In the 1960s, towards the end of the Bretton Woods monetary system (which established rules for the countries such as the US, Canada, Australia and European countries for business purposes), the French Minister of Finance Valéry Giscard d'Estaing decried America’s exorbitant privilege, says Emma Moriarty (pictured), portfolio manager on CG Asset Management’s Real Return Fund.

This was a reference to the US dollar’s global reserve currency status that allowed the US to run persistent current account deficits – meaning that domestic living standards could be financed in substantial part by the international community – and yet never risk a balance of payments crisis.

Although the Bretton Woods system came to an end in the following decade, the US dollar has continued its run as the global reserve currency. This status has provided access to the world’s deepest and most liquid financial markets which in turn has allowed the US to issue debt up to a level that is close to 100% of GDP.

While not strictly reserve currencies, the other three of the ‘big four’ reserve currencies – the euro, yen and sterling – have also enjoyed a degree of privilege, allowing government debt to balloon gradually over the past few decades at – initially – reasonably contained cost.

Now the rubber has begun to hit the road. A well-publicised feature of the recent UK general election was the inability of either party to commit to any sizable industrial policy after the September 2022 gilt market meltdown fired a warning shot to any government pledging unfunded spending commitments. The UK is not the only major issuer that has felt scrutiny.

The most recent example, still unfolding, is yet another euro area debt infraction. But this time around, the culprit sits right at the core of the currency union. Hiding in plain sight, France had amassed government debt of 110% of GDP and is predicted to run a fiscal deficit of 5.5% for 2024.

While this does not appear completely out of line with recent deficits run by the US and UK, it does stand out in the EU, as the threshold for being made subject to the European Commission’s excessive deficit procedure, is a fiscal deficit of a mere 3%.

In round terms, this means that the French government needs to find more than 15 billion euro per year in extra tax revenue or in spending cuts to make a convincing gesture of progress. This task is made harder by the result of Emmanuel Macron’s recent snap election, where no party emerged with an outright majority, and so instead a loose coalition is under negotiation between Macron’s Ensemble and the left-wing alliance Nouveau Front Populaire.

Although this wards off the immediate threat of populist right-wing government, it entrenches a National Assembly in favour of big government at the exact moment when the purse strings need to be tightened. France is but one example: there are currently eight EU countries in ongoing excessive deficit procedures.

What does this mean for the euro? In short, the combination of high debt, high interest rates, and restrained spending will weigh on euro area growth for some time. Over the medium-to-long term, we expect this overhang to weigh on the currency. In the short term, we expect bond market volatility as grid locked governments grapple with painful trade-offs.

While we have excluded French government bonds from the Real Return Fund for some time on the grounds of excessive national debt, we are alert to the reality that other euro area government bonds may suffer from being ‘in the wrong neighbourhood’, and that the economic situation will slowly erode the value of the currency. We have reduced our weighting to German index-linked bonds accordingly.

Given all of this where do we seek shelter? In our view the answer lies in the small open economies. Sweden, Canada, Australia and New Zealand are economies which have benefitted from western democratic and economic institutions, but which have not been able to share in the exorbitant privilege of being able to issue large amounts of government debt at low cost.

As a consequence, their status as smaller issuers means that they must adhere to a different set of rules, necessitating lower levels of government debt, more constrained external balances, and higher real yields. As such, we continue to overweight these issuers and intend to take advantage of opportunities to increase this overweight over the coming months. Because in a world with too much debt, small is beautiful.

By Emma Moriarty, portfolio manager on CG Asset Management’s Real Return Fund