“In such a spirit on my part and on yours we face our common difficulties…Values have shrunken to fantastic levels. Taxes have risen, our ability to pay has fallen, government of all kinds is faced by serious curtailment of income, the means of exchange are frozen, the withered leaves of enterprise lie on every side, farmers find no markets for their produce, the savings of many years in thousands of families are gone…
…Only a foolish optimist can deny the dark realities of the moment…Yet our distress comes from no failure of substance. We are stricken by no plague of locusts…Primarily, this is because the rulers of exchange of mankind’s goods have failed through their own stubbornness and their own incompetence, have admitted their failures and abdicated. Practices of unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.
They have no vision, and when there is no vision the people perish…”
(Franklin D Roosevelt. Inaugural address. 4 March 1933)
Nothing to Fear, but fear itself?
Facing the ravages of the Great Depression borne out of its own financial crisis, a statesman such as Roosevelt found his place at the vanguard of a new order seeking to redress the imbalances between the three major forces within any economy – the government, corporations and individuals. Roosevelt responded with high levels of state-funded work and infrastructure development programmes in the belief that government spending could be used to stimulate consumer spending and demand. Giving people jobs to build housing, roads, dams, airports and tunnels took 3 million men in to paid government-financed employment who would otherwise have none. All this underpinned by new social security programmes designed to establish a social safety net combined with increased financial regulation of the banking system, seeking to prevent another such crisis.
This fiscal response bore fruit with the stimulus programme’s success witnessing unemployment falling from its high point of 25% to 11%; although it wasn’t until war production started did it fall to pre-depression levels. Government finances took the strain but even so, by the late 1930’s the total amount of government debt to gross domestic product was, by modern standards, low at around 40%.
Seventy five years later, politicians (statesmen having exited stage left many moons before) faced the re-emergence of similar imbalances and a banking crisis (having repealed much of the legislative firebreaks enacted during the 1930’s). Their response in desperately seeking to avoid depression was to place trust in central bankers who provided a monetary policy response, through collapsing interest rates and by injecting vast amounts of newly created money in to the financial system. This monetary response was deemed preferable given the general deterioration of government finances and the understandable belief that a monetary policy response would have its effects felt in a shorter period of time than it otherwise would have taken to develop extensive infrastructure projects.
Ten years after the financial crisis, we can be reassured that a full-on crisis was indeed averted. When clients queue outside banks to withdraw their savings; governments convene to keep the financial system afloat, something is indeed rotten in the state of Denmark. So whatever the critics level as to the effectiveness of the policy response there has, to date, still only been one Great Depression. However, whilst the acute injuries from a damaged financial system were mended; the chronic condition of over-indebtedness lives on and the implication for investors going forward should remain at the forefront of our minds.
Debt within economies can broadly be attached to three different groups:
Whilst the total debt within an economy can only ever equal 100%, the debt levels between these 3 great spending forces wax and wane like giant tectonic plates shifting over the sands of time. Similar to earthquakes, when the pressure builds too high at the edges, there tends to be a short, sharp and painful release of pressure which can manifest itself individual bankruptcies, corporate defaults or, as we saw in 2008, a full-blown global banking crisis.
So where are we today? Well, the simplistic answer is it depends where you look.
For the US, UK and a lesser extent Europe, the broad picture from 2000 onward is one of significantly rising consumer debt levels which peaked in the US at around 100% of GDP & 95% in the UK at the time of the global financial crises (GFC). It’s a bit more nuanced in Europe as whilst overall consumer debt did rise, it peaked at a much lower level masked by the profligacy of those in Southern Europe versus the more frugal North. From the global financial crisis to date, households have taken some measures to get their borrowing under control, whereas government debt burdens have grown significantly.
Heading east to China, blurred lines exist between the State and government-owned corporations in what is a central command economy where the government is ultimately responsible for much of this corporate debt build up. Notionally, non-financial corporates are the most heavily indebted, whilst households and the government look fairly well placed. When it comes to debt in China, really the most important trend is in the rate of debt growth in China. Two large spikes in credit growth, during the early aftermath of the global financial crisis and again in 2016 on fears of slowing growth, have led to the credit taps being opened and have pushed China’s debt problem to forefront of investor concerns.
Corporate Debt – a negative feedback loop?
With debt cheap and debt servicing requirements low, the temptation for companies to use debt to return capital to shareholders through dividends or share buybacks has been steadily on the increase. According to JPM, to the end of October 2018, S&P 500 companies have announced share buybacks of nigh on $800 bn in total, easily surpassing the full-year equivalents of each of the 5 previous years. As interest rates rise, higher interest servicing costs will not only make boardrooms realise this isn’t a free lunch, but as they themselves have been some of the biggest buyers of their own equity, a reduction in buybacks will remove one of their biggest buyers of their own equity. With profit margins looking elevated versus history, merger and acquisition activity trending upward and leverage rising, it’s easy to paint an outlook for a period of declining corporate strength.
There has been a general deterioration in credit quality of ‘Corporate America’. Within the higher quality, investment grade part of the market, the number of companies falling in to the lowest ranking has risen from a third to a half over the last decade. The next step is junk status. Leverage in corporate America has been rising (across many sectors we’re at ten-year high points), at a time when the extra amount of yield over government bonds is at low points over the same period. The net result is investors in corporate credit are not being compensated and when a general reappraisal of risk and balance sheets takes place, this will help concentrate minds.
Levered Loans – The canary in the coalmine?
Leveraged finance – incorporating high yield bonds (loans to companies with a lowly credit rating) and levered loans (where banks parcel up a series of lower-quality loans and sell them to investors) have seen a sustained upswing in investor interest with new leveraged loan issuance up $400bn alone since 2013. In the run up to the global financial crisis, these were areas which showed first signs of cracking as credit financing became less appetising and mortgages, in particular, fell foul of decreased lending standards.
There are some attractions – ‘loan’ interest payments typically rise in line with broader market interest rates, which is handy in a rising rate environment compared to the capital losses conventional ‘bonds’ suffer. The counter-argument is these are the very companies least likely to be able to cope with rising rates and increasingly likely to default on debt obligations. The trend has also been for leveraged loans to come with decreasing amount of protections in place for investors (so called covenant-lite) and an increasing demand for this asset type from ETF’s tracking the loan-market (whose makers, frankly, are less concerned about the quality of the loans, and far more in raising assets in a ‘new asset class’ whose liquidity in a bear market is questionable).
Consumer – Dead happy?
Whilst consumers have to some extent used the time since the GFC to pay down debt, a scythe has not been taken to the overall debt burden. Rather, the significant falls in interest rates have allowed households to successfully service those loans. The amounts of disposable incomes to service outstanding debts have fallen by approximately 25% across the United States, the UK & in Europe. This has meant defaults have been kept low and consumers have had an offset to otherwise stagnating wages in order to maintain spending habits. Households certainly aren’t saving, as witnessed by the UK’s household savings ratio (which measures the amount of disposable income being saved by %), falling to just 4.4% – a level not seen since the early 1960’s and well below the long-term average of 8.5%.
Sensitivity to future interest rate rises is therefore immense and will act as an anchor for interest rate rises.
Students – too much, too soon?
I wonder how the lending committees of our finest banks would respond to a new loan book being presented with the following credentials:
- Current size of loan programme = £105 billion
- Annual loans advanced = £16 billion
- Estimate of current average loan size = £34,800
- Anticipated number of current loans achieving full repayment = 30%
- Estimate of annual loans being written off by late 2040’s = £30 billion per annum.
This story plays out elsewhere too, exampled by the now $1.5 trillion of US student loan finance outstanding, an amount that has doubled since the global financial crisis. The story of student debt chimes to the heartbeat of a younger generation weighed down by a debt burden, largely hidden from the generations above. However, its impact will continue to hurt consumer spending habits and the opportunities for wealth creation for a generation who have already borne a heavy price from the fallout of the global financial crisis. A process that continues to fray at the fabric of a social contract between the State and its people and between young and old, placing in to stark contrast the ‘haves’ and the ‘have not’s’.
Source: JP Morgan Asset Management, BIS, Thomson Reuters Datastream. The % fall in the US has been approx. from 12% of disposable income to service debt to 8%; in the UK 12.5% to 9.5%, in Europe 7.5% to 5.5%.
A positive neutral
When debt levels are high, there is a heightened sensitivity to interest rate changes. Economists talk about a ‘neutral rate’ – a point where the level of interest rates are neither too hot nor too cold, but just about right to keep everything (economically) ticking along nicely. As debt levels rise, this neutral rate falls as corporates, governments or individuals become less able to cope with rising interest costs. Individuals spend less in the shops; corporates spend less on future growth projects and governments become less flexible fiscally and on spending decisions, resulting in curtailed economic growth.
What we’ve seen through time is this increasing sensitivity to interest rate rises and the neutral rate falling – and with tepid economic growth and low inflation we have neither grown ourselves out of the problem or eroded it away.
With a low neutral rate, historically small moves higher in base rates have an oversized impact on economies through damaged growth prospects, and declining growth rates tend to lead to a difficult environment for share prices. Interest rate rises are not the only challenge being levelled by central banks either. Globally, with the liquidity support (in the form of quantitative easing) either stopped or stopping, the impact from this form of central bank tightening will have when running alongside rising interest rates remains unclear.
We saw strong reactions from equity markets in the face of short, sharp rises in bond yields twice in 2018. From January to late February US 10-year bond yields rose from c2.5%-3% and in late August to early October the same bond yield moved from 2.8% to 3.2%. Whilst I happily accept there were other themes running at the same time which had their impact on markets, whether it be Trump’s trade wars, tariffs or Brexit, the underlying catalyst for these equity market falls was in their questioning of the value of company’s future earnings prospects in the face of rising bond yields.
But if we are closer to the end of US Fed interest rate rises for this cycle, as Chair Jerome Powell has eluded, this may help to provide some welcome relief for equity investors who have suffered a pretty miserable Fourth Quarter and a distinct lack of festive cheer.
We wish you all a very happy 2019.