Debt Bottleneck Released
SETTING THE DEBT SCENE:
The Fed's Flow of Funds data highlights the US debt trends pre and post the Great Financial Crisis (GFC), and the most recent Q1 release shows how they changed with the onset of the Covid19 pandemic:
Due to Trump's fiscal largess, Federal debt was already increasing at a substantial ~8% p.a. over the last 2 years (top left). This accelerated in Q1 with a 14% annualised increase. The most recent US Treasury data shows that year to 18 June, Federal debt has increased by $ 3.2trn, equivalent to a 39% annualised growth rate.
Corporate debt had been rising by 4-5% p.a. since 2014 (top right). The huge debt issuance in 1Q led to a 24% annualised rise in corporate debt, the highest post WW2 growth rate.
Household (HH) debt has only recently recovered from the deleveraging seen post GFC (a never seen post WW2 event - bottom left). Q1 did not see any meaningful rise in HH leverage.
In 1Q, Financial Institutions reversed a decade of post GFC balance sheet debt deleveraging, with outstanding debt rising by an annualised pace of 23%.
The 1Q debt increase has taken overall total debt leverage back close to the highs seen during the GFC. The HH and Bank deleveraging has been countered up by increased levels of Federal and Corporate indebtedness:
The tables below show the progression of the USD as a fiat currency, highlighting how the increases in outstanding debt for both public and private sectors has outstripped the growth of GDP.
COVID19 RECESSION IMPACT ON DEBT
There has been an extraordinary large and coordinated policy action to counter the Covid19 induced recession in 2020, on a scale not seen during previous recessions in the last 30 years:
Governments have borrowed huge sums to help households and businesses
Central Banks have expanded their balance sheets to fund governments and their aid polices
Private sector banks have offered debt repayment holidays.
Thanks to this combination of support, large debt dominoes did not fall over onto each other in a chain reaction, causing a large deleveraging effect. Given the scale of outstanding debt going into Covid19, such deleveraging would have most probably resulted in a long lasting economic depression. This might seem like an exaggerated prognosis, but the outstanding debt data shows just how levered global economies were going into Covid19 (below BIS data for US, Eurozone, Japan, China and UK - all have total debt levels greater than 250% of GDP).
Each of these countries has one or more sectors with an debt level, be it in the Household, Corporate and/or Government sector. The domino effect could have resulted in many different ways, for example (and you could list so many more):
Companies stop paying salaries to over indebted Householders who need to pay Banks for mortgages who themselves pay dividends or bond interest to pension companies.
Over indebted Companies are required to pay rent to insurance companies or pension companies who are required to pay life insurance holders or pensioners, who have their own liabilities.
Governments and Central Bank intervention has directly or indirectly enabled corporates to raise debt in record amounts AND they have also paid employees' salaries through furlough schemes. This, together with banks offering "holiday" or grace periods on debt repayment, has ensured that banks have had limited increases in NPLs and CLOs have not been downgraded.
The big issue that is coming to a head is what Governments will do about furloughed workers. Together with Central Bank buying government bonds, the policy of furloughing workers has had a huge effect on financial markets as:
Companies have not have folded under the weight of employee costs at a time of very low income - instead they can potentially restart.
Unemployment rates have not risen as much as they would have.
Consumption has not collapsed as much as it would have without furloughing.
Mortgages repayments have not declined as much as they would have if employees were made redundant.
In other words, household and corporate sector cashflows have been protected to repay current and future debts.
But the furlough policy has come with a huge fiscal cost, and as the schemes come to their end, decisions now need to be made about whether to continue them, for whom and for how much. Clearly, if companies struggle to return to pre-Covid19 profitability in the "new normal" reopening environment, and employees can no longer be furloughed, there will be a further and more cemented rise in unemployment. Without furlough extension, Household cashflows will be further shocked and consumption will decline.
Given the fragility of World Trade and Industrial Production data, it would not be a surprise if Governments extend furlough schemes, in part or in full, as well as extend further aid to companies. The press is already speculating that this will occur, as well as other incentives around tax policy. The market should get ready for potentially even larger deficits.
WHERE ARE THE FISCAL PRUDES?
This recession has seen a series of Economic rules thrown completely out of the window. This does not refer to whether it has been right or wrong to spend more, financed by Central Bank balance sheet expansion - it is whether it will have major longer term consequences or not. As mentioned previously (Bending the Fiscal Rules), it has been extraordinary to see the number of current and ex Central Bankers of DM countries line up and back benefits that will arise from increased debt financed by money printing, completely ignoring the many downsides and side effects which are littered and well documented throughout financial history.
This one dimensional argument that is not being challenged by politicians, the legal system (bar the German Constitutional Court) or financial markets suggests that investors should expect
even more fiscal support, and in the near future to extend furloughed programs, and
central banks to expand their balance sheets even further.
To that end, its quite a coincidence that just as the UK debt has surpassed 100% GDP, the Bank of England Governor Bailey has today suggested that when things return to normal, the BOE would reduce their balance sheet before raising rates. Given current and expected debt trends, if that really is their intention, interest rates will not go up for an exceedingly long time, and the recent 15bp rise of long dated Gilt yield offers an opportunity to buy!
IMPACT OF FISCAL IMPRUDENCE ON FINANCIAL MARKETS
As long as Governments counter private sector deleveraging through their own increase in public sector debt, they will avert a more serious depression caused by a reduction of liabilities (Steps 4-9 in Fisher's debt-deflation theory).
Risk assets will no doubt take comfort from this public sector leverage, but there is a cost to this "evergreening" of the private sector and rise in government debt. The ability to increase whole economy profits becomes harder through lower consumption and continued excess supply. Who apart from niche industries can truly increase margins if the barriers to entry remain permanently low (as the cost of capital remains zero)? This has been the story of the US private sector over the last 3 years - hard to see it change if demand is now lower due to higher unemployment rates.
Due to the horrors of compounding, excess debt needs to be fuelled with even more debt - even if its from another source - and that extra debt has less impact on GDP creation. That's what the table of post-WW2 debt growth shows at the top of this post. The interest rate market now fully prices the japanification of the US (as it does for most DM economies), and a further rise in government debt to offset the private sector deleveraging would be the next step in this japanification process of DM economies. Many have already transitioned from the "switch" to the Public Credit Growth (see US charts on Fed and HH debt in last 2 years) - the risk now is that the public credit growth accelerates.
Risk assets are now dependant on the Central Bank's ability to finance governments and ensure government bond yields remain low, providing enough liquidity creation to maintain asset prices. It is no wonder that correlations are very high in different asset classes across the globe (see Asset Price Correlations).
Central banks will have to continue to suppress real yields through balance sheet expansion, keeping a bid on Gold and assets with a positive real return. A problem will only arise if the market loses confidence in a Central Bank's ability/willingness to expand its balance sheet at a pace commensurate with the rise in fiscal spending, just like in 2H18 and 1Q20. You can bet your bottom ingot that in such circumstances they will have no option to turn the printing presses again, just like they did in 1Q19 and 1Q20, but in ever larger amounts.
In conclusion, there is a simple case whereby increased public sector debt coupled with expanding Central Bank balance sheet will result in rates remaining low for longer, precious metals rising, and equity and corporate bonds maintaining their "expensive" values. Volatility will arise on any market doubts of Central Bank support, or if they try and remove the punch bowl (only if to fill it up again!).
The old fashioned skill of undertaking a rigorous credit analysis of companies, which has become partially redundant in the last 20 years as companies have done extremely well, will become more and more important going forward, as the signalling effect of poor credit quality will be lost from the the market. Protection will be found by sticking to indices as zombie companies, who for what ever reason suddenly can no longer refinance their debt, will see their valuations drop just as suddenly.
AN ASIDE - PULLING WOOL OVER THE MARKET'S EYES
Recent Central Bank comments have suggested that this period of QE will be different. For example, Powell recently said the following about their latest QE program:
- It was done because the Treasury market was "not working".
- The buying was not about meeting US Treasury supply.
- The program was about market function. - There was always good demand for this asset "in times of stress, people want to own treasuries".
The Fed has spent $1.842 trillion dollars this year on an already highly sought after asset to make the market work.
In a similar fashion, Andrew Bailey today writes about the BOE's continued "independence" and how banks are stronger and "are in a position to support households and companies through this emergency, acting to absorb the shock rather than amplify it". He describes QE as "enabling the creation of reserves to meet surges in demand for high-quality liquid assets in stressed conditions. Absent this, we may well have seen a spiralling in disorderly market conditions". He concludes "the current scale of central bank reserves mustn’t become a permanent feature".
Debt trends show that these statements only show one version of events and ignore a whole set of others. They don't address the likely consequence that debt will continue to rise, funded by even more central bank funding.
This likelihood becomes clear when one considers the huge quirk in the way public debt solvency is analysed compared to private debt solvency, something that is very rarely discussed:
PRIVATE SECTOR: A householder's credit worthiness is based by comparing the size and reliability of their income against their current and expected future costs. This determines current and future net disposable income. In a similar fashion, a company's creditworthiness is based on its past and expected cashflows and profitability, with consideration of its balance sheet and industry. For the private sector, net cashflow is key in determining credit worthiness and the ability to service and repay debt.
PUBLIC SECTOR: Developed Market (DM) public sector debt is expressed as a % of a country's GDP (which is equivalent to a company's revenue or a householders income). An equivalent measure to disposable income or cashflow/profit would be a country's fiscal surplus/deficit. If creditworthiness was done in this way, no one would lend to most DM countries. Thus every government bond holder knows that debt will never repaid but refinanced.
In the past, as long as there was a combination of a) small deficits and surpluses AND b) low levels of outstanding debt levels AND c) decent global growth, the erroneous way of analysing Debt/GDP was not important. Auctions were small and the refinancing risk was minimal.
But with an outlook of multi year deficits, very high debt levels and low potential growth rates, it becomes clear that unless the Private Sector manages to increase leverage to even higher levels from existing altitudes, the market should expect an ever increasing amount of public sector debt to maintain economic growth. This, of course, assumes that the political appetite for debt cancellation will remain as low as it has for the last 400 years - traditionally debt write-offs are not a vote winner, which is why they are hardly ever carried out!