Over the next few weeks, I will be publishing a series of articles on TheBull.com.au to help investors understand what will be the Global Economic drivers for the next ten years. I will discuss consequences and how to profit from the changes ahead through a series of ten investment themes.
‘The fact that we are here today to debate raising America’s debt limit is a sign of leadership failure. America has a debt problem and a failure of leadership.’ Barack Obama, March 16, 2006
The more things change, the more they stay the same. Almost all countries are now presenting budget deficits and we’re now five years after the Global Financial Crisis. Where is the surplus to be enjoyed after the orgies of spending and money printing?
As I am writing these lines, the global debt clock from Economist.com just crossed the USD50 trillion marks. The accumulation of all these deficits is pushing the debt level of many countries to breaking point. The phenomenon has reach a global epidemic and the debt cancer is now devastating all continents.
Lets take a look at the Public debt as a % of GDP for 2011 and 2012 for an important sample of world economies (Fig 1)
Fig 1 Public debt as a % of GDP for 2011, 2012 source: theeconomist.com
As we can see, liabilities fell for most countries in 2012. As a matter of fact, several countries with the highest Debt/GDP ratio in 2011 found ways to make the situation worst in 2012. Greece, Japan and Portugal saw ratios increase drastically. Many countries have passed the point of no return. A study by Reinhart/Rogoff argues that economic growth begins to suffer when a country’s Debt-to-GDP ratio exceeds 90%. 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 levels are faced with the choice of either increasing debts to try to stimulate their economy and boost 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 become unmanageable, countries face one or all of the following:
– Currency Devaluation
– High Inflation
High level of debts can be addressed. Canada was able to tackle its problems with drastic spending cuts and a major devaluation of its currency in the nineties (we should note, however, that Canada reduced its burden in a time of global prosperity when demand for Canadian commodities increased). However, historically only one developed nation was able to repay its debt after crossing the 110% Debt/GDP mark; the United Kingdom after WWII.
What about America? People always mention the size of the 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 then many 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 is 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 then it should. We only have to look at Japan to realised that there are no limits to the political will of kicking the can down the road for generations to come.
You may ask, if all countries from the richest to the poorest have debt – 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, Mr. 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 then the “normal” market demand. However, this brings the question as who will be buying all those 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 equities that will be caused by excessive debts. When the next recession comes, many countries may not have the mean to stimulate their economy with increased spending without seeing interest rates shoot up. What will Italy or Spain rates be like when the situation gets worst 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 heaven anymore.
– Investors should expect increased numbers of defaults going forward, from emerging and developed markets.
– Global currency devaluation is just starting, as it’s the easiest way out for countries with high debts to stimulate GDP through exports.
– As central bankers destroyed 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 possible losses are much higher than possible gains. One should be underweight in all portfolios.
– The next recession may bring higher interest rates for countries with high debt levels. Investors should favor countries with a low debt ratio, as they will be better positioned to support their economies.
Next week: Third Driver, Global Money Supply
Eric St-Cyr is the founder and CEO of Clover Asset Management, a Brokerage and Wealth Management company located in the offshore jurisdiction of the Cayman Islands and servicing clients across the world. Before founding Clover Asset Management, Eric led the investment arm of one of the largest Life Insurance companies in the region, providing investors with impressive performance. Eric spent the first twenty years of his career working in Canada where he became Senior Vice President of one of the largest asset management firms, with assets under management exceeding $60 Billion. Eric can be reached at: [email protected]
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