DEBT : STILL AN ISSUE / SEEKING ALPHA

Debt: Still An Issue

Sep. 30, 2014 5:12 AM ET

by: John M. Mason

 

Summary

• A new report by the International Center for Monetary and Banking Studies has a new warning about the world's debt situation: world debt is still rising in relation to GDP.
• Economic growth is slowing in some areas while others are in process of raising interest rates; both threaten to make the debt situation worse.
• All solutions seem to be problematic in one way or another. Investors need to consider the consequences of each of the policy choices available.

A new report, the 16th annual Geneva Report, commissioned by the International Center for Monetary and Banking Studies, carries a warning about the debt situation in the world.
This report documents "the continued rise of debt in both advanced and emerging economies at a time when most talk is about how the global economy is deleveraging…"

Not only is the amount of global debt high, and rising, but slowing nominal GDP (coming from both slower real economic growth and disinflation or possible deflation) is raising the total burden of world debt, public and private.

Total debt in the world "has risen from 160 percent of national income in 2001 to almost 200 percent after the crisis struck in 2009 and 215 percent in 2013." The report goes on, "The global debt-to-GDP ratio is still growing, breaking new highs."

The concern - the Federal Reserve seems poised to raise interest rates - and economic growth is severely lagging in major parts of the world, like in "the eurozone periphery in southern Europe and China…."

The world just cannot seem to slip out of its debt problems. Re-read, "This Time is Different" by Carmen Reinhart and Kenneth Rogoff. Either deleveraging has declined or stopped or economic growth has stagnated or both. And, if the burden of the debt even remains the same, let alone "growing, breaking new highs," the warning coming out of this report is: beware. The world is still looking for "good" statistical releases, but it seems that when we do get a bunch on new releases that point to an optimistic outcome, they are soon dashed by another bunch of new releases that indicate things are not going that well.

President Obama believes the economy is doing OK and he is just staying to "the facts" as he reiterated on television this past weekend. Obama's job ratings for managing the economy remain mired in the 37 percent to 43 percent range. Another view is that there is a secular stagnation going on in the United States, but also in much of the rest of the world. In this view there are structural problems in most economies and until these structural problems are ironed out the United States, and the rest of the world, will not be able to perform well at all.

For example, if one looks at the projections for economic growth over the next four to five years provided by the members of the Open Market Committee of the Federal Reserve System, one only sees stagnation. The range of annual growth rates for real GDP runs from 1.8 percent to 2.6 percent, way below the average rate of growth of the United States in the last forty years of the twentieth century.

Forecasts for Europe and elsewhere is not encouraging. In terms of a lower debt burden, the United States has shown one of the better recoveries, particularly as household debts as a share of income have stopped rising, although public debt is not doing as well. However, like the economic growth results, the United States debt situation is one of the better ones in the developed world, although that is not saying much when one looks at the condition of the rest of the world.

The authors of the Geneva Report point to one other thing that has given people confidence in the current situation. They state that "the value of assets has tended to rise alongside the growth of debt, so balance sheets do not look stretched." The concern here is what happens when interest rates begin to rise - in the United States - or, anywhere? The basic fear here is that a rise in interest rates would cause asset values to decline. And, declining asset values would place balance sheets at risk.

Furthermore, as some have argued, the value of assets may be inflated due to the excessively easy monetary policy that has been at play in the world connected with the extraordinarily low interest rates. If asset values are overvalued, their prices would even be more exposed to rising interest rates than otherwise. A reversal of asset prices could force "a credit squeeze." In addition, there is a fear that if US interest rates begin to rise, it might cause the value of the US dollar to go even higher. The rising value of the US dollar could force then a reversal of the flow of funds that has been going into "carry trade" in emerging markets. This would further threaten growth in emerging countries.

Investors are increasingly deciding that their losses in the foreign exchange market eclipse their gains from the interest rate differential, prompting them to cut and run. Were market participants to unwind their carry trades in unison, selling EM assets to buy dollars, the process would exacerbate the market conditions that they were fleeing.

Finally, there is the concern about the banking systems. Concerns have been raised about banks in the eurozone and the quality of their assets. Additionally, there are worries about many bank loans in China. And, in the United States, commercial banks are still being merged into other commercial banks at a pace that indicates regulator encouragement, rather than just normal M&A activity. It does not seem as if the banks of the world have fully recovered from the previous crisis.

So, it appears as if debt is still a major issue in the world today… and, the slowly recovering economies are doing little or nothing to ease this burden.

In the Geneva Report there is a suggestion that interest rates be kept low… for as long as possible. Given the results of their study, the authors conclude that central banks are still under pressure to protect asset values as much as possible. Keeping interest rates low would, of course, help to keep asset values high. But, and this is something many economists hope for, faster economic growth would help people reduce debt and higher rates of inflation would help to reduce the real burden of the debt.

Given this outlook, the prescription is for central banks to do whatever they can to create an inflationary environment with faster economic growth as well as rising prices. But, in my experience, faster economic growth and rising prices just tend to encourage people to take on more debt.

If governments and central banks have little or no discipline, how can people and businesses expect to have any discipline? Obviously, once you enter this cycle, it is awfully hard to break out of it.

How should investors operate in this kind of environment? My advice, think like a hedge fund.