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Market View

Some deleveraging has occurred in the United States, but growth remains in low gear. 

 

In Brief

  • Developed countries have been accumulating public- and private-sector debt for decades in what some observers have called a “debt supercycle.” Some observers believe that the indebtedness is nearing a point past which it cannot continue.
  • But U.S. consumers have reduced their debt by 18% as a percentage of gross national product since 2007, according to the McKinsey Global Institute. Corporate debt has fallen less, but on a relative basis versus corporate equity it is much lower, as corporate profits, as represented by the earnings on the S&P 500® Index, have risen by approximately 37%. Federal government debt has risen substantially, but the annual deficit has improved, and investors continue to view Treasuries as risk-free.
  • According to economists Carmen Reinhart and Kenneth Rogoff, after a financial crisis, deleveraging periods can last as long as 10 years before economic growth resumes at a normal pace. In the United States, debt reduction has been progressing for about seven years. So, if U.S. economic growth is going to return to its historical average, that may still be a few years off.
  • To reduce their public debt, countries historically have sought to boost growth, often via exports. While this is an option for some countries in the eurozone, many of the periphery countries will have to make more progress in liberalizing their economies to increase their competitiveness.
  • In a world that needs to continue deleveraging, economic growth could remain below the historical trend in the short term, and maybe longer, especially given demographic trends. Capital market returns could remain lower for a while as well. 

 

Without a young, rapidly growing working-age population to help drive economic growth, it is unclear how heavily indebted countries, including the United States, Japan, and much of Europe, are going to address their large looming financial obligations, according to many observers.1 In fact, some have argued that the developed world is finally nearing the end of a decades-long “debt supercycle” in which leverage will have to be reduced one way or another to avoid economic disaster.2 On the other hand, low yields on government and corporate debt suggest that the danger is not imminent. Bond buyers—hardly the most Pollyannaish of investors—continue to have faith in the ability of these borrowers to make their payments. Addressing these topics are Lord Abbett Partners Milton Ezrati, Senior Economist and Market Strategist; Zane Brown, Fixed Income Strategist; Harold Sharon, International Strategist; and David Linsen, CFA, Director of Research.

Q. Some observers have argued that the United States and many other developed economies are nearing the end of a 70-year buildup in debt in what some have called a “debt supercycle.” Debt levels among households, businesses, and government are so high that they are slowing the economy, threatening to make the debt unsustainable. Are we at the end of a long debt buildup cycle?

Ezrati: Government debt has been accumulating for the past 80 years, not just the past 70 years. It also exploded in the years preceding the end of World War II. After the war, it had grown to more than 100% of gross domestic product (GDP), and the U.S. government began to pay it down, but in the 1950s with the Korean War, the welfare state, and the building of the interstate highway system, the debt continued to rise. But, as a percentage of GDP, it shrank, not because it was paid down, but because GDP grew so rapidly.

As for the rise in debt that has occurred since 2008-09, it’s a drop in the bucket compared to the buildup over the past 70 years. But as to whether we’re at the end of a cycle, I don’t know that we can say that we’re done with debt accumulation.

Brown: In the United States, household debt has actually been paid down by 18% as a percentage of GDP since 2007, according to McKinsey (See Chart 1). And as for the corporate sector, debt levels have not changed much, but debt servicing costs relative to revenues have dropped substantially since 2007.

Currently there isn’t much of a problem with the absolute level of federal government debt. Although the debt is still growing, it’s growing much less rapidly than it has in recent years. As a percentage of gross domestic product (GDP), the annual budget deficit is now below 3%, which is much lower than in 2009, when it peaked at just under 11%.3

State and local governments also continue to make progress. Over the past couple of years, they have paid down some of their debt. So, as a country, we’re in much better shape than we were in 2007.

Linsen: On the corporate side, you mentioned that debt has not changed much. It has declined by just 2% in relation to GDP, according to McKinsey, but that is over a period in which earnings on the S&P 500 were up approximately 37%.4 In other words, corporations are deleveraging materially by growing their earnings. So although the absolute level of debt hasn’t declined much, relative to corporate equity, it has improved.

Ezrati: Here’s how the U.S. federal budget breaks down: 70% goes to entitlements, 17% is for defense, and a little more than 6% is interest expense, leaving about 6% or so for everything else. Defense spending may go up or down in the future, but we know that entitlements are not going to shrink, and we know that debt servicing costs are going to rise. Even if interest rates stay low, debt servicing will grow because the outstanding debt will continue to grow. So, unless Congress raises taxes, enacts entitlement reform, or defaults, the debt is going to continue grow.

 

Chart 1. Since 2007, Some Debt Reduction Has Occurred, but Overall Debt Levels Are Up
Top 25 Indebted Countries, Ranked by Real Economy Debt-to-GDP Ratio

Source:  McKinsey Global Institute, February 2015.

 

Sharon: But Japan has shown us that a country can go a long time with a lot of government debt and still have low interest rates. The key question is, “Is the country a wealthy economy?” And the U.S. is a wealthy economy.

Do interest rates have to rise sometimes to entice the marginal buyer? Yes, but the U.S. bond market is also widely perceived as the largest, safest, and most liquid bond market in the world, and Treasuries are without a doubt the world’s premium risk-free asset, with few substitutes.

Ezrati: So, to summarize our view, we do not think the U.S. economy is at the end of a debt supercycle, and we’re a long way from a tipping point. But we are in an era in which everybody, including the federal government, is much more sensitive to their level of debt.

Q. Is there some danger that the U.S. economy will never return to the historical rates of growth of 3-4% and that we’re in a period of “secular stagnation,” as some have called it? Or is the slowdown temporary, with historical growth rates likely to resume once deleveraging is complete?

Ezrati: It’s the fundamental growth of the economy that enables a country to take on debt. Let me characterize the danger in terms of a company. If a company is growing at 15% a year, and the chairman of the board refuses to allow the company to take on debt, he should be fired. But he should also be fired if he takes on any debt if the company is growing at only 1% a year.  

So, the question is, what is the potential growth rate of the economy? If it’s higher than we think it is, and we will refuse to take on more debt, we won’t achieve that potential.

The important thing is not whether we are going back to ramping up on debt, but whether we have reached some sort of equilibrium in which, unlike the period from 2005-07, we’re taking on debt only as fast as the fundamentals can support. It would be very healthy if we started taking on more debt, but only if that is consistent with the potential growth in the economy.

Sharon: I’m not so sure the U.S. is near a tipping point. The deleveraging period, according to Reinhart and Rogoff, can be as long as 10 years, and we’re only seven years into the process.5

But overseas, emerging markets have ramped up their debt levels, so some of them might be at risk. In the case of Europe, Greece is front and center, but for some of the other countries, such as Ireland, there are assistance programs in place, there is the wherewithal to pay down these debts, and they are once again being financed by the market.

Ezrati: If you look at leverage in terms of people’s perceptions of potential gains, they aren’t leveraging up again and taking on risk because the expected returns are lower. Corporations are just letting cash pile up. So, it’s a question of confidence. Consumers will be willing to take on more debt, when they believe they are confident they can find another job if they need to. Right now there is very little confidence of that.

Brown: Recovery has to do with other factors as well, not just debt levels. In the past when we’ve had a crash, housing has gotten us out of it. But this time, housing was at the center of this downturn, and therefore the overhang in that market had to be absorbed before housing could start contributing to the recovery. The slow recovery has also dampened consumer borrowing and consumption, which has also contributed to the economic sluggishness.

So once employment strengthens, consumer spending will improve, and that will result in more momentum in the economy. Then growth will rise and approach its theoretical potential. The jury is still out on what that potential is, but we would hope that it would adjust back to around 3%.

Q. Economic growth has been a way that indebted economies have reduced their debts in the past, and boosting exports is one way to do that. How much of an option is that for developed markets?

Brown:  Boosting exports is not a realistic option for the United States, given the current strength of the dollar, although not all U.S. exports will be hindered. As Milton has pointed out, many of our exports are distinguished by their sophistication, and that means that even a rising dollar won’t hurt overseas sales that much. Exports of medical devices, for example, are unlikely to be hampered much by a strong dollar because these are high value-added products, not commodity-like products.

But the cheaper euro resulting from the ECB’s purchase of about €60 billion in debt every month, will help eurozone exports and growth. Germany is probably the most likely to benefit from this policy and to grow out of their debt problem. They’re natural exporters; 50% of their GDP comes from foreign markets. (See Chart 2 for estimates of growth levels needed for public sector deleveraging to begin.)

Ezrati: The Dutch and the Finns are also likely to be able to reduce their debt via economic growth, but countries on the periphery of the eurozone probably won’t be able to. They don’t really have that much growth potential. The European Union and the ECB have said these countries need to liberalize their markets, or they’re not going to grow.

In some of these countries, the company has to actually ask the union if it would be okay to drop production of a product. If a company wants to switch production from one product to another because of a shift in demand by the market, the company isn’t allowed to do that without government and union involvement.

 

Chart 2. For Many Countries, Growth Needs to Accelerate Before Government Deleveraging Can Begin
Real GDP growth rate required to start public-sector deleveraging

1 Average real GDP growth forecast from 2014 to 2019 per IMF, HIS, EIU, Oxford Economics, OECD, and McKinsey Global Growth Model.
2 Based on current GDP forecasts, Ireland, Greece, and Germany do not require any additional growth to start public-sector deleveraging.
Source:  Debt and (Not Much) Deleveraging, McKinsey Global Institute, February 2014.

 

Sharon: Besides Germany, Spain and Italy are two countries in the periphery where exports make up a significant portion of the economy. Spain has made some progress on structural reforms and reduced its unit labor costs relative to Germany, according to Haver Analytics. But a large portion of their exports are within the eurozone, so a weaker euro won’t help much. The current account balance has improved, however, and was positive in 2013 and 2014, according to OECD data. 

Italy has also lowered its unit labor costs, according to Haver Analytics, bringing it more into line with those of Germany, and exports continue to be an important part of an industrial renaissance. OECD data shows that Italy also had a current account surplus in 2013 and 2014.

Ezrati: These economies have a chance to grow out of their debt problems if they liberalize their economies. But it’s difficult to do that. Look at Greece. The government was able to enact this severe austerity program, but it still hasn’t been able to take on the unions and the regulators. You would think that, given a choice between liberalizing the labor laws and other regulations, and laying off a lot of government workers, Greece would have liberalized. But the government chose to let workers go. 

Q. If economic growth is not a realistic solution and default is not acceptable, what is the alternative?

Brown: If the endgame is that debt levels will become so high that investors won’t buy it unless yields rise significantly, then the government may be forced to monetize the debt, perhaps through aggressive quantitative easing. That should lead to inflation, which reduces the size of the debt in real terms.

Of course, the Federal Reserve has done some quantitative easing, but it has been relatively restrained when compared to other central banks at other times in history. But if the Fed continued down that path, inflation would rise, making the debt more manageable over time.

Q. Some observers have said returns on stocks and bonds are going to be much lower than they have been over the past three decades, in part due to the end of this debt supercycle. What is the long-term outlook for returns?

Brown: The question is, are we now in a different economy, where potential growth is just 2% instead of 3%? If our potential real growth is only 2%, investors may have to manage their expectations. And implicit in that is a lower level of inflation. So instead of 3% growth and 2% inflation, maybe the economy has a real growth potential of 2% with inflation of 1.25%. So although growth would be slower, investors would still end up with a reasonable real return on debt.

Ezrati: The world that some are pining for is one in which investors could earn a decent inflation-adjusted return on insured bank deposits. That was from the early 1980s through 2007. Those days are gone.

Brown: But as job growth improves and as employment costs continue to rise, we should start to see some inflation. With continued economic growth and the gradual rise in inflation, we’ll start to approach more normal nominal returns. But returns may still be lower than historical averages, given demographic factors, including an aging population and a slower-growing work force.  

In this environment, fixed-income investors should consider taking on credit risk because although on an absolute basis yields are less, on a relative basis the spread on high-yield bonds is greater. For example, in a normal interest rate environment, high-yield bonds might offer a 5% spread on top of a 5% yield on a 10-year Treasury. In today’s environment, they might offer a 5% yield on top of only a 2% yield on a 10-year Treasury. On a relative basis, the spread the investor would get today on high-yield is greater. So, if lower returns are going to be the norm for a time, then investing in credit makes sense. But if growth and inflation continue to rise, then equities should also do well as long as inflation remains at moderate levels.

 

1 Szu Ping Chan, “The World Is Drowning in Debt, Says Goldman Sachs,” www.telegraph.co.uk, May 26, 2015.
2 See, for example, Endgame, John Mauldin and Jonathon Tepper, 2011.
3 Congressional Budget Office, Revenues, Outlays, Deficits, Surpluses, and Debt Held by the Public Since 1965.
4 Standard & Poor’s. In 2007, S&P 500 operating earnings were $82.54, and in 2014 they were $113.02, an increase of 36.9%.
5 Research by Reinhart and Rogoff published in 2010 shows that private sector deleveraging begins two to three years after a crisis and continues for about seven years. 

 

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