Debt, debt everywhere

Prepared by UBS AG and published in on of their recent “Research Focus” reports.

Over the last 12 months, we have witnessed a very strong rally in global equity and fixed income markets and all major economies have returned to growth. The financial crisis that started in 2008 and the subsequent global recession appears to be fading into history. However, it is dangerous to think that all is well now and that we can simply go back to business as usual. The crisis has left us with different legacies, one of which is the dramatic increase in public debt in most of the advanced economies.

To understand the present economic issues, it is important to consider the historical context – the last two decades were characterized by above-average levels of economic growth, partly fuelled by credit and high levels of government spending. The boom (and subsequent bust) in equity markets encouraged a rapid increase in compensation within certain private sectors and led many public sector workers to demand parity. Generally speaking, many developed world governments and their citizens spent more money than they earned. As such, when the credit bubble well and truly burst in 2008, governments stepped in to prevent systemic breakdown and support economic growth. This led to unprecedented increases in government spending and loose monetary policy. While this was arguably necessary to prevent further malaise, public debt has reached levels that have never been seen in peacetime history.

In coming months and years, governments all over the world will have to find ways to deal with the debt. The task is enormous and will have to be undertaken against a backdrop of adverse trends, most noticeably weak economic growth and sharply rising social costs. Importantly, in dealing with the challenges of high and rising public debt, we think that governments will adopt policies, either by choice or by force, that have not been seen in many decades. We argue that the traditional tools of austerity and growth will be insufficient for the developed world to lower its debt burden. Inflation, which some believed to be dead for good, could make a comeback as ballooning government deficits and the prospects for social discontent make the cutting of government budgets a difficult process. Thus, faced with the politically unpalatable austerity route – governments in tandem with their central banks maybe more inclined to take the inflation route. Also, the risk of sovereign default, something that was once unthinkable for advanced economies in the post-war period, will probably be a lingering fear in the coming years.

For investors, all this will have profound implications. How will economic performance be affected? Are developed world government bonds still safe haven investments? What investments will protect portfolios if price inflation were to accelerate again? These are some of the questions that we deal with in this publication. Overall, our goal is for investors to be able to consider the long-term implications of government debt and position their portfolios accordingly for future growth.

Highlights from this report:

The financial crisis and the recession that followed have had profound effects on the global economy. One legacy of the crisis is the sharp increase in public debt in practically all advanced economies, which will present formidable challenges for policymakers going forward. Debt ratios have reached peacetime records and may continue to drift higher if no decisive action is taken. What is more, current estimates suggest that debt ratios are about to cross a threshold above which debt itself becomes a drag on growth. 

The drastic steps to consolidate public finances that governments will need to take will have far-reaching implications for economies and financial markets.

Insufficient growth and unfavourable fundamentals
Over the past 20 to 30 years, debt reduction policies involved a mixture of public spending cuts and measures to increase tax revenue. Importantly, such policies really only worked if economic growth was strong as well. In addition, such periods of fiscal austerity were often accompanied by falling interest rates and revenues from one-off privatizations of public assets. Going forward, most advanced economies with high debt-to-GDP ratios will face much less favourable conditions under which to reduce their debt. Fiscal austerity will certainly play a role, especially in the initial phase of fiscal consolidation. In the long term, we think there is a risk that economic growth will not be sufficient to support a sustainable reduction in debt ratios. In addition, the current low interest rates are likely to rise in the future, thus adding to the financing burden of governments. Finally, in many advanced economies fiscal consolidation will have to take place against a backdrop of rising age-related expenditure, meaning that structural reforms of social systems will also have to be contemplated.

Inflation, deflation and sovereign default
Although the more traditional fiscal austerity measures will likely be important, we think the toolbox for dealing with adverse public debt dynamics will have to include options that have not been seen in the developed world in three decades. Thus, after the so called “Great Moderation“ – that saw strong and stable growth coupled with low inflation over the last few decades – we think that the developed world‘s debt problems could see a return of higher inflation in some regions and outright deflationary policies and the prospect of sovereign default in others. We think countries that have full control of their monetary policy and currency will find it difficult to resist the temptation to let inflation help erode their debt burden. This applies primarily to the US and the UK. In contrast, inflationary policies are not an option for Euro zone economies – at least not under current institutional arrangements. Thus, these countries will have to exercise extreme fiscal austerity, and even adopt deflationary policies to cut wages and prices across their economies to promote growth and thereby reduce their debt burden. However, success is far from certain and investors should not rule out the risk of some form of default scenario or partial fiscal restructuring in one or more of the advanced economies.

Winners and losers
The road back to economic stability and fiscal sustainability is likely to be long and burdensome. However, where there are risks there are also opportunities – investors are well advised to remain diligent, alert and well diversified. The possible long-term inflation implications in the US and UK suggest that investments in inflation-linked bonds and/or real assets (real estate, commodities and equities) are advisable.

Within the Euro zone, likely austerity measures may hurt domestic consumption – so international diversification of equity and corporate bonds should be considered. The traditional pricing model for G7 debt assumes an almost insignificant probability of default. We do not believe this will be the case going forward – due to the spiralling levels of government debt. Markets have, arguably, not yet priced in this risk as historically low bond yields are still offered on government debt. We have long-term concerns
for certain developed world government debt or, at the very least, believe investors should be compensated for holding this risk. The long-term investment winners are likely to be countries that have not had such an explosion in government debt levels. The obvious candidates are emerging markets, which face less structural debt challenges and are supported by higher economic growth. We are also positive on commodities, due to their value as an inflation hedge and expected price increases driven by
emerging market demand.