this series of articles to help investors understand what will be the
global economic drivers for the next ten years I will discuss their
effects on our lives and how to profit from the changes ahead through a
series of ten investment themes.
Next time I will address monetary
policy’s bastard child: Inflation.
The more things change, the more they stay the same. Almost all countries are now presenting budget deficits and this five years after the global financial crisis. Where are the surpluses to be enjoyed after the orgies of spending and money printing?
As I am writing these lines the global debt clock from Economist.com has just crossed the US$50 trillion mark. The accumulation of all these deficits is pushing the debt level of many countries to breaking point. The phenomenon has reached a global epidemic and the debt cancer is now devastating all continents.
Let’s take a look at public debt as a percentage of GDP for 2011 and 2012 to show an important sample of the world economies (Fig 1).
As we can see, the liabilities situation degraded for many in 2012. As a matter of fact several countries, presenting some of the highest debt/GDP ratio in 2011, found ways to make the situation even worse in 2012. Greece, Japan and Portugal all saw their ratios increase drastically. Many countries have passed the point of no return. A study by Reinhart/Rogoff suggests that economic growth begins to suffer when a country’s debt-to-GDP ratio exceeds 90 per cent.
As the servicing of the debt takes its toll, countries become ill equipped to deal with future recessions and rapidly fall into a debt inflation spiral. Countries with high debt level are faced with the choice of either increasing their debts to try to stimulate their economy and to reflate their GDP or cutting spending to reduce the debt to the detriment of their GDP. Short term both scenarios bring the same result, a higher debt/GDP ratio. Long term there are no guarantees that the situation will get better.
Simply put, when sovereign debt becomes unmanageable countries are faced with one or all of the followings:
- Currency devaluation
- High inflation
High level of debts can be addressed. Canada was able to tackle its problems with some drastic cuts in spending and a major devaluation of its currency in the nineties. We should note that Canada reduced its burden in a time of global prosperity when demands for Canadian commodities increased. Historically, however, only one developed nation was able to repay its debt after crossing the 110 per cent debt/GDP mark: the United Kingdom after World War II.
What about America? During each seminar I give, people always mention the size of US debt and most predict the collapse of the dollar and a future default of Uncle Sam. The United States situation is not as bad as many think, the debt ratio remains manageable and is much lower than the one observed in most European countries. As a matter of fact the US has a lower debt/GDP than Canada, the economic darling of the G20. The United States also presents a lower tax rate. Obviously there is room to address the situation. The problem with the USA is the speed at which the debt is growing. The orgies of spending observed during the last 12 years are unprecedented. The cancer is curable but is spreading rapidly. (Fig 2)
Even if we all know that the situation can’t continue forever, history tells us that it can last for much longer than it should. We only have to look at Japan to realise that there are no limits to the politic will of kicking the can down the road for the generation to come.
You may ask if all countries, from the richest to the poorest, have debts. Who do we owe this money to? We owe it to other countries, banks, pension funds, individuals, corporations but most of all, in the US, the money is owed to the Federal Reserve. Over the last four years Bernanke’s group purchased the largest part of the bonds issued by the US government. This explains why the rates have remained so low when supply increased faster than the “normal” market demand. This brings the question as to who will be buying all these bonds when the Federal Reserve stops its quantitative easing policy? Can the Fed ever stop buying treasuries without bringing an important recession?
Looking forward we need to assess the different country risk for bonds and equity that will be caused by excessive debts. When the next recession comes many countries may not have the means to stimulate their economy with increased spending without seeing interest rates shoot up. What will Italy or Spain’s rates be like when the situation gets worse, or if Germany refuses to continue to carry Europe? The next recession may rapidly turn into a depression…
What does this mean for your portfolio?
Sovereign debts now present a higher risk than in the past and should not be considered a safe haven anymore.
Investors should expect increased numbers of defaults going forward, from both emerging and developed markets.
Global Currency devaluation is just starting, as it is the easiest way out for countries with high debt levels to stimulate their GDP through exports.
As central banks destroy the natural order of supply and demand, to increase liquidity in the system and keep interest rates low, we should expect inflation to emerge (more on this next week).
There is an asymmetry of risk in Sovereign bonds where the possible losses are much higher than the possible gains. They should be underweight in all portfolios.
The next recession may bring higher interest rates for countries with high debt level. Investors should favour countries with low debt ratio as they will be better positioned to support their economies.