All the implications of the global debt explosion
Global debt analysis by Tammie Tang, Portfolio Manager and Paul Smillie, Senior Investment Analyst, Fixed Income at Columbia Threadneedle Investments
In the first half of this year alone, political authorities launched or promised stimulus measures worth more than $ 14 trillion, or 18% of 2019 GDP. The stimulus took the form of fiscal interventions ($ 9 trillion). dollars) and monetary ($ 5 trillion), although in some regions certain aspects of these measures are actually unlimited in terms of time or amount.
Monetary interventions, such as central bank stimuli, and indirect fiscal interventions, such as state loan guarantees, do not affect the debt burden, which is increased by direct fiscal and budgetary measures, such as subsidies and unemployment and leave. These measures currently exceed $ 4.4 trillion. If we look at the growth of private sector debt, both through bank loans and through the net issuance of corporate bonds, global debt will increase by at least $ 9 trillion, or 12% of GDP in 2019, as a result of the measures taken only in the first six months of this year.
In the future, the stimulus action is likely to continue, albeit at a variable rate or form. We are aware that the authorities particularly fear a deflationary trap. If consumers and businesses stop spending in the belief that prices will fall, a dangerous vicious circle is created that is difficult to escape from. It goes without saying that Japan has spent more than two decades fighting deflation with persistent use of fiscal stimuli, which have pushed the public debt to GDP ratio to nearly 240%.
With more stimulus, rising public and private debt and falling GDP, the global debt ratio is set to worsen. Between the onset of the global financial crisis in 2007 and the end of 2019, this indicator rose by 40 points, from 280% to 320%.
This year we are on track to reach a level of 350%, and if we face another major demand shock, such as that resulting from a second global wave of Covid-19, the ratio could approach 400% in the next decade, unless that drastic measures are not taken to reduce the global debt burden.
INDICATIONS FOR GOVERNMENT SECURITIES
There has not been such strong growth in budget deficits or in the public debt ratio since the Second World War. Market attention is currently focused on the policy response, and as long as central banks continue to buy large volumes of government bonds through quantitative easing (QE) programs, debt sustainability will not be in question. Over time, however, this assumption will become increasingly dangerous.
Once the situation has settled, country risk will take on increasing importance for bond investors as corporate bond spreads will further reflect the sustainability of sovereign debt. It can be difficult to determine at what point a sovereign issuer could hit a fiscal "wall", as a result of which markets would no longer be willing to finance a deficit.
When we think of country risk in the investment grade segment, we favor countries with fiscal room for maneuver and the political will to continue stimulating and borrowing, such as Germany, the Netherlands and the Nordic countries. As for countries with a high stock of debt, i.e. over 100% of GDP, we prefer those with central banks and their own currencies and able to implement yield curve control policies if necessary. In this category we see the United States and the United Kingdom favorably over, for example, France and Spain, which do not have this capability.
We are also cautious about the political risk of the eurozone. To manage the stock of Italian debt will require significant political will at the European level, and questions about the use of the Recovery Fund, burden-sharing and debt forgiveness could increase in the future. We fear that the market is all too ready to accept that these important political changes are made in a reasonable and timely manner.
IMPLICATIONS FOR BANKS
After the global financial crisis, the banking sector has been affected by a decade of re-regulation and deleveraging. The ratio of Common Equity Tier 1 (Core Tier 1) to risk-weighted assets, a key indicator of a bank's financial strength, increased from 7% to 12.5%. As a result, the banking sector was in a strong position on the eve of the crisis and is now seen as part of the solution.
Policy measures taken by governments and regulators are aimed at ensuring that the financial sector does not amplify the shock of the pandemic. These include state loan guarantees, fiscal transfers, payment moratoriums, capital easing and (almost) unlimited liquidity. So far these measures seem effective. Loan guarantees and tax packages determine the distribution of losses between public sector balance sheets and those of the banking sector.
For example, leave programs allow households and small and medium-sized enterprises (SMEs) to continue servicing their bank debt. This protects not only families, but also companies and indirectly banks, at the cost of increasing sovereign debt as the funds come from the government. With state-guaranteed loans, the lender provides the loan, the central bank provides the funds, and the taxpayer bears the credit risk.
In this way, unlike the crisis of 2008-09, both banks and businesses have sufficient liquidity and avoid a credit crunch. However, the private sector has taken on additional debt, and the state will ultimately bear the losses.
If we look at the figures for the banks we deal with globally, we expect European institutions to see a peak in bad credit burdens similar to that seen during the global financial crisis, and a level roughly half what it was then in the global financial crisis. United States, despite GDP growth being much slower. Over the next year, the two primary capital ratios are expected to decline by around 100bps across the industry globally, while overall remaining well above regulatory requirements.
Although at the beginning of the Covid-19 crisis, banks had less leverage and are now in better conditions to deal with the pandemic, thanks in particular to the strong political support that supported loans and buffered recognized losses, banking sector credit will be even more tied to sovereign debt.
IMPLICATIONS FOR CORPORATE BONDS
Since the global financial crisis, the amount of outstanding corporate debt has almost doubled, exceeding 74 trillion dollars) and bypassing public debt to amount. One of the main drivers of this growth is investment grade (IG) corporate bonds, especially those issued by BBB-rated companies, including companies involved in widespread debt-financed M&A activity.
Taking the United States for example, non-financial corporate debt to GDP rose to an all-time high of 75% at the end of 2019.
We expect a further increase of around 10 percentage points this year. In 2008, BBB bonds eligible for inclusion in US indices amounted to 4% of GDP; in 2019 that percentage had increased to 11%, and we expect it to reach around 14% by the end of this year, as businesses accumulate cash in response to declining revenues.
This increased debt affects the solvency of the companies in which we invest. Looking at the IG-rated non-financial companies we deal with globally, in the US we expect the net debt / EBITDA ratio to exceed 200% by the end of the year, having recorded a steady increase from 116% in 2009. For the Europe the same ratio is expected to stand at 310% by the end of 2020, up from 250% in 2009.
Companies in the sectors most affected by the pandemic, such as hospitality, transport and energy, rushed to raise funds. More generally, the decline in earnings – due to a multi-year recovery that led to structural and behavioral changes – will keep the risk of a rating downgrade high. It is possible that the average rating of IG corporate bonds will drop from A- to BBB +.
However, companies in this category are not usually at the mercy of fate. Management teams can choose to reposition their balance sheets to operate with a lower degree of leverage. If anything, the pace of debt observed over the past decade is simply unsustainable. If the low growth prospects consolidate, management teams struggling with significant levels of debt will be increasingly motivated to deleverage. We expect this process to begin next year. We may select bonds from companies engaged in deleveraging to take exposure to issuers with improving balance sheets. However, deleveraging would likely end up perpetuating a low-growth regime, as companies would cut back on investment in staff and business.
ASSET CLASS IMPLICATIONS: INVESTMENT GRADE CORPORATE BONDS
Historically, accommodative policies have been accompanied by a tightening of spreads due to greater liquidity in the system, and vice versa. As we explained above, the authorities should maintain an expansionary bias, creating a positive technical environment for demand for corporate bonds.
To illustrate this point, we recall that the European Central Bank (ECB) has resorted to a negative interest rate policy in the last five years, and one of the consequences is that more than half of the bonds included in the Barclays European Aggregate Bond Index offer currently subzero yields. In addition, the ECB is estimated to have bought 40% of net primary market bond issues as part of its QE in recent months (particularly the second quarter).
While an accommodative stance should favor credit investors in the short term, we would like to stress that the long-term effectiveness of this policy should not be taken for granted.
We have some doubts about the sustainability of sovereign debt and recognize that companies have not yet started any deleveraging process.
Finally, we note that global IG bond spreads have largely normalized. After ushering in the year at +100bps, spreads hit a high of 340bps and then stabilized at +130bps. At these levels, bond holders are still compensated for exposure to liquidity and default risk. In an environment characterized by stimulus and support measures, liquidity premiums remain high, especially in light of the difference between corporate bond spreads and credit default swap premiums. Furthermore, the default rates implicit in IG spreads are also significantly above the historical average. The 5-year cumulative historical default rate is approximately 0.9% for the IG (i.e. around 0.2% per annum). However, we point out that in the investment grade segment, defaults are much less frequent than in the high yield segment, as IG issuers move to the HY category before ending in default.
The risks of downgrading have never been higher. Speculative corporate debt defaults will also persist, particularly among smaller companies operating in sectors most exposed to the crisis. In the IG universe, therefore, the generation of value will depend more significantly on stock and issuer selection. It will be possible to extract value by avoiding candidates for downgrading and by focusing on companies capable of reducing their debt.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/tutte-le-implicazioni-dellesplosione-del-debito-globale/ on Sun, 18 Oct 2020 05:17:47 +0000.