Will Fiscal Concerns Affect International Stocks?

Fiscal deficits have risen in many countries around the world in recent years, outpacing tax revenue, resulting in an increase in debt-to-GDP (gross domestic product) ratios. An example is France, which last saw a government surplus (tax revenue exceeding government spending) 50 years ago. Deficits looked to be less of a concern for the markets in the years before the pandemic likely due to low interest rates; recent investor attitudes have seemed to change. Now that interest rates are higher, investors generally want to see governments committing to progress on reducing fiscal deficits and slow the growth in national debt. Should GDP growth rise faster than the debt, it can reduce the debt-to-GDP level. Individual countries' progress toward reducing debt-to-GDP levels has varied, as seen in the chart below.

Reducing deficits often equates to spending cuts and/or tax hikes, which tend to be politically unpopular. Approval ratings for France's Prime Minister François Bayrou and Japan's Prime Minister Shigeru Ishiba have been low heading into this week. When combined with political systems that allow for government turnover based on confidence votes, this resulted in Bayrou being voted out of office and Ishiba stepping down to avoid facing a no-confidence motion he was likely to lose. The U.K. has also wrestled with this issue in recent years and Prime Minister Keir Starmer made a major reshuffle that resulted in half of his cabinet changing roles on Friday. However, by conceding to demands to maintain spending and not take unpopular measures to tackle deficits, politicians risk the ire of bond investors, who may demand higher yields to compensate for excessive government spending. The situation seems to have escalated recently, and while government bond yields are off the highs reached last week, overseas yields have risen, as seen in the chart.

Stocks in France, Japan and the U.K. fell on concerns about rising government bond yields at the end of August and beginning of September. The Financials sector was particularly affected. Reasons include:

• Higher government bond yields may "crowd out" private investment and lending. Loan rates across an economy can rise when government bond yields rise. The higher rates may result in less corporate investment and lending and a slowing of consumer spending.
• Relatedly, banks collect deposits and then either lend out the money or invest it in government debt, which tends to have higher credit ratings and is considered "safer" from default than corporate debt. This difference, or spread, in rates is a profit center for many financial institutions. When government debt yields rise, the related decrease in bond prices could result in banks marking down the value of assets on their balance sheets, generating a need to raise capital to comply with regulatory standards.
• Like banks, insurance companies and pension plans may also experience lower asset values on their balance sheets if longer-term government bond prices fall. This can potentially reduce the amount available for retiree payouts.

Higher government yields are likely to be less of an issue if government spending results in faster economic growth and corporate earnings. This may be the case in Germany, where years of conservative fiscal spending has kept its debt-to-GDP low and the expected uptick in investment in infrastructure and defense could accelerate economic growth.

If government spending is cut and/or taxes are hiked, companies that are more exposed to domestic demand could experience slower earnings growth. In contrast, multinational companies may be more insulated from country-specific impacts due to a more geographically diverse revenue base. The following chart breaks out the geographic exposure of the French, Japanese, and U.K. indices as well as the S&P 500 index.

France, the U.K., and Japan may have less room for expansionary fiscal spending given the dual constraints of lack of progress on reducing deficits and higher debt-to-GDP ratios over the past decade. Investors may recall the eurozone debt crisis in 2009-2011, where a high level of government debt and spending in Greece spilled over into concerns about Italy, Spain and Portugal, and threatened the survival of the euro as a currency union.

Fast forward to today. Greece, Italy, Spain, and Portugal have made more progress on reducing their debt-to-GDP ratios from their 2020 peaks than France, the U.K., the U.S., and Japan as illustrated in the chart above. Notably, Greece, Italy, and Portugal have shifted from fiscal primary deficits (deficits before interest payments) to surpluses.

There is potential for defense spending, illustrated by NATO countries' stated commitment to increase spending as a percentage of GDP from 2% to 5% by 2032, to create an acceleration in Europe's economic growth. Germany has been the leader in committing to increased spending by making a historic pivot toward deficit spending to meet the NATO goal, as well as bolstering infrastructure spending. What is less clear is how other NATO countries will reach the 5% target. The recent difficulty in passing fiscal budgets highlights a risk to our thesis of a new growth story in Europe.

Japan is not a member of NATO. Rather than fiscal spending, its growth story is more related to exiting a 30-year period of deflation and the ability for wages to grow faster than inflation.

Despite a high fiscal deficit and debt-to-GDP ratio, U.S. Treasuries have not had the same level of concerns as other developed economies. Reasons include having the world's reserve currency (the U.S. dollar) and the largest and most liquid government bond market in the world by a large percentage.

Who will win the tug of war between voter pressure on politicians and investor demand to reduce fiscal deficits outside the U.S.? Ultimately, we believe politicians are likely to comply with the bond market's demands. Political consultant James Carville famously said, "I would like to come back as the bond market. You can intimidate everybody." A spike in yields in the U.K. government bond market in October 2022 in reaction to a fiscal budget that would have increased the U.K. deficit resulted in the resignation of then-Prime Minister Liz Truss and a subsequent retraction of that budget.

The pressure to reduce fiscal deficits in France, Japan, and the U.K. could result in near-term volatility. Investors may want to consider international exposures that have lower weightings in banks. With the potential for fiscal tightening, investors in individual international companies may want to lean toward those that earn more revenues and profits outside of France, the U.K., and Japan. Since we believe the trend in the U.S. dollar is likely to continue to fall, companies based overseas that also have a low exposure to U.S. revenues and sales may be best positioned to avoid the negative currency impact of a weak dollar on their operations.