When the Covid-19 pandemic hit in 2020, the global economy plunged into the deepest recession since World War II. Governments reacted quickly to the economic shock with massive aid and relief packages — at the expense of record-high debt levels (see Chart 1). It was absolutely the right thing to do — to protect productive capacities, provide liquidity to businesses and households and ensure that the economy can recover quickly once the worst of the pandemic is behind us. In effect, governments all over the world are socialising private-sector debt. We explained this in our column last week. But were the stimulus measures of unprecedented scale excessive?
Anecdotal evidence would suggest that they are, especially in the developed world. The number of corporate bankruptcies fell in 2020, companies are flush with cheap cash and households are piling up excess savings, estimated at US$5.4 trillion ($7.27 trillion) as at end-March 2021, according to Moody’s Analytics. Giving the people free money is popular, and popularity wins elections under the democratic system of governance.
However, the ability of governments to spend is unequal and the consequences are certainly not the same. Major developed economies can — and have — sustained high public debt-to-GDP ratios for an extended period. Notably, these countries have a greater capacity to borrow in their domestic currencies, which limits the potential fallout. In theory, a country can never default on local currency-denominated debt as it can simply print more.
High levels of public debt are sustainable as long as there are takers to roll over the borrowings, without the country having to pay higher interest rates and/or depreciating its currency. Japan is one prime example.
The US, with the luxury of being the world’s reserve currency — and the US dollar being the primary transactional currency (at least for the foreseeable future), which leads to an innate underlying demand — is likely to have little problem in this respect. In Europe, the path to debt mutualisation — joint borrowings and sanctioned fiscal transfers from “frugal” to “profligate” member countries — also means that we are unlikely to see a repeat of the sovereign debt crisis of the last decade.
Make no mistake, though. The consequences of excessive public debt can be extremely dire, especially for emerging markets (EMs). To the Western media and rating agencies, this is often attributed to the perceived “credibility” of the country’s institutions. In reality, this means EMs are given far less leeway in terms of their ability to take on debt. Latin American countries such as Argentina and Venezuela are very good examples of high indebtedness leading to rating agency downgrades, which result in the countries being shut out of international capital markets, leading to sovereign defaults.
Argentina’s economy is in deep recession, having contracted for the past three years. Its currency, the peso, is in free fall and inflation is running at high double-digits annually — destroying the people’s purchasing power, savings and investor confidence, prompting capital flight and deterring investments. Wages and productivity suffer and with it, global competitiveness. Its stock market has collapsed. GDP in US dollar terms is now lower than it was back in 2010. Unemployment stands at 11.7%. Four out of 10 people in the country now live below the poverty line.
Yes, Argentina may be an extreme case. But it gives us a glimpse of what the future could be — when we throw caution to the wind. Malaysia entered the Covid-19 crisis with public finances that were severely weakened by years of financial scandals, overspending and underinvestment in productive assets as well as lack of structural reforms to transform the economy. Government debt and guarantees are high, at 83% of GDP. In December 2020, Fitch Ratings downgraded Malaysia’s credit rating from “A-” to “BBB+”. In short, giving cash payouts may be a popular thing to do. But a responsible government must be vigilant against falling into an Argentina-like downward spiral.
Some economists are already sounding the alarm on mounting global debts, which could trigger the next major crisis. It is a risk, though we think not the most probable outcome in the foreseeable future.
While the capacity to take on debt is far greater for developed countries, it is not limitless. At some point, investors will baulk at the extent of the currency debasement and will start demanding higher interest rates. There is no “free” money. Debts have to be repaid, if not by you, then certainly by your children and grandchildren.
Traditionally, government borrowings are paid down through a combination of higher taxes and reduced fiscal spending. For instance, the Biden administration is looking at reversing some of the Trump tax cuts and has won backing from some 130 countries to impose a global 15% minimum tax rate, to more effectively tax large MNCs.
Austerity, on the other hand, would hurt economic growth, while cutbacks in public spending tend to penalise the lower-income groups and only serve to widen inequality. Critically, it inflicts a lot of pain and is hugely unpopular. In reality, few democratically elected governments have the political will to pursue this path. Default and debt restructuring would be the very last resort — and highly unlikely for major developed economies.
Therefore, the most likely scenario going forward is that central banks will try to maintain interest rates as low as possible — including yield curve control if required — and for as long as possible. This will keep debt servicing manageable while cheap money encourages investments and economic growth — and at the same time, generates some inflation. If GDP growth continues to outpace debt-servicing costs (interest rates), countries can grow out of — or at the very least, stabilise — high debt situations. A case in point: The benchmark 10-year US Treasury — using Treasury Inflation-Protected Securities (TIPs) as a measure of inflation expectations — is now yielding a negative real return of 0.89%. This strategy is a form of wealth transfer, as negative real rates/returns will penalise savers and favour borrowers (both the government and the private sector). It is, in effect, a very subtle — and hence, more politically palatable — government tax on the people.
Keeping the interest rate, which is the price of money, artificially low has longerterm implications, of course — in terms of misallocation of resources. Indeed, we already see price inflation across asset classes, including stocks and real estate as well as highly speculative assets like cryptocurrencies (see Table).
Nominal debt can, at least on paper, be inflated away. It can be risky — and ultimately self-defeating — if inflationary expectations become entrenched. If so, that only results in broader price increases and higher interest rates, which will be counter-effective in reducing the debt burden — and worse, if inflation gets out of control. That said, we think inflation will remain moderate — beyond the near-term supply-disruption-driven spike — owing primarily, to digitalisation, as well as secular forces such as demographics (ageing population that saves more and consumes less) and widening income-wealth inequality.
The bond market seems to agree, at least for now. The US Treasury yield curve has flattened in recent days, after steepening for the better part of 1H2021 (see Chart 2). Gold, the traditional inflation hedge, too has underperformed in recent months.
Clearly, a lower-for-longer interest rate environment has significant long-term impact on your financial and retirement planning in terms of asset allocation. It becomes harder to achieve financial goals, forcing investors to take on more risks in the search for yields. Excess cash must be put to work — in assets that give higher returns than bank deposits — or risk having inflation eat away at your purchasing power.
For instance, value stocks with higher-than-market-average dividend incomes are a good alternative to fixed deposits. We published a suggested portfolio of such stocks — with a 10-year investment horizon for your retirement or children’s education trust fund — in Issue 989 (June 21). Steady-growth companies that maintain constant dividend payout ratios (which means rising dividends with time) are also good options. Reinvested dividends have proven to be the main driver of long-term total returns. For more stock ideas, visit www.absolutelystocks.com.
Box Article: Everyone’s a Keynesian in bad times
Governments the world over have already implemented massive fiscal and monetary stimulus during this Covid-19 pandemic. This is a fact. And we are still hearing calls for more, from politicians, business people and the man in the street. Many are probably justified, based on anecdotal evidence of people in dire need of a helping hand. It would seem everyone is now a self-proclaimed Keynesian, in touting for more handouts, more aid, more stimulus.
For those who are unaware, John Maynard Keynes (1883-1946) was a famous British economist. Keynes is widely associated with aggressive government intervention to pump-prime the economy — increase government spending (G) to cover for shortfalls from private consumption (C) and investments (I) during recession since aggregate demand is composed of C, I, G and net exports (X-M). Doing so can quickly stabilise the economy and prevent high, prolonged unemployment. His ideas were published in 1936 and widely embraced in the ensuing years in which increased government spending was credited with jumpstarting production and leading economies out of the Great Depression and into the post-World War II years of prosperity.
What is often (wilfully) forgotten is that Keynes, in fact, advocated countercyclical fiscal policies for the times when market forces fail to do the job. In other words, governments should act to counter normal business cycles — spending more during recessions but also reining in excesses during boom times. But of course, taking away the punch bowl in the middle of the party is never popular. This is the reason why everyone is a Keynesian during bad times but not so during good times.
A case in point: Almost every US president has run a budget deficit in the past five decades of booms and busts. Republicans are popular for big tax cuts while Democrats favour big spending on social programmes. Only under the years of former President Bill Clinton did the US achieve a surplus. Since then, the deficit has only grown larger, to successive historical highs. We see a similar trend in the UK — where there was a budget surplus in only six of the past 50 years (see Charts). As we said, popularity wins elections under the democratic system of governance and elections are held every four to five years. Hence, there is no incentive for politicians to plan long term. A huge deficit becomes someone else’s problem, especially when the ruling government regularly changes between two dominant parties.
Of course, there are exceptions, though they are few and far between. For example, traditionally fiscal disciplined countries such as Germany and Singapore have adhered more closely to the Keynesian economics of countercyclical fiscal policies. Perhaps these governments have greater political capital to make the hard decisions, from the trust built on years of past policy successes and historical experience.
-Box article ends-
Not surprisingly, risky assets, by and large, have outperformed in 1H2021. That is why we are keeping the Global Portfolio fully invested, and also weighted towards growth stocks.
The Global Portfolio gained 0.6% for the week ended July 7. The majority of tech stocks in our portfolio did well, with Amazon.com rising 7.5% and Apple up 5.6%. Shares in Alibaba Group Holding, however, remained under pressure after Chinese authorities cracked down on newly listed DiDi Global, which dampened sentiment over all China-based tech companies. Alibaba was the biggest loser last week, down 6.5%. Other notable losers were General Motors Co (-4.4%) and Bank of America (-3.6%). Nevertheless, total Global Portfolio returns since inception of 59.1% are still ahead of the benchmark MSCI World Net Return Index’s gain of 54.4% over the same period.
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