“If there’s not enough money in the bank account, you don’t spend it.” Charles Schwab
It is not coincidental that the International Monetary Fund (IMF) Deputy Managing Director, Geoffrey Okamoto (while speaking at the Peterson Institute for International Economics Conference in Washington DC), in October 2020 focused his opening speech on Global Debt and the importance of immediate and urgent collective action.
Chart 1: Gross Government debt as % of GDP
Source: IMF (26 Nov 2020), Northstar Asset Management (1991 to 2025)
The size of the problem
According to the Institute of International Finance (IIF) who sample key mature and emerging markets, global debt at the end of 2019 reached US$255 trillion, 322% of the world’s collective GDP, 40% higher than at the onset of the Global Financial Crisis in 2008. In 2020, due to COVID-19, governments have been issuing debt at a multiple of 3 times the monthly rate seen between 2017 and 2019. The IIF predict that by the end of this year, global debt will rise to 342% of GDP.
Chart 2: GDP growth versus gross debt positioning and interest rate levels
Source: IMF (26 Nov 2020), The World Bank, Northstar Asset Management (1990 to 2020)
Some key points from the IIF’s Debt Monitor Report of April 2020
- Governments have been the largest contributors to rising debt.
- The US and Chinese governments were responsible for more than half of this increase.
- Emerging market debt is at 220% of GDP, a new high, up from 147% in 2007.
- Over 85% of the countries have higher debt-to-GDP ratios in 2019 than they did prior to the 2008 financial crisis.
- Spain, the UK, Japan, France, Italy and the US have been significant originators of debt in developed markets.
- South Africa, Chile, Brazil and Argentina have led the pack in emerging markets.
- Global household debt has also surged since 2007, with Chinese households showing the largest growth.
- Non-financial corporate debt, being debt raised by non-financial sector businesses, increased from 70% in 2007 to 92% of global GDP.
- Over US$20 trillion of bonds and loans are due for repayment by the end of 2020, with emerging market debt accounting for 23% of this. The IMF is calling for debt relief!
The history of the world’s debt since 1950
According to Ayhon Kose, Peter Nagle, Franziska Ohnsorge and Naotaka Sugawara in their book titled Global Waves of Debt, Causes and Consequences, the world has experienced four waves of debt accumulation since the 1950’s. Their chronology and geographic nucleus being as follows:
What similarities did these debt waves have?
- Periods of very low interest rates whilst investors searched for yield.
- Changes in financial markets (such as the development of subprime prior to 2007) that contributed to rapid borrowing.
- Susceptible economies had some or many of these characteristics: fiscal weaknesses, poor revenue collection, widespread tax evasion, public and pension indexing, energy and food subsidies, managed exchange rate regimes, weakly regulated banks, poor corporate governance and protracted political uncertainty.
- The first three waves all ended in a financial crisis.
- All caused or resulted in a global recession.
How is the current wave more concerning?
- It is unprecedented in terms of its size, speed and reach both in emerging and developed markets.
- It has been fueled by close to zero nominal interest rates, providing no room for manoeuver.
- The private sector has played a prominent role fueling the increase.
- China has become highly indebted.
- A shadow banking sector has emerged as a key participant with its own creditor rules.
- The non-resident share of government debt, foreign debt, in 2005 was 37% and is now 45%.
- The foreign currency component of corporate debt, which introduces currency risk, in 2005 was 15% and is now 25%.
Positive buffers introduced since the last crisis include:
- Improved fiscal management, albeit unfortunately diluted by COVID-19 interventions.
- Inflation targeting, which has smoothed economic cycles.
- Flexible exchange rate regimes, which allow for currencies to become shock absorbers during a crisis.
- Central bank transparency has reduced uncertainty for market participants.
- Stronger financial sector regulations and standards have been adopted globally.
So what are the lessons learnt from three previous debt waves?
Firstly, high global debt, low interest rates and subpar economic growth are a lethal mix that creates systemic vulnerabilities catalysing a crises. Secondly, economic shocks originate from unexpected sources, are unpredictable and other than avoidance, no effective antidote exists. Thirdly, these crises unfold with similar glide paths – a shock, followed by higher borrowing costs, reduced capital flows and a decade of weak economic growth. Fourthly, high debt limits the scope for countercyclical fiscal stimulus when an unexpected crisis does unfold. Think of SA’s response to COVID-19, our indebtedness even before the onset of the virus was already so elevated that our government’s financial intervention was utterly underwhelming. Lastly, that debt accumulation is not healthy unless it is very well spent to finance output-enhancing purposes – particularly export activity.
We acknowledge that we do not have the abilities to predict the time and date of the next financial crisis. This article highlights our awareness of the conditions that create crises and that some are evident currently. Whilst being cognizant of the risks at play, our approach is to operate within a framework that ensures successful long-term investment outcomes for our clients.
- Diversifying our portfolios across asset classes, geographies and currencies with a deep appreciation of each component’s contribution towards returns and risks within a portfolio.
- Owning competitively advantaged businesses that can sustain themselves through challenging times.
- Avoiding deeply indebted business as they are not masters of their own financial destinies.
- Applying security (fixed income, property and equity) valuations in a ‘normal world’ – as an example very low interest rates often overprice assets.
- Communicating to our clients the importance of time versus randomness – market movements are random in the short-term, outcomes over the longer-term (ten years and more) are not.
- Appreciating that it is impossible to manage money engulfed in a perpetual state of fear whilst waiting for a pending crisis to unfold. The focus must be on the facts at hand in the present.
- Being in tune with markets and key hazard gauges, which include excessive risk taking, overpriced assets and debt accumulation, to name but a few.
Since 1970, governments, businesses and households have borrowed from the future – in effect front-loading their consumption. Using debt to consume now, must mean lower prospective consumption and growth. As Charles Schwab rightly points out, there are no free lunches in financial markets.