Switching from Public to Private Debt

CONFRONTING AN IMPORTANT MARKET BIAS

For the last 20 years the bond market has been dominated by a very biased belief that both inflation and bond yields would rise. Central Bankers, analysts and economists have repeatedly every year forecasted for an increase in inflation and bond yields, notwithstanding the long term down trend in both. They were anchored to past higher yields and inflation and were framing their information to fit this, ignoring new trends in debt, global trade and technology that were driving yields and inflation down.

“Anchoring” and “Framing” biases are two of the “Simplification Heuristics”, which lead to the brain processing information in an erroneous way. The excerpts below are from James Montier’s excellent 2004 “DrKW Behavioural Finance Compendium” (his book is a must read):

“In the absence of any reliable information, past prices are likely to act as an anchor to current prices. Anchoring has obvious implications for valuations, especially in a world in which we all sit in front of screens flashing prices at us all day long. It is far too easy to latch onto the current market price as an anchor. The degree of anchoring is heavily influenced by the salience of the anchor. That is to say, the more seemingly relevant the anchor, the more people will tend to cling to it, which helps explain why analysts are so frequently afraid to have target prices that differ vastly from market prices.”

“Inattentional blindness is the name given to a phenomenon in which people fail to notice stimuli appearing in front of their eyes when they are preoccupied with an attentionally demanding task. Narrow framing is the term used for a failure to see through the way in which information is presented. Investors and analysts frequently suffer from narrow framing or frame dependence. That is to say, we simply don’t see through the way in which information is presented to us.”

Japanese economic and bond market trends were very good templates for bond market participants to understand how the rest of the Developed Market (DM) world would proceed, and yet not only did people largely ignore these, thinking that Japan was unique in nature, but the “short Japanese rates” trade became a graveyard for many speculators.

Looking at how Japan has evolved, comparing the recent DM debt trends to those of Japan, and casting aside anchors and not framing information will allow investors to have a good indication of the road ahead and highlight some of the signposts for investing.

BOND MARKETS

There is an obsession that because yields go down, yields have to rise, in a V shaped fashion. An alternative view is that when a country reaches a state of over indebtedness, and its’ deficit and debt become very sensitive to interest rates, yields will have to remain close to 0% for a very long time. This occurs in one or both of the following ways:

- Financial Repression, where private sector savings are channelled into a county’s governments bonds. This is possible especially when there is a current account surplus.

- Central Banks intervene through debt monetisation (i.e. buying enough debt to stop yields rising).

Below left is the yield of a Japanese 5 year Government Bond, and on the right are those of the US, European (Bund) and UK. Below those charts are those countries’ respective Sovereign Debt to GDP ratios. Japanese yields declined below 2% in 1995 when their Sovereign Debt/GDP was 95%. That is not disimilar to current Debt/GDP levels of many of the large DM countries.

INFLATION

For the last 20 years, DM Central Banks as well as independent and investment bank economists have persistently forecasted that inflation would rise. This is most likely due to their anchoring and framing biases which led to the construction of poor inflation forecasting models. Charts below are forecasts for Eurozone HICP made by “professional forecasters” and the ECB, against the actual outcome. They consistently expected inflation to be higher than the actual outcome.

The basket of goods and services which is used to determine the Consumer Price Inflation rate can be broken into 3 components :

• Volatile and mean reverting products (Food and Energy). These are subtracted to generate core inflation.

• Discretionary items that the Consumer can choose to purchase – let’s call it CHOICE inflation (e.g. cars, furniture, restaurants etc)

• Non Discretionary items that the consumer has to purchase – lets call it BURDEN inflation, as when it rises it’s a burden on disposable income (e.g shelter, healthcare, education etc).

The key drivers of long term inflation trends are to be found in Choice and Burden inflation. The trends in these two main sub components have been the same in nearly all the DM inflation baskets that I analyse. Below are the choice and Burden inflation rates for 11 countries – note the Y axis scales are the same. Burden inflation is generally higher than Choice inflation, which itself has been close to 0% for many years.

There are tremendously important takeaways from that simple sentence:

- Low Choice inflation shows the impact of global trade, technology and the low cost of capital (that brought excess supply and thus low margins) on the price of goods in the choice basket.

- Low Choice inflation could also be an indicator showing the high level of household indebtedness.

- Because Burden inflation has been higher, real disposable income (deflated for Burden rather than headline CPI) is less favourable than generally thought.

Covid19 might cause Choice inflation to rise should global trade meaningfully contract, and supply chains get seriously disrupted – this would reduce supply and increase margins. However much lower consumption should in the first instance drag it lower as seen by the recent inflation data. The bigger Covid19 impact is likely to be on Burden inflation as real estate, which has a relatively large basket weight, is negatively impacted on both the supply and demand side.

DEBT TRENDS

My previous post on US CPI highlighted the highly unusual March data print that has only happened 5 times since 1970 and twice since the 90s. Another highly unusual event happened after the Great Financial Crisis in the US. For the first time since 1945, the outstanding amount of Household (HH) debt in the US actually declined in nominal terms. Even in the worst post war recessions, the outstanding debt had risen by at least 5% annually. To make this matter even more extraordinary, this occurred when interest rates were at 0%, their lowest level in 60 years. To anyone who has studied Japan this was a huge warning signal that consumer behaviour had changed in the US which would impact asset prices.

The Sep15 BIS quarterly was a defining report for debt trend followers. The BIS produced a debt data set that compared apples with apples across most countries. But in that report there was an excellent study that showed what happened to debt trends in countries that had experienced a financial crisis, highlighting the cases of Japan and the scandi banking crisis in the early 90s. Simply put, following such a crisis there would be a rise in Government Debt/GDP and no growth in Corporate and HH debt.

Below shows the Sovereign, Corporate and Household Debt/GDP ratios for Japan, the US, Eurozone and UK over the last 30 years from the BIS database. Post GFC, Sovereign (RED) and Household (GREEN) debt trends seem to have followed the paths suggested by the BIS study, which goes some way to explaining the low post GFC consumption levels. However, the standout is that this has NOT been the case for US Corporates. Why not?

US CORPORATE DEBT

Whilst impacting many throughout the world, the GFC was most keenly felt in the US by 3 groups – households who had levered up on overpriced real estate, financial institutions and savers. Some countries (e.g. Australia) did not suffer a recession. In the US the contraction in industrial production was short lived and both the Services and Manufacturing ISMs rebounded to 50 within a year of the crisis. The household and banking sectors took much longer to recover, and therefore the HH deleveraging is understandable given the losses and stresses that they and the banks delivered. This was in no doubt also forced upon them by tougher banking regulation.

Corporates were relatively less impacted. As banks were rescued, credit became available again, and as interest rates declined and Central Banks bought government bonds and drove yields down, the hunt for yield by savers allowed corporates to issue debt in large size at tight credit spreads. The lack of any meaningful regulation over share buy backs or internet selling allowed for a substantial rise in balance sheet leverage, and an increase in negative cashflow companies to exist. And then Covid19 struck. What might happen now?

The Japanese corporate sector went through a huge unregulated leveraging boom in the 80s early 90s. Corporate debt/GDP increased from an already high 100% in 1980 to 142% in 1990. It was an unbelievable ponzi scheme built on real estate, corporate cross shareholding and bank balance sheets. For example, banks would lend to corporates to buy shares in corporates who would buy shares in their own stock. Banks lent to industrial corporates who speculated on real estate, taking the land as collateral. The numbers were staggering, as can be seen from the chart below. But when the bubble burst, this led to a new behaviour which has existed to today – deleveraging and more prudence. Part regulation, part shock, part dignity, many factors contributed to this behaviour, in the same way that has led to a different behaviour in western banks and consumers post GFC. And in the meantime, Japanese Households have deleveraged despite decades of 0% interest rates…….

A NEW US CORPORATE BEHAVIOUR?

The US Government and Fed have quite rightly reacted to support businesses through the Covid19 pandemic. But how will US corporates behave when the economy recovers? There is a good case to think that the rate of growth in leverage seen in the last 20 years will not return for 3 reasons:

If the yield curve remains low and flat, banks will struggle to generate the capital required for new lending (see previous post on the outlook for Banks)

US Households already started deleveraging post the GFC. Given the pain inflicted on SMEs and the large rise in unemployment, it is hard to imagine a change to that deleveraging behavioural trend. It is quite possible that savings rate rise, as seen in many countries post GFC.

Corporates are undergoing a shock that could be transformational in nature, just like the one Japan went through when their bubble burst. Directors and managers are likely to be scarred by the fallout of the Covid19 lockdown, from the abrupt stop to business, the requirement to make job losses, and the inability to raise finance quickly. There is a good chance that in the post Covid19 recovery, company managers will simplify supply chains to make them more robust and run less levered balance sheets with higher capital buffers.

And finally, it would not come as a surprise to see higher business regulation in the future. Trade barriers had already started going up before Covid19 (US/China, Brexit etc.). Bank regulation has changed significantly post GFC (and in Australia post the Royal Commission). Share buybacks, which were once deemed illegal as they were thought to “manipulate share prices” are unlikely to be allowed for companies being bailed out. A tougher regulatory environment is likely to limit leverage, just as it did to banks post GFC.

WHO TAKES UP THE SLACK THEN?

My investment framework is based on understanding the private and public credit cycles, drawing on historical precedent. There is a key moment in the cycle, which is when the private sector leverage no longer increases, and public sector credit growth takes over. The “cause” of lower private credit growth leads to various “effects”, such as an economic slowdown and disinflation, which leads to fiscal intervention by the government and a rise in public sector indebtedness. This intervention might be delayed (causing a prolonged recession – see Italy post GFC) or be fast, but the key is that fiscal expansion takes up the slack from a muted private sector credit expansion.

This is exactly what the above BIS chart shows. The chart below depicts the public and private sector debt trends in Japan post bubble bursting in the 90s – notice the switch from one to the other. This is exactly what economies are witnessing today. Traditional interest rate Monetary Policy became spent some time ago so Central Banks, via their balance sheet expansion, became the conduit for looser fiscal policy and thus public sector debt expansion. This private to public investment framework does not anchor behaviours to the recent past, or frame information to a small comfortable set of convenient data. Right at the outset when QE1 was announced, this framework laid bare the untold truth that QE would be “temporary” in nature, but likewise accepted QE as a confirmation that a depression was not likely either.

As mentioned before, the outstanding “known unknowns” are how much will the fiscal expansion be and to whom will it be directed. Who will finance the fiscal deficit is a “known known”! A higher private sector savings rate and unlimited Central Bank balance sheet expansion will sort that – the mix of the two will decide the fate of the currency of the country expanding its’ public sector debt pile.

IMPLICATIONS FOR ASSET PRICES

• If the huge fiscal policy announcements are only large enough to support and maintain existing balance sheets, then corporate deleveraging could persist in Japan, UK, and Europe and start in the US.

• Corporate and Household deleveraging is disinflationary in nature until the supply/demand imbalances eventually change to favour price setting over price taking.

• Interest rates and yield curves should remain in a “lower for longer” environment for some time.

• The DXY should appreciate in a global deleveraging environment whilst the currencies of leveraged economies will devalue (SNACS). This scenario is poor for EM.

• The outlook for banks remains poor, whilst non-financial corporate equity multiples in general should struggle to reach the lofty levels if balance sheets become less leveraged. The return on equity profiles will just be lower.

• BUT in this environment, enough fiscal policy will ensure that nominal asset prices remain supported. The issue is that investors will have to change the way they look at returns from nominal to REAL earnings. Indeed, the fact that 30 year real risk-free returns of government bonds are already negative in the US (-0.1%), Germany (-1.0%), UK (-2.0%) and Japan (20ys @ ~-0.1%) tells you this is the case.