Two overlooked economic variables that matter for bonds

With analysts steadily publishing their projections for 2025 (ours are here), the macro variables that tend to get the spotlight are naturally growth and inflation. These are major factors in determining where monetary policy and government bond curves are heading, and by extension critical to assessing how different financial assets might perform as the year progresses. While this makes perfect sense, we think investors should also be paying attention to slightly longer-term trends that can reveal how resilient or otherwise countries might be when faced with a crisis, and how this evolves over time.

Two often-overlooked macro variables are the current account balance (CAB) and the net international investment position (NIIP). The CAB records all transactions, excluding financial items, between the residents of a particular country and foreigners. These typically comprise trade in goods and services, income derived from investments abroad (net of income paid out to foreigners who own assets in the country) and unilateral transfers such as financial aid. You will sometimes see the CAB is defined as the difference between savings and investment, and while it may appear difficult to marry these two seemingly different definitions, they effectively tell you the same thing.

In a given period, say a year, a country that saves more than it invests is said to have a current account surplus, whereas a country that saves less than it invests is said to run a current account deficit. Countries running a surplus effectively lend to rest of the world on a net basis, while those running a deficit must borrow from the rest of world to fund a portion of their investments. In a very simplistic example, a country that runs a deficit of £100 in year 1 and a surplus of £100 in year 2 would have no net debt with the rest of the world by end of year 2. A country that runs the same deficit for two years in a row would owe the rest of the world £200 by the end of year 2. The first country’s NIIP is zero, while the second’s is -£200. 

It goes without saying that identifying the level at which the rest of the world becomes unwilling to continue funding a country is more art than science. Emerging market countries typically have lower thresholds beyond which markets are reluctant to keep funding them. The market’s view of the sustainability or otherwise of a deficit is impacted by a long list of considerations, but one thing is clear: from a credit quality point of view, a country that runs consistent current account surpluses and has a positive NIIP should be less risky to lend money to than a country with a large and consistent current account deficit and a negative NIIP, all else equal.

The Eurozone is an interesting case study in this respect, since deficits were one of the reasons behind its sovereign debt crisis a decade or so ago. In 2008, Portugal, Ireland, Italy, Greece and Spain (the infamous PIIGS) ran current account deficits of between 3% of GDP (Italy) and 14% of GDP (Greece). These countries needed significant borrowing from abroad every year to fund domestic investment, as consumption in their economies was too elevated compared to the production of goods and services. When markets started doubting the future of the euro, there was far less concern around Germany or the Netherlands, which were running current account surpluses of 4% and 5.5% respectively at the time and had been doing so for years. Moreover, the accumulation of years of current account deficits had put the NIIP of peripheral Europe deeply in the red. Similar to companies, when a crisis comes, countries more reliant on external funding are more vulnerable if the taps get turned off.

Fast forward to today and the only one of the PIIGS still running a current account deficit is Greece. Ireland has a current account surplus of 8% of GDP, some turnaround from a deficit of 6% in 2008. This is a significant improvement in the vulnerability of these countries should a crisis arrive. As the chart below shows, the Eurozone as a whole swung into a positive NIIP a couple of years ago, helped by Germany continuing to increase its positive NIIP through successive current account surpluses (highlighting the enormous capacity Germany has to stimulate its economy). Since 2013, there have been a few countries have moved to a positive NIIP. If we look at NIIP as a percentage of GDP, all of them have actually improved.

Some readers might be wondering how the US scores in these metrics, and the answer at first glance is not particularly well. The US runs the largest current account deficit in the G7 at 3.2% of GDP, while its NIIP is -$21tr. There is one caveat though. We said above that countries with a current account surplus and a positive NIIP should be safer to lend money to, all else equal. But there is a well-known feature of the US economy that breaks the “all else equal” condition – the US dollar is the world’s reserve currency. When there is a panic, markets dash for US government debt and are happy to receive typically lower yields than before the panic began for the privilege of owning it. It is impossible to know if there is a level (and where that level might be) at which investors decide enough is enough, but for now it is fair to say that the US dollar’s status is a major positive for the US government’s credit quality and limits the chances of a “buyers’ strike” on US Treasuries (USTs) in our opinion. That is not to say increased UST supply and a growing deficit, the anticipated result of the new Trump administration’s budget plans, are not a potential problem. These are likely to resurface from time to time and create some volatility in UST yields, as they did in Q3 2023 for example. But the threshold for a more serious debt sustainability problem is much higher for the US than it is for a “normal” country.

It is difficult to compare countries when all else is not equal. What we can say is that in terms of its credit quality and its resilience to future crises, the Eurozone’s position has improved markedly in recent years. There is a trade-off though. When you save more, you necessarily consume and/or invest less than otherwise. This is part of the explanation for the Eurozone’s lower growth since the global financial crisis. As fixed income investors, we don’t mind countries saving more as we are willing to sacrifice some growth (which doesn’t benefit us in the same way as it does equity investors, for example) for the extra cushion against a crisis. The fact that France’s political crisis has been largely ignored by European markets, outside of French government bonds and equities, is not a coincidence. Nor is the fact that we don’t hear the term “peripheral Europe” as much as we used to.