Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 531

Global recession looms as debt balloons

Global equity markets are facing serious and complex challenges, including expensive equity valuations, sticky inflation, high interest rates, and huge debt levels in most major economies. Whilst we think the probability is heavily in favour of a global economic slowdown, at these prices the likely long-term returns from equities are low regardless.

While high stock valuations and the cycle are the more immediate challenges, the problem of huge debt levels across developed economies is looming and could cause disruption as governments and the private sector struggle in the face of rising interest rates.

The risk is that debt to GDP levels see the numerator go up as the denominator falls. In the public and private sector, debt service ratios count as they measure the proportion of income taken up in paying interest costs. In several countries, they are at points that have historically caused problems.

The Government debt problem

Looking at the US, the explosion in fiscal spending during the pandemic drove the country’s government-debt-to-GDP ratio to around 100%, close to the high recorded after World War II. Whilst forecasting a minuscule pullback in the short-term, the Congressional Budget Office (CBO) projects government-debt-to-GDP to rise to 110% at the end of 2032, higher as a percentage of GDP than at any point in the nation’s history – and heading still higher in the following two decades.

Driving this deterioration will be US budget deficits which the CBO projects should average US$1.6 trillion between 2023 and 2032 or 5.1% of GDP. In 2033, the CBO sees the US deficit at an eye-watering 6.9% of GDP, which we have only seen five times since 1946. The projections below show that the US deficit could continue to deteriorate after that.

Although like-for-like comparisons between countries are imprecise, most of the world’s major developed economies are similarly positioned. Japan, the UK and some countries in the EU are running significant deficits and many have high government public to GDP ratios. China has the same problem of huge government debt but some different economic characteristic.

Private debt a problem too

Public debt is not the only problem in the US and other developed nations; private debt is also elevated. In terms of debt service ratios (interest costs to income), countries like China (21.3%), France (20.5%) and Switzerland (20.6%) are at or close to their previous highs and above the 20% that risks triggering a crisis when interest rates are rising.

By contrast, the US (14.9%) and the UK (13.9%) are in better shape, although looking at debt levels in the US during the GFC, the position is worse in both the public and corporate sectors (as the chart below shows).

Debt levels matter now

Like so much in financial markets, debt does not matter until it does. In a world of zero or negative interest rates, debt was not a big concern. The levels of debt-to-GDP and the options available to improve the ratio have been secondary considerations for most of the previous fifteen years. But interest rates have risen quickly, significantly raising the debt burden in the US and other nations.

Investors are starting to get worried. One of the most striking recent signals has come from US treasuries, where yields have moved up sharply to reach more than 4.5%. The excess return investors require for duration risk seems to be the main driver of this jump in bond yields.

History shows that governments have only a few options to counter high debt levels, with the following usually used in combination: grow the economy, cut costs and increase taxes (austerity), default on or restructure debt, and employ financial repression, usually accompanied by inflation.

In the current environment, it seems inevitable that financial repression is coming. Financial repression is an umbrella term for measures by which a government may reduce debt via transfers from creditors (savers) to borrowers, the government itself being the most important borrower in this instance. Examples of financial repression are caps on interest rates, high reserve requirements, and transaction taxes on assets.  One way or another, savers will be forced to own assets that will give them low or negative returns.

However, even with this sombre outlook, we still believe there are opportunities for investors. The good news is that interest on cash means investors have a decent starting point for capital preservation and positive returns.

We maintain the view that investors should own different equities from those that prospered from the early 2009 low to the 2022 high. Given the growth outlook, income should be given equal emphasis with capital return at a minimum. The buffer and returns from value investing should also become increasingly attractive. Equity assets with less downside and less volatility than the overall market should be more attractive than some highly valued growth assets. They will make holding on during selloffs or even leaning into weakness easier propositions whilst still providing upside.  Moreover, strong balance sheets and good free cash flow generation will become important in the debt-encumbered world in which we now live.

 

Hugh Selby-Smith is Co-Chief Investment Officer of Talaria Capital. Talaria’s listed funds are Global Equity (TLRA) and Global Equity Currency Hedged (TLRH). This article is general information and does not consider the circumstances of any investor.

 

RELATED ARTICLES

Time to announce the X-factor for 2023

The seeds of a downturn, and opportunity

Seven lessons on how investors should prepare for a recession

banner

Most viewed in recent weeks

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 581 with weekend update

A recent industry event made me realise that a 30 year old investing trend could still have serious legs. Could it eventually pose a threat to two of Australia's biggest companies?

  • 10 October 2024

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

The quirks of retirement planning with an age gap

A big age gap can make it harder to find a solution that works for both partners – financially and otherwise. Having a frank conversation about the future, and having it as early as possible, is essential.

Latest Updates

Planning

What will be your legacy?

As we get older, many of us start to think about how we’ll be remembered by those left behind. This looks at why that may not be the best strategy to ensure that you live life well and leave loved ones in good stead.

Economy

It's the cost of government, stupid

Australia's bloated government sector is every bit as responsible for our economic worries as the cost of living crisis. Grand schemes like the 'Future Made in Australia' only look set to make it worse.

SMSF strategies

A guide to valuing SMSF assets correctly

SMSF trustees are required to value all fund assets, including property, at market value when preparing the fund's financial statements each year. Here are some key tips to ensure that you get it right.

Economics

Australia is lucky the British were the first 'intruders'

British colonisation's Common Law system contributed to economic prosperity, in contrast to Latin America's lower wealth under Civil Law. It influenced capitalism's success in former British colonies, like Australia.

Economics

A significant shift in the jobs market

The expansion of the 'care sector' represents the most profound structural change to Australia's job market since the mining boom. This analyses how it's come about and the impact it will have on the economy.

Shares

Searching for value in tech stocks

Just because a stock is cheap doesn't necessarily make it good value. This uses case studies in the tech sector to help identify when stocks trading on 30x earnings may be inexpensive and when others on 10x may be value traps.

Investing

Are more informed investors prone to making poorer decisions?

Finance Professor Michael Finke recently discussed the double-edged sword of taking an interest in your investments, three predictors of panic selling, and why nurses tend to be better investors than doctors.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.