The painful path of global debt
Sept. 18, 2015
There’s a lot to discuss in today’s bond markets, and I’m not one to waste time on cute soliloquies. So let’s get right to the market condition that has governed policy responses and capital market moves as of late, and looks as though it will continue to do so: enormous global debt!
International consulting firm McKinsey & Company has sifted through global economic data and tracked the path of global debt levels, as illustrated in Chart 1.
Chart 1. Global debt has increased by $57 trillion since the global financial crisis
|Total global debt as a percentage of global gross domestic product (GDP)
Data: McKinsey Global Institute analysis; International Monetary Fund; Bank for International Settlements
From the fourth quarter of 2007 — which is the official start of the Great Recession or global financial crisis (GFC) — through the second quarter of 2014, the planet added $57 trillion in outstanding debt. More troubling is that when compared to global GDP levels, global debt increased by a multiple of 2.8 (286%) from an already-high multiple of 2.7. In past commentariespast commentariespast commentaries I have expressed my views that central banks’ money-printing initiatives have taken away from market discipline, inflated many asset prices away from fundamentals, and of greatest concern, encouraged more debt and a levering of economic systems. In a sense, central banks create a higher hill to fall from during bear markets.
A profusion of debt, driven by monetary policy
Much of the increase in global debt has occurred within emerging markets, especially in the Asian nations. Liquidity infusions from the Federal Reserve, the Bank of England, the European Central Bank, and lately the Bank of Japan have collapsed risk premiums in the post-GFC environment. Combine that condition with the fact that risk-free rates have been unusually low, and you create an attractive environment for emerging market countries to take on more debt. The credit team at the Royal Bank of Scotland (RBS) has given us two ways to visualize the significant debt build-up in emerging market countries as well as in Asia (see Charts 1 and 2).
Chart 2. Private-sector debt relative to GDP
*Middle East and North Africa
Sources: RBS Macro Credit Research, World Bank. As of September 2015.
As shown, there has been a remarkable increase in private-sector debt across emerging market regions (except for sub-Saharan Africa). In our view, the most troubling is the ramp-up in private-sector debt across emerging market countries in Asia. We believe that the money-printing policy of developed countries, together with domestic Asian monetary policy (to support growth after the GFC), are to blame for this result. We've seen that loose monetary policy has led investors into securities with higher yields, and much of this debt has been issued by companies in emerging market countries. Exacerbating the debt build-up is the fact that many companies borrowed in U.S. dollars or euros, and they now have a currency mismatch to deal with. With a significant dollar rally against many Asian currencies, companies may find themselves with higher debt service costs.
Chart 3. Borrowing in dollars has created a currency mismatch
A strong dollar has created pressure for borrowers who need to repay in weaker currencies
Sources: RBS Macro Credit Research, Bloomberg. Data accessed in September 2015. As of Aug. 31, 2015, debt issued by the following companies was included in select portfolios overseen by the investment manager: Cnooc, Vale, Petrobras, Lukoil, MMC Norilsk, ICICI, Sinopec, ICBC, and Bank of China.
Global growth effects of a debt overhang
I have long believed that high debt levels can significantly influence a country’s potential growth prospects. Despite the chorus of criticism about the controversial analysis conducted by American economists Carmen Reinhart and Kenneth Rogoff (in which they discuss the drag that debt can have on economic growth), I believe that we are living the proof of their thesis.
After expanding moderately in 2014, the world economy has slowed again in 2015. The Bloomberg World Growth Index, shown in Chart 4, is reading below 2%. (It’s worth keeping in mind that in the past, a world GDP level below 2% has been associated with significant negative economic events.) This data point assumes Chinese growth of 7%, and if the country’s economy is actually growing much more slowly (as many people suspect), the index level could be significantly lower.
With global monetary policy currently providing significant stimulus, countries appear to be able to temporarily cope with elevated levels of debt. However, the Fed has removed stimulus with the partial wind-down of quantitative easing measures. It is also attempting to increase short-term rates despite slow economic progress here in the United States. Due to world debt effects, this phenomenon is already causing significant moves in both the commodities and currency markets. Small idiosyncratic events seem to be foretelling further issues to come. Consider that:
- Greece has been in serial economic crises during the past four years, with the severity of the economic situation coming to light this year. Several layers of Greek bank debt will be written down in order to absorb the latest bailout monies.
- Puerto Rico has engaged in debt workout talks with creditors.
- Ukraine has just negotiated a partial write-down of its outstanding debt, and will attempt to receive further debt relief from Russia (an important creditor).
- Many energy exploration companies, particularly smaller ones, are engaged in Chapter 11 workouts or are desperately trying to raise capital to deal with bloated balance sheets in a low-oil-price environment.
Chart 4. Global economic growth tapering
Data: Bloomberg Analytics. Accessed in September 2015.
Amid market fragility, sensitivity toward risk
Moving forward, we believe that global markets will experience more idiosyncratic credit events as the global economy continues to slow.
In light of this, we think the following key questions are worthy of consideration when investing.
- Where do I stand in the borrower’s capital structure?
- Am I invested in companies that may succumb to growth issues?
- Is my position collateralized or supported by some other credit enhancement?
We believe that careful assessment of risks such as these is an essential element of active portfolio management amid today’s fragile and reactionary markets. As such, they are key to our portfolio construction process. Unconventional central bank policy has fueled volatility, and we argue that markets have yet to feel the effects it can have on corporate balance sheets. We believe that a fixed income team that is aware of precarious conditions around the world — and is ready to manage risks associated with these conditions — can be an important partner for fixed income investors who need to navigate what could potentially be increasingly choppy markets.
All charts shown throughout are for illustrative purposes only.
The views expressed represent the Manager's assessment of the market environment as of September 2015 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
The Bloomberg World Growth Index is calculated based on economic performance for component countries (and regions) that include France, Germany, Belgium, Italy, Japan, the Netherlands, Sweden, the United Kingdom, the United States, Canada, Switzerland, Eastern Europe, Africa, Asia, Latin America, and the Middle East.
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