revenues across the mainly-rich OECD economies have only once come close to equalling government spending during the unsustainable boom conditions of the late 199s (see Figure ). Of course, public spending cannot carry on rising as a share of income forever. In practice, many economies have reached a tipping point where public spending has simply become too high and needs to be corrected. Some countries reached their tipping point in the early 198s: e.g. Belgium and the Netherlands, where government spending to GDP reached and 7, respectively. For others, it was the 199s: Sweden (9), Italy () and Spain (9), all in Germany reached a tipping point at in 199. In all cases, that represented a peak in public spending as a share of the economy either taxes could not be raised further or accumulated debts had become too large. In many instances, cutting government spending is deeply unpopular and leads to widespread social unrest (Greece during its bailout negotiations being a prime example). In other cases there is a general acceptance. The aim of German fiscal policy is the black zero a balanced budget or small surplus. Wolfgang Schäuble, Germany s finance minister who delivered the first black zero for decades, left office last year as the most popular member of the government Wagner s Law. Major economies: tax and spend 3 3 of GDP Government spending as a share of GDP, average of 17 economies* *Australia, Austria, Belgium, Canada, France, Germany, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Spain, Sweden, Switzerland, UK and USA. Sources: Tanzi and Schuknecht Public Spending in the th Century and OECD Economic Outlook database. Data as at 3 March OECD government spending OECD government revenue Global financial crisis Austerity Source: OECD Economic Outlook database, actual and forecast to 19. Data as at 3 March Wagner, A.H. (1883), Finanzwissenschaft. Leipzig: C. F. Winter. For a review of Wagner s Law and subsequent work on this issue see Magazzino et al: Wagner s Law and Peacock and Wiseman s Displacement Effect in European Union Countries, International Journal of Economics and Financial Issues, Financial Times, March 18, Why are Germans so obsessed with saving money? Insight Q 18

3 OVERVIEW 3. Juggling act Lower taxes Higher spending Debt reduction Bringing back US manufacturing? Boosting US economic growth and bringing jobs back to the US, particularly in manufacturing, is one aim of President Trump s proposed trade restrictions on a range of goods. Manufacturing, however, has been in decline in the US and other major developed economies for many years (see Figure ) and it seems largely unrealistic to expect a revival. The US remains a high labour cost economy and its comparative advantage lies in more highly skilled industries. Furthermore, IMF simulations show that a 1 US tariff on all imports of goods from the rest of the world cuts US GDP by about one percentage point in the long term, and it also reduces GDP in the rest of the world by.3 per cent. Everyone loses. Source: TIER Co., as at 3 March 18. For illustrative purposes only.. G economies: manufacturing share Juggling act In general, however, governments face a juggling act (Figure 3): they want to spend more along the lines of Wagner s Law; but they don t want to raise taxes too much for fear of damaging incentives to work and invest; and they don t want their debt levels to rise to too high a level. Although Reinhart and Rogoff s 9 government debt/gdp threshold may have been discredited as the precise point at which debt levels become excessive and start to compromise economic growth, concerns about unsustainable debt levels pre-dated their work. Which ball gets dropped? Given that all three objectives cannot be attained at the same time, which ball gets metaphorically dropped? In the US, it is the government s indebtedness which is forecast to rise under the influence of more government spending and tax cuts (see Figure ). Historically, one way to ease that debt burden has been to generate faster economic growth and, indeed, if real GDP growth were to average 3 p.a. over the next decade (as the White House expects) then debt levels may even fall in the future. But, on what we think are more realistic growth projections ( p.a.), that will not happen.. US federal debt South Korea China Germany Indonesia Japan Mexico Turkey Argentina Italy India EU South Africa USA Saudi Arabia France Brazil Russia Canada UK Australia Manufacturing as of GDP Source: United Nations Conference on Trade and Development (UNCTAD). Data as at 3 March 18. Stronger dollar implied by rate differentials Another concern with regard to US prospects is that although US competitiveness has enjoyed some respite from the US dollar s weakness over the last year or so we doubt that this will last. The interest rate and bond yield differential between the US and Germany, for example (see Figure ), is particularly wide. Some commentators see this as indicating that the US dollar will decline in value in the future: the interest rate differential is, essentially, offset by dollar weakness. We see it differently. In the past, a wide interest rate differential has signalled a stronger, not a weaker, dollar in the future. We expect that will, once again, be the case Wars Federal debt held by the public as a of GDP Trump 18 Budget forecast (assuming 3 average GDP growth) CRFB* forecast (assuming average GDP growth) Sources: US CBO (Congressional Budget Office) and CRFB (Committee for a Responsible Federal Budget). Data as at 3 March 18.. Yield differential and the dollar Basis points US-Germany year yield spread US$ index (rh axis) Index Source: Thomson Reuters Datastream. Data as at 3 March 18. Reinhart and Rogoff, Growth in a Time of Debt. IMF Working Paper 13/. Insight Q 18 3

4 ASSET MARKET PERFORMANCE Three themes dominated global markets in the first quarter: rising trade tensions between the US and China; concerns about prospects for the tech sector; and the return of generally higher levels of equity market volatility. Asset market performance The first quarter of 18 saw world bond markets outperform equity markets (see Figure 7). The overall small negative return in US dollar terms from global equity markets obscures the fact that there was strong performance in January; a period of weakness then recovery in February; and renewed weakness towards the end of the quarter continuing into the start of the second quarter. Behind that volatility were heightened concerns about US-China trade relations; and prospects for the tech sector following the rapid growth of many companies in the sector, the strong rise in their share prices in 17 and high valuations. 7. Asset market performance US Europe Japan Emerging World Bonds, total returns, US dollar terms Equities, total returns, US dollar terms Sources: Citigroup (bonds); MSCI (equities). Data for three months to end-march 18. Past performance is not necessarily a guide to the future. Bond markets In contrast, global bond markets were relatively calm. The yield on the most closely-watched benchmark bond, the 1-year US Treasury, rose from. to.7 during the quarter and there were consequent capital losses. Yields in core government bond markets in the rest of the world were relatively stable; and yields in several peripheral eurozone markets dropped appreciably (Spanish ten-year bond yields to just 1., for example). Combined with a further strengthening of the euro against the US dollar, this meant that in US dollar terms, returns from eurozone government bond markets were as high as 3.9 in the quarter (see Figure 8). The yen s appreciation meant that US-dollar terms returns were even higher in that market. In Australia and Canada, concerns about global trade and commodity prices, as well as increased risk aversion, saw a weakening of their currencies and a consequent drag on the performance on their bond markets in US dollar terms. Global corporate, emerging and high yield bonds all produced lower returns than government bonds in the first 8. Bond market returns Canada US Australia Switzerland Eurozone UK Japan Local currency terms Source: Citigroup. Data for three months to end-march 18. Past performance is not necessarily a guide to the future. quarter of 18, with US-dollar terms returns of -.8, -.7 and -., respectively. Equity markets After difficult recessions, optimism of economic recovery in their economies helped two emerging equity markets Brazil and Russia in the first quarter (see Figure 9). They were amongst the best-performing in both local currency and US dollar terms. The other two major emerging markets did less well: trade concerns affected both China and India, while the latter was hit by a large volume of new issues (partly as a result of the government s privatisation programme). The UK was one of the weakest major developed markets in local currency terms. Sterling s further appreciation against the US dollar adversely affected the sterling-denominated earnings prospects of those companies with substantial foreign earnings; additionally there were concerns about weaker sales and profits from a number of more domestically-focused companies. 9. Equity market returns Canada Australia UK US dollar terms US India Switzerland Germany South Korea Local currency terms US dollar terms Source: MSCI. Data for three months to end-march 18. Past performance is not necessarily a guide to the future. France Japan China Taiwan Russia Brazil All based on Merrill Lynch indices in US$ terms Insight Q 18

5 UNITED STATES The path towards normalisation of US interest rates has developed a new twist: an increase in rates in the next two years followed by a reversal. Wages and prices The modest increase in US wages which has been seen in recent years (see Figure 1) was cited as a surprise by Jerome Powell, the new Fed chair, at his first Federal Open Market Committee (FOMC) press briefing. He added that we will know the labour market is getting tight when we do see a more meaningful upward move in wages implying that even at the current low levels of unemployment (see Figure 11) labour market slack remains. 11. US unemployment rates 18 Recessions US wage costs and inflation.. 3. Recessions Headline unemployment rate Plus those discouraged and marginally attached to the workforce Plus those working part-time for economic reasons Source: Thomson Reuters Datastream. Data as at 3 March 18. change on year their previous forecasts, but were accompanied by an increase in the Fed s expected Fed Funds rate for to 3.. After that, it drops to.9 in the longer run Employment cost index Core consumer inflation (Consumer Expenditure Deflator less food and energy) Source: Thomson Reuters Datastream. Data as at 3 March 18. One route to higher wages may be via the recently-introduced corporate tax cuts. It seems that some firms are using part of the proceeds to raise employee compensation. That could boost consumer spending power in the short-term and, after a lag, feed through to higher consumer price inflation. Productivity improvement Or not. Company investment spending, which has been very weak in the post-financial crisis world, also looks likely to be a beneficiary of the tax cuts. If that is the case, it may well help to improve corporate productivity, which has been particularly weak since 8. Business productivity output per worker is currently growing at.9 year-on-year compared to a long-term average growth rate of.3. A recent report by McKinsey 7 demonstrates the potential for raising US productivity back to its long-term average. If that were to happen, any wage increases could easily by offset by productivity gains offsetting any pass-through to consumer price inflation. Fed interest rate projections Certainly, the Fed does not expect any marked rise in inflation. Their latest summary of economic projections has both their preferred measures of inflation at.1 by the end of. Those forecasts are just one tenth of one percent higher than Corporate earnings Even if companies do pay higher wages in some cases and reinvest in others, overall corporate earnings look set to increase by more than in 18 compared with last year. Around half of that increase is from an underlying improvement in corporate profits; the other half from the corporate tax cuts. If that earnings growth materialises then aggregate S&P earnings per share will amount to US$1 (see Figure 1). On that basis, the S&P, trading at around in late March 18, is on a 18 price/earnings multiple of 1.7, a valuation which does not appear particularly demanding. 1. US earnings EPS (US$) Operating earnings per share Index (average for year, rhs) Sources: Standard & Poors and Thomson Reuters Datastream. Data as at 3 March S&P Index 7 McKinsey, Solving the Productivity Puzzle, February 18. See Insight Q 18

6 UNITED KINGDOM The clouds over the UK s post-brexit future, and its economy, are starting to lift. Sterling has recovered, inflation has fallen and economic growth prospects look better. Transition deal The UK has agreed with the EU that there will be a transition period between its formal exit from the EU (at 11pm UK time on 9 March 19) and 31 December. During that period the UK will continue to be bound by EU trade and single market rules, including free movement of people. For the UK, there are two important aspects of this transition period. First, the UK will be able to agree, but not enter into, new trade deals with non-eu countries during the period. It is possible that many such deals will be ready to be implemented on 1 January 1, when the transition period ends. Second, the position of the financial services industry is set to be further clarified. Already, however, it seems that co-operation between the UK and EU will be based on mutual recognition in financial regulation, aligned standards and supervisory co-operation. Sterling s value against the US dollar, which has been a key indicator of the success of the EU-UK negotiations, has subsequently appreciated to above US$1./. Real wage squeeze easing The recovery in sterling will help bring further downward pressure on UK consumer price inflation, which has already dropped back to.7 year-on-year (see Figure 13). With the rate of wage increases now.8 year-on-year and set to move higher (notably as the cap on public sector wages is eased) the squeeze on consumer spending (see Figure 1) will ease. The recession which many feared as a result of the UK s leave vote has not materialised although it is the case that the UK s growth rate has dropped relative to its European and global peers. That, however, is set to change over the coming years according to the IMF s latest forecasts. By, the UK growth rate is expected to be 1.7, only marginally behind the US (at 1.8) but ahead of Germany, Italy and Japan. 13. UK real wage squeeze change on year UK retail sales Year-on-year change, -month moving average Source: Thomson Reuters Datastream. Data as at 3 March 18. Brexit referendum UK equity market For the UK equity market, the foreign earnings of UK-listed companies are depressed, in sterling terms, by the pound s appreciation. That is important as more than two-thirds of the earnings of companies included in the FTSE 1 Index come from outside the UK. The de-rating of the UK equity market has, however, been marked (see Figure 1) as a lower stock index has combined with stronger earnings. The latter is, to a large extent, due to the recovery in earnings from oil, energy, financials and resource companies. Trading on a price/earnings multiple well below its -year average, the FTSE All Share Index (which includes domestic stocks as well as the more internationally-dependent companies in the FTSE 1 Index) seems to be discounting much bad news for the UK economy, politics (especially concerns about a possible Labour government) and corporate earnings. 1. UK equity market valuation Multiple Total wages, 3-month moving average Source: Thomson Reuters Datastream. Data as at 3 March 18. CPI inflation FTSE All Share price/earnings ratio Average Source: Thomson Reuters Datastream. Data as at 3 March 18. Insight Q 18

7 EUROPE Eurozone economic growth is holding up well although survey data suggest some softening ahead. Inflation has weakened once again. Any move away from the ECB s easy monetary policy is set to be gradual. Economic growth: signs of some weakness Overall eurozone real GDP growth continued to hold up well at the end of 17 at a rate of.7 year-on-year (see Figure 1). Throughout 17 survey data were generally stronger than many anticipated. It is therefore no great surprise that the start of 18 has seen some softening. For now, we do not think that indicates any marked slowing in overall growth but the evolution will be watched closely. 1. Eurozone GDP growth 17. Eurozone inflation change on year Labour compensation per employee Consumer prices - services change on quarter, annualised rate change on year Source: Thomson Reuters Datastream. Data as at 3 March 18. Recessions Inflation eases back Overall eurozone inflation eased back to a rate of just 1.1 in February. As in the US, there is some indication of a modest pick-up in wage growth, and this has in the past been closely associated with the rate of inflation in the service sector (see Figure 17). The key issue is how robust such an increase in wage and service sector inflation proves to be and whether inflation will move back up towards its target of less than but close to. The ECB s own projections show this happening only gradually, with the average rate at 1.7 in. To avoid risking growth in a subdued inflationary environment, monetary stimulus by the ECB will likely be phased out only gradually. Cause for concern? The juggling act of meeting demands for higher government spending while keeping tax rates competitive and preventing large government budget deficits and debt accumulation is one with which eurozone economies are very familiar. The outcome, in terms of debt accumulation, has been very different across the different economies. Germany, as discussed in the Overview, has been successful in attaining the black zero on its government budget. Consequently, its outstanding stock of government debt has actually fallen relative to GDP between (the year immediately before the global financial crisis started) and 18. Other eurozone Source: Thomson Reuters Datastream. Data as at 3 March 18. economies have consistently been below the Maastricht limit: Estonia, Latvia, Lithuania and Luxembourg. Outside the eurozone, government debt in Switzerland has fallen steadily as a share of GDP since to just in 18; and debt levels are only around one-third of GDP in Norway, Denmark, Sweden and the Czech Republic. 8 But the crisis economies have seen big increases in their debt levels. In Greece, despite restructuring which has cut the outstanding value of government debt it has still risen from 13 to 173 of GDP (see Figure 18). With economic growth returning and sizable primary budget surpluses being maintained, debt is forecast to fall as a share of GDP in coming years not just in Greece but the other crisis economies. But the fact that this has happened in a relatively benign set of circumstances highlights that longer-term risks stemming from public sector indebtedness remain. 18. Eurozone government debt of GDP Ireland Spain Germany Portugal Italy Greece 18 Maastricht limit Source: OECD Economic Outlook database. Data as at 3 March All government debt data here from the Economic Outlook database, as at 3 March 18. Insight Q 18 7

8 JAPAN Japan has wrestled with the issue of large government budget deficits and rising debt for many years. For that economy, continued low interest rates and sturdy growth suggest the issue may not pose a big problem. Inflation: recovering slightly Japan has three measures of inflation which are closely watched. In February all three remained below the Bank of Japan s target and the general expectation is that the target will remain elusive. The Bank of Japan s preferred measure, core-core inflation, which strips out fresh food and fuel and energy costs, was just. in February. Looking ahead, the main factor which may drive inflation higher is stronger wage growth, given the evident tightness of the labour market. Furthermore, legislation has been put in place to give companies tax breaks in return for wage increases. Nevertheless, there is a global pattern of tight labour markets having seemingly little impact on wage inflation: and Japan looks most unlikely to be in the vanguard of a change in that pattern. Structural change is happening However, structural changes in the economy are taking place. To a large extent that is because Shinzo Abe is set to be Japan s longest-serving prime minister ever: his predecessors have generally had short tenures, making the implementation of reforms difficult. Three aspects of these reforms are now working. First, there has been a big increase in female employment, which has reached 8.8 million. In many ways this has been one of the toughest reforms as it has required cultural and legislative changes. The government has increased the number of childcare facilities (for many women there has, in the past, been a simple choice between working and looking after children, with many choosing the latter); companies have changed their views on the merits of female employment; and legal changes have made it possible to specifically advertise jobs for women only. The female participation rate (of the 1 to age group) is now almost 7, higher than in the US. Second, the number of foreign workers has increased. Many arrive on student visas (often to study at a Japanese language school) which allow them to work up to 8 hours a week. Third, there has been an improvement in corporate governance. The new corporate governance code, implemented in 1, is modelled on the UK stewardship code and seems to be effective in improving engagement with shareholders. Debt: why worry? Nevertheless, structural reform has had little impact on the public finances. Japan has lived with rising government debt levels for many years: from 1 of GDP in the early 197s to well over today, a rise far more marked than in other 19. Japan: government debt continues to rise of GDP Government debt as a of GDP: Japan Source: OECD Economic Outlook database, actual and forecast to 19. Data as at 3 March 18. advanced economies (see Figure 19). Japan recognises the need for tax increases, but the rise in sales tax in April 1 to 8 had a marked adverse effect on consumer spending and economic growth (see Figure ). The further increase to 1, first planned for October 1 has been repeatedly delayed and is now scheduled for October 19. Despite the rising debt level, there has been no meaningful increase in longterm or short-term interest rates. We think there are three reasons for this: (i) persistently low inflation (ii) the large share of debt held domestically, and (iii) the Bank of Japan s yield target for the 1 year Japanese Government Bond. Yen to remain weak The implication of continued easy monetary policy, we think, is that the yen will weaken again after its period of strength in early 18. That will ease concerns about Japanese companies profitability, but even without such assistance we remain positive on Japanese equities. They trade on attractive valuations and corporate reform is progressing, albeit slowly.. Japan: consumer spending and tax increases change on year 8-1 OECD average Consumer spending -year moving average Sales tax introduction/increases introduced at raised to 3. 1 raised to planned increase to 1 Sources: Thomson Reuters Datastream and Japan Ministry of Finance. Data as at 3 March Insight Q 18

9 ASIA China s trade surplus with the US is in the spotlight. Reducing it will be far from straightforward. But unless an outright trade war erupts, the impact on China and other Asian economies should be small. China s trade surplus China has had an overall trade surplus with the US since it joined the World Trade Organisation in 1. That surplus has increased over time (see Figure 1) and its size in 17 (US$37bn) 9 seems to have been the trigger for President Trump to proceed with his campaign pledge to impose tariffs on China: first, on steel and aluminium and then on a variety of Chinese imports. 1 The details of the latter are not yet clear but seem likely to be aimed at four industries robotics, semiconductors, aviation and computing. These are at the centre of China s Made in China plan. A key element of this is for Chinese companies to partner with foreign companies or acquire overseas technologies that will help them become globally important. 1. China: overall trade surplus and with US US$ billions China's trade surplus with US China's overall trade surplus (all countries) Source: Thomson Reuters Datastream. Data as at 3 March 18. US$37 billion US$7 billion China s planned economy This strategy is not new: Chinese companies have already acquired a variety of assets, including a German manufacturer of industrial robots, and entered into many joint ventures (including with an Icelandic company to develop geothermal energy) with the intention of developing its own industry. In a related development, China s one belt one road plan aims to extend China s influence, investment and market access to more than economies around the world. We think the risk of a trade war spreading via retaliatory action is still quite small and that the impact on China will be limited. Net exports make a relatively small contribution to the overall growth of China s economy, which is predominantly driven by domestic demand (see Figure 3). Within that domestic orientation, important changes continue to take place.. China: contributions to GDP growth Final consumption expenditure Gross capital formation Source: National Bureau of Statistics of China. Data as at 3 March 18. Net exports of goods & services Real GDP, change on year Firm structure Perhaps the most important of these is the reform of State- Owned Enterprises (SOEs). Their return on assets in 1 was just.9, compared to 1. in the private sector; 11 and much of the debt accumulation in China is accounted for by lending to such SOEs from banks which are, themselves, state controlled. Reducing the role of SOEs is still, very much, a work in progress. However, job losses in such enterprises can often be absorbed in China s rapidly-developing service sector, especially given China s high degree of labour mobility. Not just in China, but across Asia, ways of doing business are often quite different to those of the West. Family-owned companies, for example, have a much greater role. In these, concepts of appropriate (operational and financial) management and the treatment of shareholders can be very different to those of Western-listed companies. Such differences often have deep historic and cultural roots and are slow to change. In South Korea, for example, there is a current focus on improving corporate governance and generating better returns for shareholders. Companies there tend to hoard cash (and are reluctant to take on debt) rather than make greater distributions to shareholders. Given that South Korea is already a highly-developed economy, that highlights just how far other Asian economies have yet to travel. Western investors in China have often tended to favour exposure to tech companies, being concerned about the risks in the financial sector and in exposure to state-owned companies. However, in the financial sector good progress is being made on curbing shadow banking activity; and consolidation and restructuring in SOEs make such companies a more viable investment proposition. 9 There are some variations in the precise size of the surplus, depending on whether US or Chinese statistics are used, the scope of the trade flows measured and the treatment of taxes and shipping costs. 1 For a detailed analysis, see our Infocus Market Snapshot, March 18, China-US: Trade war or trade bore? 11 Source: Bloomberg, as at 3 March 18. Insight Q 18 9

10 LATIN AMERICA The trilemma of juggling demands for state spending, generating tax revenues and avoiding large deficits and debt accumulation is a current, but persistent, issue across Latin America. History of default It is fair to say that, across Latin America, there is a difficult history of managing government finances. The most notable sign of that is in the number and frequency of defaults on the region s external sovereign debt. All the major economies defaulted during the 198s Latin American debt crisis. Since 19, Mexico has defaulted three times, Argentina five times and Brazil seven times. 1 Most recently, Venezuela recognised the need for a refinancing and restructuring of all its foreign debts in November 17. Argentina, of course, had a decadelong dispute with its debt holders after its default in 1. External discipline Typically, after such an event, fiscal order is maintained for a while, often under the auspices of the IMF. Brazil took what was, at the time, the largest ever loan (US$3bn) from that organisation in 3. Under its programme and subsequent self-imposed fiscal constraints (it was keen to demonstrate fiscal discipline and repaid its IMF loan early), its government debt fell from almost 8 to just of GDP over the ten years to 13 (see Figure 3). 3. Brazil: debt burden rising President: Cardoso Lula da Silva Rousseff Temer? 9 of GDP Gross government debt as of GDP Sources: IMF Fiscal Monitor. Data as at 3 March 18.. Latin America: government finances unbalanced of GDP Argentina Brazil Mexico Chile Colombia Government spending Sources: IMF Fiscal Monitor. Data as at 3 March 18. Government revenue That certainly seems too harsh and is almost certainly unrealistic in an economy with substantial needs for public infrastructure development. Difficult reforms notably of public sector pensions are on hold until after the elections in October. Election year Indeed, elections take place in many of the region s economies during the year (see Figure ). Few feel able to predict the outcome of these with any degree of certainty. In Brazil, notably, social media will play a significant role: its population is young and social media penetration is amongst the highest in the world. In Mexico, disenchantment with reform (especially in the energy industry) and perceptions of still widespread corruption are the key issues. When the fog of political uncertainty clears towards the end of the year, it remains to be seen what is left to do, and what can be done, in the region s government finances and economies.. Latin American elections in 18 Since then, however, the story has been different. The commodities boom, up until 1, and substantial inflows from overseas into the economy, encouraged a more relaxed attitude to public finances. Revenue-spending gap This year, Brazil, along with all other major Latin American economies has a substantial excess of government spending over revenue (see Figure ). Spending is being squeezed in most economies to try to rectify the position. In Brazil, under a decree, government expenditure is not allowed to grow in real, inflation-adjusted terms for the next terms. Country Election Date (18) Brazil Presidential and legislative elections 7 October 8 October run-off Colombia Presidential election 7 May 17 June run-off Mexico Presidential and legislative elections 1 July Paraguay Presidential and legislative elections April Venezuela Presidential election May Source: American Society/Council of the Americas, as at 3 March Reinhart and Rogoff, This Time is Different (Princeton 9). 1 Insight Q 18

11 SPECIAL FOCUS WHO HOLDS THE DEBT? Despite much talk of debt reduction and deleveraging since the financial crisis, global debt levels are higher than ever before. Several risks for investors, and for financial and economic stability arise. Rise in global debt After the global financial crisis debt reduction, or deleveraging (reducing debt relative to assets or income), became an important theme. In the US and UK, household and financial sector deleveraging did occur but progress in other countries and sectors was much less marked. 13 In aggregate, global debt (see Figure ) now amounts to almost US$ trillion. Much of that increase has been in the emerging market corporate sector. How much of a concern is this high level of debt? Five issues are particularly important.. Global debt outstanding US$ trillions Total debt outstanding of non-financial sectors, in US$ trillions: US Other developed economies 11 Sources: BIS and IMF. Data as at 3 March China Other developing economies 1 Private debt becomes public debt The first is that debt issued by the private sector may eventually become public sector debt. In the eurozone crisis, for example, many governments had to support domestic financial institutions, taking on their debt or issuing government debt to pay for financial support. Currency mismatch Some of the debt issued by emerging market companies in the last ten years has been denominated in foreign currency. This means that there is a risk of not being able to make debt servicing payments if the domestic currency of the issuer were to fall in value. That has been a common issue in emerging market financial crises in the past notably in the Asian financial crisis in 1997 and in Argentina s 1 default. 3 Foreign holders Foreign holders of debt may periodically lose confidence in either the creditworthiness of the issuer or in the currency of denomination. Debt held domestically may therefore be in safer hands than that held overseas. In that context, Japan s government debt, which is predominantly held domestically, poses less of a risk (see Figure 7). Within the eurozone, Italy has the highest proportion of debt held domestically Holdings of government debt Germany Portugal Spain Italy US UK Japan* held domestically of which by banks *Japan bank data not available. Source: Bruegel database of sovereign bond holdings. Data as at 3 March 18. A doom loop However, the eurozone crisis also demonstrated the vulnerability associated with domestic banks holding a high level of domestic government debt. A doom loop developed in some economies: concerns about sovereign creditworthiness impacted the banks; and concerns about bank creditworthiness fed back to sovereigns. Buyers strike One other concern related to foreign holders is that they may periodically go on a buyers strike. That was seen in the late 198s/early 199s when Japan was a big buyer of US Treasury bonds. In 198, for example, a rise in US bond prices was offset, for Japanese buyers, by yen strength (see Figure 8). The same pattern was seen in 198. Many Japanese investors lost patience, being unwilling to buy more US bonds until their price had dropped. Fears of a Japanese buyers strike became a more-or-less permanent feature of US Treasury bond auctions during the period. 8. Buyers strike? Index, US$ terms Total return from US 1-year bond in yen terms (including reinvested coupon income) US 1-year bond price Yen/US dollar exchange rate, rhs Sources: Thomson Reuters Datastream and EFG estimates. Data as at 3 March 18. Past performance is not necessarily a guide to the future JPY/USD 13 As highlighted in McKinsey s 1 study, Debt and (not much) deleveraging. Insight Q 18 11

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This document has been produced by EFG Asset Management (UK) Limited for use by the EFG group and the worldwide subsidiaries and affiliates within the EFG group. EFG Asset Management (UK) Limited is authorised and regulated by the UK Financial Conduct Authority, registered no Registered address: EFG Asset Management (UK) Limited, Leconfield House, Curzon Street, London W1J JB, United Kingdom, telephone + () If you have received this document from any affiliate or branch referred to below, please note the following: Bahamas: EFG Bank & Trust (Bahamas) Ltd. is licensed by the Securities Commission of The Bahamas pursuant to the Securities Industry Act, 11 and Securities Industry Regulations, 1 and is authorised to conduct securities business in and from The Bahamas including dealing in securities, arranging deals in securities, managing securities and advising on securities. EFG Bank & Trust (Bahamas) Ltd. is also licensed by the Central Bank of The Bahamas pursuant to the Banks and Trust Companies Regulation Act, as a Bank and Trust company. Bermuda: EFG Wealth Management (Bermuda) Ltd. is an exempted company incorporated in Bermuda with limited liability. Registered address: Thistle House, nd Floor, Burnaby Street, Hamilton HM 11, Bermuda. Cayman Islands: EFG Bank is licensed by the Cayman Islands Monetary Authority for the conduct of banking business pursuant to the Banks and Trust Companies Law of the Cayman Islands. EFG Wealth Management (Cayman) Ltd. is licensed by the Cayman Islands Monetary Authority for the conduct of trust business pursuant to the Banks and Trust Companies Law of the Cayman Islands, and for the conduct of securities investment business pursuant to the Securities Investment Business Law of the Cayman Islands. Chile: EFG Corredores de Bolsa SpA is licensed by the Superintendencia de Valores y Seguros ( SVS, Chilean securities regulator) as a stock broker authorised to conduct securities brokerage transactions in Chile and ancillary regulated activities including discretionary securities portfolio management, arranging deals in securities and investment advice. Registration No: 1. Registered address: Avenida Isidora Goyenechea 8 Of. 91, Las Condes, Santiago. Guernsey: EFG Private Bank (Channel Islands) Limited is licensed by the Guernsey Financial Services Commission. Hong Kong: EFG Bank AG is authorised as a licensed bank by the Hong Kong Monetary Authority pursuant to the Banking Ordinance (Cap. 1, Laws of Hong Kong) and is authorised to carry out Type 1 (dealing in securities), Type (advising on securities) and Type 9 (asset management) regulated activity in Hong Kong. Jersey: EFG Wealth Solutions (Jersey) Limited is regulated by the Jersey Financial Services Commission in the conduct of investment business under the Financial Services (Jersey) Law Liechtenstein: EFG Bank von Ernst AG is regulated by the Financial Market Authority Liechtenstein, Landstrasse 19, P.O. Box 79, 99 Vaduz, Liechtenstein. Luxembourg: EFG Bank (Luxembourg) S.A. is listed on the official list of banks established in Luxembourg in accordance with the Luxembourg law of April 1993 on the financial sector (as amended) (the Law of 1993 ), held by the Luxembourg supervisory authority (Commission de Surveillance du Secteur Financier), as a public limited company under Luxembourg law (société anonyme) authorised to carry on its activities pursuant to Article of the Law of Luxembourg residents should exclusively contact EFG Bank (Luxembourg) S.A., Grand Rue, Luxembourg 13 Luxembourg, telephone +3 1, for any information regarding the services of EFG Bank (Luxembourg) S.A. Monaco: EFG Bank (Monaco) SAM is a Monegasque Public Limited Company with a company registration no. 9 S 7 (Registre du Commerce et de l Industrie de la Principauté de Monaco). EFG Bank (Monaco) SAM is a bank with financial activities authorised and regulated by the French Prudential Supervision and Resolution Authority and by the Monegasque Commission for the Control of Financial Activities. Registered address: EFG Bank (Monaco) SAM, Villa les Aigles, 1, avenue d Ostende BP Monaco (Principauté de Monaco), telephone: The recipient of this document is perfectly fluent in English and waives the possibility to obtain a French version of this publication. People s Republic of China ( PRC ): EFG Bank AG Shanghai Representative Office is approved by China Banking Regulatory Commission and registered with the Shanghai Administration for Industry and Commerce in accordance with the Regulations of the People s Republic of China for the Administration of Foreign-invested Banks and the related implementing rules. Registration No: 319. Registered address: Room T1, F, Shanghai World Financial Center, No. 1, Century Avenue, Pudong New Area, Shanghai. The business scope of EFG Bank AG Shanghai Representative Office is limited to non-profit making activities only including liaison, market research and consultancy. Singapore: The Singapore branch of EFG Bank AG (UEN No. T3FC371J) is licensed by the Monetary Authority of Singapore as a wholesale bank to conduct banking business and additionally carries on the regulated activities of dealing in securities, fund management and securities financing. Switzerland: EFG Bank AG, Zurich, including its Geneva and Lugano branches, is authorised and regulated by the Swiss Financial Market Supervisory Authority ( FINMA ). Registered Office: EFG Bank AG, Bleicherweg 8, 8 Zurich, Switzerland. Registered Branches: EFG Bank SA, quai du Seujet, 111 Geneva, Switzerland and EFG Bank SA, Via Magatti, 9 Lugano, Switzerland. Taiwan: EFG Securities Investment Consulting Co. Ltd, Suite A-1, 1th Floor, Hung Tai Center, No. 18 Tun Hwa North Road Taipei, , SICE License No. BO8. United Kingdom: EFG Private Bank Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority, registered no. 13. EFG Private Bank Limited is a member of the London Stock Exchange. Registered company no Registered address: EFG Private Bank Limited, Leconfield House, Curzon Street, London W1J JB, United Kingdom, telephone + () In relation to EFG Asset Management (UK) Limited please note the status disclosure appearing above. United States: EFG Asset Management (UK) Limited is an affiliate of EFG Capital, a U.S. Securities and Exchange Commission ( SEC ) registered broker-dealer and member of the Financial Industry Regulatory Authority ( FINRA ) and the Securities Investor Protection Corporation ( SIPC ). None of the SEC, FINRA or SIPC, have endorsed this document or the services and products provided by EFG Capital or its U.S. based affiliates, EFGAM Americas and EFG Capital Advisors (EFGCA). Both EFGAM Americas and EFGCA are registered with the SEC as investment advisers. Securities products and brokerage services are provided by EFG Capital, and asset management services are provided by EFGAM Americas and EFGCA. EFG Capital, EFGAM Americas and EFGCA are affiliated by common ownership and may maintain mutually associated personnel. This document is not intended for distribution in the United States or for the account of U.S. persons (as defined in Regulation S under the United States Securities Act of 1933, as amended (the Securities Act )) except to persons who are qualified purchasers (as defined in the United States Investment Company Act of 19, as amended (the Investment Company Act )) and accredited investors (as defined in Rule 1(a) under the Securities Act). Any securities referred to in this document will not be registered under the Securities Act or qualified under any applicable state securities statutes. Any funds referred to in this document will not be registered as investment companies under the Investment Company Act. Source information The source for data used in this publication is Thomson Reuters Datastream, as at 3 March 18, unless otherwise stated. 1 Insight Q 18