Independent Thinking^®

Navigating a Sea of Debt

In the six years since governments started taking on increasing amounts of debt to combat deleveraging in the private sector, total global debt has surged by $57 trillion to $199 trillion, outstripping the growth in global GDP.
 
The United States is in relatively good shape, but as investors, we know that we are not immune to trouble elsewhere – or to our own national debt burden, which now equates to 269% of GDP. There is increasing evidence that debt levels of this magnitude suppress economic growth.
 
New data, as illustrated below, reveals that the much-heralded household deleveraging in the United States since the financial crisis to historically normal levels has been more than offset by government borrowing. The quality of the debt has improved, of course, now that $3 trillion in subprime mortgages that were falsely packaged as triple-A debt have been largely flushed out of the system and the burden has shifted from households to government. Continually combating excess debt with ever more debt is not sustainable, however.
 
As wealth managers responsible for individual and family assets, it is our job to manage portfolio risk, as well as look for opportunity. While we remain broadly positive on the U.S. economy, as discussed in the previous issue of Independent Thinking, we are also prepared for a range of scenarios that could temper that view, three of which are highlighted here.
 
The first is that this experiment in quantitative easing, winding up in the United States but continuing in Japan and just starting now in Europe, could end badly, setting the global economy on a course not dissimilar from the one experienced in Japan for more than 20 years. While the United States is reporting improvements in employment and other data, and benefits substantially from low energy prices, the Federal Reserve has not as of writing committed to raising interest rates after six years of holding the Fed Funds rate at close to zero. With rates even lower, effectively negative, in Europe and Japan, central bankers in developed markets have few tools in their toolbox to jump-start their economies if they sputter further or stall.
 
In emerging markets, where debt has grown at an even faster rate, the outlook is more disturbing. Now at 282%, China’s debt to GDP rate is broadly in line with a number of countries, including the United States, but its rate of debt accumulation, as illustrated on page 4, is much higher, rising 22.8% a year since 2007, and central bank action is failing to stop the economy from decelerating. Still, there are pockets of opportunity, as you would expect in a country with a growth rate of approximately 7%, and we retain exposure to China through the Matthews Pacific Tiger fund, which targets consumer-oriented companies in Asia and avoids large, state-owned enterprises. The fund is also overweight India, one of the very few large economies that does not have excessive debt.

The risk of a stalling or even deflationary global economy is greater than many investors would like to acknowledge, perhaps as high as 25%, in our estimation. Many of the associated portfolio risks seem to us manageable, however. A well-balanced portfolio will have a meaningful allocation to high-quality, intermediate-term bonds, which will be the asset of choice in a stagnating economy, and allocations to our diversified markets strategy and illiquid alternatives as appropriate for each client (see Brian Pollak’s article on page 5).
 
Default is another scenario, but one that seems unlikely in the United States, Japan or China, where government debt is denominated in the respective local currency. In Japan and China, that debt is held domestically, which makes this option more unlikely still.
 
That’s not the case in the Eurozone, where the currency is supranational and the risks and repercussions are still being revealed, most obviously in Greece. It is worth noting, however, that Germany’s export-oriented economy and its relative health within Europe make its equity market appealing. We have recently increased our exposure to Germany through an indexed ETF with a hedging strategy for the Euro exposure, as we expect the Euro to continue to weaken to the benefit of German exports.
 
We are also keeping our eye on the countries, notably in the emerging markets, that have considerable U.S. dollar-denominated debt. The strength of the dollar could cause a debt crisis if the burden becomes too great.
 
The third, far more appealing scenario is that the global economy simply grows its way out of this debt burden. After all, the difference between the compounded annual global debt growth rate and that of GDP growth as a whole is just about one percentage point (5.3% and 4.3%, respectively). For this to happen, China would need to steady GDP growth in the 6%-7% area with a shift away from debt and investment; India would need GDP growth to accelerate further; and the United States would need to grow at 3% or more. Together, these events could jump-start Europe. In this scenario, the U.S. stock market would grow in line with company earnings and the valuation gap with other markets would narrow. That growth would be uneven, of course, and would likely reward active investment managers with a fundamental approach in security selection.
 
These are just three of many possible scenarios, and the fact remains that no one knows how this debt crisis will eventually unwind. The scale is simply unprecedented and there has never been an attempt to return to normal interest rates after zero or negative rates, especially in such leveraged economies. In the interim, we believe that the U.S. stock market is at or near the high end of its historical valuation range after a six-year bull market. We must be vigilant about positioning portfolios so that they are not overweight equities. Markets can remain at high valuation levels for long periods of time, especially when the central bank is being accommodative, but the margin of safety is reduced.

John Apruzzese is the Chief Investment Officer at Evercore Wealth Management. He can be contacted at [email protected].