Debt gets a bad rap, creating images of human figures bound in chains… but is it really that bad? It is a lot more complex than that, says asset allocator and debt investor Lukas Daalder in his analysis of the thorny subject for Robeco’s new five-year outlook.
The amount of debt in the world seems to be rising faster than the economic growth needed to sustain it, creating the concept of a ‘debt supercycle’ that has no end in sight. However, debt is also a very useful tool: most of mankind’s greatest advances have been funded by it, and modern investment would be impossible without it.
“What most people seem to forget is that wherever there is a debtor, there is also a creditor: one person’s debt is another person’s asset,” says Daalder, Chief Investment Officer of Robeco Investment Solutions and a co-author of Expected Returns 2017-2021.
“Providing that the debt can be repaid, it is also a ‘wealth supercycle’, though this is a phrase you never hear being used. Would it have been feasible to see a massive increase in wealth, without it leading to high debt?”
Daalder cites five reasons to be cheerful about debt:
“Debt, as it turns out, is not as black and white as it is sometimes made out to be,” says Daalder, whose multi-asset fund invests in both government and corporate bonds. “However, we’re not simply saying that we should welcome an ever increasing rise in debt; although debt can be seen as a net zero for the economy as a whole (debt = wealth), there are still reasons why too high a level of debt leads to trouble in the end.”
Daalder says the three main potential pressure points for debt turning into trouble are the escalating levels of Chinese debt, the potential for US corporate debt to turn sour – particularly if US interest rates rise, as expected – and the ‘elephant in the room’ of debt issued to fund western government deficits.
“In China, private debt had risen from below 120% in 2008 to an unprecedented 205% by 2015, mostly driven by a near stellar increase in corporate debt,” he says. “The good news though is that China is a centralized managed economy with a very high savings rate, and a current nominal growth rate of 8%. The bad news is that this growth may have been boosted by the stellar rise in debt. Much will depend on the policy pursued by the Chinese authorities.”
He says the more worrying prospect is the US; unlike China, its debt is spread around the globe and a debt default cycle could certainly have adverse consequences for the broader financial markets. The figures are also astronomical: annual US bond issuance doubled to USD 1.5 trillion between 2008 and 2015, a figure higher than France’s annual GDP.
“The worrying part seems to be that this debt issuance has gone hand in hand with a steady erosion in underlying credit quality, while defaults have clearly picked up over the past 12 months,” says Daalder. “However, the real question is whether we have already reached the critical levels. While debt has risen strongly, but so have cash holdings. Reported cash holdings have reached the USD 1.7 trillion this year, more than double the level they were at in 2007. And the interest costs of servicing this debt have of course declined to historically low levels in recent years.”
“Which brings us to the elephant in the room: governments. They acted as the lender of the last resort during the economic collapse of 2007-2009, which led to high deficits across the board. In a four-year period, debt as a percentage of GDP rose by 30% for the advanced economies on aggregate, after which it stabilized at around the 100% of GDP level.”
So who’s buying all this deficit-funding debt? Enter the central banks, which are still in the midst of extensive quantitative easing programs, and by the end of 2016 will have mopped up USD 7 trillion in government bonds. “And thanks to negative interest rates in some countries, governments can actually get ‘paid’ to borrow right now. This does not exactly sound like a classic debt cycle that is about to reach tipping point,” Daalder says.
Concluding his synopsis for Expected Returns, Daalder doesn’t believe that debt will come back to haunt the financial markets over the next five years. “But there are certainly some risk pockets that have the potential to create havoc,” he warns investors.
“Much will depend on the active position taken by the Chinese authorities: if they continue to kick the can down the road, we will certainly run into trouble. Also, although governments look safe with central banks buying most of the debt, we cannot rule out the potential of a non-traditional confidence crisis in central banks.”
“But these are risks, not our baseline scenario: we expect both China and central banks to stay vigilant, and to able to mitigate these risks, preempting the much feared debt supercycle.”
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