On the monetary policy side, global central banks have repeatedly come to the rescue in times of crisis. As a percentage of GDP, DM central bank balance sheets have been growing since 2008, ballooning most recently in the spring of 2020 in response to COVID-19. Relatively tame inflation for the better part of the past decade has made it easier for central banks to pursue and maintain accommodative policy, including historically low interest rates.
In addition to financial stressors, the quality of government institutions worldwide appears to have deteriorated. The Economist Intelligence Unit Democracy Index recently showed that the world is in the midst of what we term a “governance recession” based on five key categories across a range of global governments: 1) electoral process and pluralism; 2) civil liberties; 3) the functioning of government; 4) political participation; and 5) political culture. A key takeaway here is that minority and lower-income populations in some countries feel “disenfranchised.”
This is worrisome because stronger government institutional quality and greater income equality tend to breed higher GDP per capita — a trait often associated with some DMs — as well as lower volatility in the form of a more predictable business operating environment. It is noteworthy that the US and the UK, two of the world’s “most developed” markets, both seem to be moving in the wrong direction on this front.
Thus far, investors have more or less given DMs a “pass” on these issues due to an entrenched belief in DMs’ continued policy flexibility and institutional strength. Indeed, markets haven’t seemed to really care about mounting government debt loads and balance sheets except during very challenging periods like the eurozone debt crisis, Brexit turmoil, and COVID-19. (On all three occasions, European investment-grade corporate bond spreads spiked sharply.)
To us, this lack of any sustained adverse investment fallout suggests that global markets remain largely oblivious to, or at least complacent about, the fragile state of fundamentals in many DMs. And as we know from past experience, complacent markets are often a recipe for trouble.
Possible paths, investment implications
That complacency could be shaken going forward if DM fundamentals were to further erode and become more difficult to overlook, or if some DMs were to exhibit more “EM-like” behavior (Figure 2) that began to test investors’ faith in their degree of policy flexibility. (As one recent example, UK markets acted decidedly more “EM-like” following the pivotal 2016 Brexit vote.) This would be approaching a worst-case outcome, but one that cannot necessarily be ruled out.