Developed market indebtedness and the adverse consequences of massive national debt are still with us 240 years after Adam Smith’s ground ground breaking economic book The Wealth of Nations (written by Adam Smith and published 1776). Some of his lessons in the chapter “Public Debts” should be remembered by investors today.
Since 2007 no major economy has decreased its debt-to-national-income levels according to a McKinsey study published in Feb 2016. Worryingly since the 2007 financial crisis (the worst economic event since the Great Depression) debt has grown faster than economic expansion.
In a slower economy and softening corporate environment should investors be investing in debt-ridden developed nations? We advocate a process of investing with institutions and governments that have attractive balance sheets, good debt profiles and positive cashflows plus cash at bank.
The chart shows the expansion of debt in the past seven years. In advanced economies debt grew greater than in developing economies; in seven years China’s debt quadrupled (led by real estate and shadow banking); government debts in some countries are now so large new methods will be needed to reduce them as tax rises and austerity budgets will not suffice; and rising house prices and household debts in Asia and Northern Europe are contributing to new peaks in private debt levels. On average, developing market debt is 121% of GDP, less than half the 280% average in advanced economies.
High debt levels have left scars the recent generation seem to forget. In the late nineties large government debts in Indonesia, Thailand and South Korea (coinciding with the Russian government default) caused the emerging debt crisis of 1997 that required serious bailouts. In 2008 the US subprime implosion led to the worst economic downturn since the Great Depression, infecting Europe with a sovereign debt crisis and leading central government pumps to be turned on in an exercise called quantitative easing.
These challenges need to be addressed and investors need to review how they buy bonds and lend their savings to debtors. Economies seem to be reliant on debt to grow so we need to live with debts but that means a greater likelihood of asset bubbles, increasing private-sector defaults and reevaluate debt incentives in the tax system.
The investment strategy of Serenity Fund has been to hold hard currency bonds and no local currency exposure – this has been a positive factor for peer performance. Local currency bonds have been popular among investors but things began to change in late 2015 with low commodity prices, a strong dollar and upward interest rate policy in the USA. Emerging markets suffered a net outflow of capital for the first time since the 1980s, according to the Institute of International Finance. Emerging market currencies have fallen sharply: the Brazilian Real hit its lowest level against the dollar in two decades last year. This year the South Africa Rand and Russian rouble reached a record low.
In the face of larger national debts and softening economic environment income investors need to consider alternatives for income and bond investing.