Finance: The age of debt

Borrowing has choked off growth, says George Magnus, but investors can still pick profitable paths forward
August 24, 2011

If, as an investor, you had been blessed with perfect foresight in early 2009, you might have made for the hills, armed with a suitcase of cash, a weapon, a tin helmet, and a stock of canned food. If the insurrections across north Africa and the Middle East, soaring energy prices, and rising inflation in emerging markets hadn’t put you off, you would have trembled at the aftershocks of the debt crisis. These have since included stop-start economic growth, budget cuts in the west, continuing falls in house prices. They also included an existential eurozone debt crisis and the rather meaningless decision by Standard and Poor’s, the credit rating agency, to strip the US of its AAA credit rating. But if you had disengaged from financial markets at that point, you would have been dead wrong. Even after the sharp falls in July and August, stock markets, including the FTSE 100 index, are still 30-70 per cent higher than in March 2009. Currency and commodity markets have provided good returns. Farmland has done well, and even commercial property has proved a money-spinner, with prices rising from their lows, and some decent rental income returns.

So what’s going on? My view is that financial markets bungee-jumped upwards out of the abyss three years ago, thanks to the extraordinary policies implemented by governments and central banks to prevent the banking system from collapsing and the economy from sinking into a depression. Many of those policies are now being terminated or reversed. The leap in the financial markets has been exhilarating but the crisis of over-indebtedness is not over, as evidenced by the continued weakness of the US and eurozone economies. It is time to watch out for both volatility and disappointment.

Why debt is a threat

The financial crisis of 2008/09 marked the end of a two-decade long credit boom, leaving a sea of debt. Reducing the burden of debt weakens economic growth and takes a long time. It also deepens tensions between debtor and creditor countries about who is supposed to do what, for example, between the US and China, and Germany and the eurozone periphery. Lowering debt burdens undermines investment returns because it creates a deflationary environment: economic and employment growth is weak, the credit system becomes dysfunctional, interest rates remain low and asset prices struggle. There are two ways out.

One route is austerity, or the financial equivalent of “rehab.” Debt has to repaid or restructured, and sometimes forgiven, and borrowers have to earn the income necessary to service and repay their debts. But austerity only works if the economy keeps growing. If not, you end up heading towards a “debt trap.” The debt burden continues to grow and public debt, in particular, becomes unsustainably large and unstable. This can lead to disorderly default, the imposition of hitherto unacceptable economic and financial controls, and in extremis, social collapse and hyperinflation.

Britain and other western debtor countries are still lumbering down the austerity route—some more quickly than others. But these are still early days, and the outlook for economic growth is highly uncertain. One or two countries, notably Greece, are in danger of sliding into a debt trap. To see the consequences for a country already in one, look at Japan, whose debt crisis erupted in 1989. Private (mostly company) indebtedness did decline sharply after 1997, but because of the fundamental weakness of the economy—growth has been up and down five times since 1990 and averages about 1 per cent a year — price deflation and persistent policy inertia, public debt has exploded from about 52 per cent of GDP in 1989 to about 220 per cent today.

While institutional investors may have made money by riding the ups and downs of these cycles, Mr and Mrs Watanabe have had a miserable time, drawing on their savings to maintain living standards. The Nikkei stock market index is still 75 per cent below its peak, and government bond yields have been in around 1-2 per cent for years. Property and land prices have picked up a bit since 2005, but remain half their level in 1989, and no higher than they were in 1986.

The only reason Japan has muddled through two “lost decades” is because it is a creditor country. It holds net foreign assets amounting to around half of its national income, and can rely upon a high stock of domestic savings. But these strengths are liable to be undermined by the financial consequences of a rapidly ageing population—which the west also now faces, though without Japan’s financial credentials.

Deleveraging constrains financial markets

The key to what happens in financial markets over the coming years is a fundamental adjustment known as “deleveraging.” This is the protracted process during which debts must be reduced as asset prices fall in order to prevent insolvency. Only once this adjustment has happened will normal spending, lending and borrowing resume. Housing is a classic example: the overhang of excessive mortgage debt has to fall now that house prices have dropped, causing hardship or fear for many. The only way out of this might be for the government to start a scheme to allow eligible mortgage holders to write off some of their debt against repayment from future house price increases.

Although the banking system has been strengthened and re-regulated, the deleverageing of the financial system is a work-in-progress. British bank assets (mainly loans) exploded to more than £9,000bn before the crisis, at which point they represented 45 times the value of the banks’ capital (giving a leverage ratio of 45:1). Assets have since fallen by about £1,500bn, and along with required increases in capital, the banks’ leverage ratio has fallen back to 25:1, which is still high. Regulatory changes, both domestic and international, will force banks to have still larger cushions of capital to protect against losses, which will mean higher costs, and persistent lending restraint.

The rising tide of non-performing loans (eg residential and commercial mortgages, and sovereign debt) will weigh heavily on banks, partly because they have not yet formally acknowledged the full extent of the problems. If the economy falters or slips back into recession in the next year or two, this situation will get worse. Eventually, banks will have to book losses on these loans or risk turning into financial zombies that will undermine government finances, and act as a deadweight over the economy.

Regulatory or prudential pressure on banks has a counterpart among some of the biggest investors, such as pension funds and insurance companies, which have been withdrawing their support from equity and riskier financial markets. For pension funds, rising life expectancy and low interest rates have pushed up their future liabilities, but asset markets haven’t kept pace. This has opened up troublesome deficits that require constant funding top-ups from sometimes wary corporate sponsors. British pension funds have already cut their equity weightings from around 70 per cent in 2000 to just over 50 per cent and surveys indicate this will fall further. Insurance companies are also under regulatory pressure to keep more of their assets in liquid form, including government bonds.

British households’ liabilities, mostly mortgages, rose by £200bn more than their assets between 2004-08. But by 2009-10, this had gone into reverse—growth in household assets exceeded growth in liabilities by about £33bn. The ratio of household debt to disposable income has fallen from a pre-crisis 155 per cent to about 140 per cent—though this is still 40 per cent higher than the average of the decade up to 2000. It’s hard to see an end to household deleveraging while we have weak employment and income growth, a high (25 per cent) incidence of negative equity in the housing market, and, according to the Bank of England’s latest credit conditions survey, a probability of increasing mortgage defaults. And no one needs reminding that the government intends to eliminate the budget deficit by the end of this parliament by cutting public spending and employment.

Head for the hills?

Deleveraging is a fractious process but it need not be a desert for investors. In the last year or so, some of the riskiest assets, such as the Australian dollar, seen as a weather-vane of global growth, and technology stocks have done as well as some of the traditional “haven” assets such as gold, the Swiss franc, and consumer staple stocks such as food, beverages and tobacco companies. This phenomenon probably won’t last, but even if you believe the debt crisis has exposed your investments to much greater risk, there are still things you can do.

Rather than back consensus views on markets, look for thoughtful investment “themes.” These might be based on new technologies that will define our economies and societies in the future. Not all property markets are toxic, as evidenced by those with special characteristics such as London, Paris and Geneva. If you think emerging market investing is risky and lacks transparency, many western companies stand to benefit from exploiting emerging market themes, such as rising consumption and technological sophistication, increases in commodity demand, and water shortages. And if you don’t like the 2.5-3 per cent on gilts, there are some pretty decent companies sitting on large cash piles that are paying dividends well above this rate.

As the debt work-out at home and abroad evolves, the financial markets outlook is prone to alternating periods of euphoria and disappointment. But only head for the hills if you think some sort of economic Armageddon is imminent. Just in case, though, how about some gold bullion in readily transportable amounts?