Debt, deficits and the limits of the cycle

Key takeaways

• Developed market governments will likely follow a path of financial repression, possibly culminating in yield curve control
• Policy repositioning towards ‘Strategic Autonomy’ resulting from Covid, Ukraine & Iran and a more bellicose US will raise both the inflation rate and its volatility
• Both of these demand a yield risk premium and a continued focus on real assets (equities with pricing power, commodities and other tangible assets)
• We are likely to experience a cyclical upswing in 2H 2026, courtesy of falling oil prices; meanwhile, the US consumer remains resilient and AI capex continues
• Capital cycle and market concentration risks abound; remain neutrally weighted risk assets

Inflating away the debt

A common theme amongst most Developed Markets is deficit-funded spending leading to ever-higher government debt levels. For now, the system absorbs it, perhaps enticed by higher nominal yields than have been on offer for decades and a faster nominal economic growth rate courtesy of higher inflation (as opposed to higher real growth, in many cases). Governments borrow and spend and the merry-go-round of modern economic growth continues. But at some point, the cost of servicing that debt will become the limiting factor on further economic expansion. It is therefore critical to get the real value of government debt down.

There are various ways to do this, most of them politically or economically unpalatable, and the incentives simply aren't there to make the tough decision. The most realistic path, therefore, is the subtlest, and one we have seen used time and again in history: financial repression - keeping borrowing costs below nominal growth and effectively inflating away the nominal value of the debt. Taken to extremes, this would imply a policy of Yield Curve Control (YCC), last applied between 1942-51 in the US and between 1945-47 in the UK to deal with the post WWII debt load. Today, implementing YCC would likely require some form of international accord limiting the flow of capital into and out of countries. We are not there yet, but pro-cyclical deficit funding on already-high debt levels builds on the already shaky foundations.

Shifting policy priorities

Amidst this backdrop, we appear to be witnessing a generational shift in policy priorities - from global economic optimisation to national self-determinism; from efficiency to resilience. The trajectory towards 'Strategic Autonomy' will include investments in defence, energy security, supply chain diversification, domestic manufacturing capability and (for some) technological superiority. This will likely be achieved by some combination of government incentive and private sector investment.

But the other side of the investment coin is higher inflation. Building redundancy into supply chains, re-shoring production and so on all raise the baseline level of prices and, importantly, increase inflation volatility. The latter point matters for asset pricing: higher inflation volatility will demand a higher risk premium, starting, with government bonds themselves.

The current economic style

With the reopening of Hormuz now in play and spot oil prices back down below $80, the economic outlook has improved materially.

The United States was least effected by Hormuz' closure, and the economy is growing well, underpinned by higher government spending, AI investment and a broadening of business capex. The US consumer is (still, and always) remarkably resilient, and recent jobs data suggests reason to be positive on the employment outlook. The prospect of falling inflation and consequently higher real incomes is also positive. Inflation is the fly in the ointment, and the new Fed Chair Kevin Warsh is clearly not entirely comfortable with its prevailing rate, but weaker oil and a resumption of rent price declines should be enough to assuage him from hiking. Wage price inflation is the main risk here. 

Elsewhere, economic conditions are softer but improving. Europe, the UK and parts of Asia are likely to see a disinflationary cyclical upswing over the next 6–12 months, supported by easing cost pressures and a recovery in real incomes. Inflation risks in most European countries are more limited, with more slack in the labour market and less of an investment impetus than is present in the US.

The dominant theme: AI

This cyclical upswing will combine with the market (and economy's) major driver, AI capex, to see an even stronger second half of the year.

The scale of spending on AI is unprecedented and, for now, justified by demand. Capital is abundant, urgency is high and profits are surging. This could continue for some time, but incentives are such that it is likely we ultimately invest too much, and at some point see excess capacity negatively affect prices. Indeed, the memory chip market is a commodity market, and notoriously cyclical. Perhaps this time will be different, but history suggests otherwise.

Glossary

Financial repression: A policy approach where borrowing costs are kept below nominal economic growth, allowing governments to reduce the real value of debt over time.

Yield Curve Control (YCC): A monetary policy where central banks target specific government bond yields, typically used to keep borrowing costs low during periods of high debt.

Strategic autonomy: A policy shift towards greater national self-sufficiency, including investment in defence, energy security, supply chains and domestic production.

Risk premium: The additional return investors demand to compensate for uncertainty, particularly in environments of higher inflation and volatility.