Global Institutional Consulting Chief Investment Office Global Debt: MAY 2017 Emmanuel D. Hatzakis Challenges and Opportunities Director Chief Investment Office The world is deep in a flood tide of debt. Do we care, and what can we do about it? Debt is inextricably linked to economic growth. Whether in the form of government, business or household credit, debt can fuel economic growth, and economic growth can increase the propensity to borrow. And when growth is too weak, credit can be used to stimulate it. The cumulative effect of credit use by the various sectors of an economy is a rise in its overall debt. While economic prosperity is often credit-financed, higher levels of debt appear connected to lower future economic growth. Almost all debt accumulations have been hard to reverse, most have involved tough policy choices, and some notable ones have ended badly. In this whitepaper, we discuss the state of global debt, how it came to be, where it may lead, and what we believe portfolio implications to be. The state of global debt More than eight years since the 2008 global financial crisis started, the world seems to be drowning in debt. Global economic growth, meanwhile, remains anemic, after years of sluggishness. Some economists attribute it to high levels of debt1, reasoning that they have been preventing economies from realizing their full potential because governments, businesses and households have been devoting significant resources to debt servicing — resources that otherwise would have been available for productive activities. Global debt was on a steep rise before the crisis, and continued growing after it. The McKinsey Global Institute estimates that, by mid-2015, the world’s debt stood at $204 trillion — $68 trillion (or 50%) higher than it had been in 2007, immediately before the crisis, and $121 trillion (or 145%) higher than in 2000. Governments, businesses and households all contributed to the increase. (See Exhibit 1.) What is more, global debt has been growing faster than the world’s economy. As of mid- 2015, it stood at 294% of global gross domestic product (GDP), up 25 percentage points (pp) since the end of 2007 and 48 pp since the end of 20002. In many countries, debt has increased to levels not normally seen during peacetime3. In advanced economies, government debt has had several spikes associated with wartime borrowing or economic crises over more than two centuries, and is now at its highest levels since World War II4 (see Exhibit 2). Businesses and households have never been as indebted before5. 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Global Debt: Challenges and Opportunities | 2 Exhibit 1: Global Debt Outstanding, by Type Exhibit 3: China’s Outstanding Debt, by Type Household Business-Non-Financial Government Business-Financial Household Business-Non-Financial Government Business - Financial 250 300 290% $204 39pp 200 250 $40 + $121 + $68 200 150 $136 132pp $57 158% $32 150 20pp 100 121% $83 8pp $37 100 72pp $18 $58 51pp Debt as % of GDP 50 $25 $31 83pp 50 $21 42pp $36 $48 68pp $ Trillion, Constant Exchange Rates $19 23pp 24pp 0 0 7pp 2000 2007 Q2 2015 2000 2007 Q2 2015 TOTAL DEBT AS % OF GDP TOTAL DEBT, $ TRILLION, CONSTANT EXCHANGE RATES 246% 269% 294% $1.9 $6.9 $30.0 Source: McKinsey Global Institute and Chief Investment Office. Source: McKinsey Global Institute and Chief Investment Office. Note: Totals may be off due to rounding. Exhibit 2: Global Government Debt Outstanding — How this came to be Advanced versus Emerging Economies Debt has characteristics that make it attractive both to Advanced Economies Emerging Economies borrowers, as a source of funds, and to lenders, as an 140 investment. Borrowers may like its favorable tax treatment, 120 and the limited surrender of control rights it offers when 100 compared to equity; lenders often perceive it as less 80 risky than equity, and its contractually specified stream 60 of cash flows may serve their needs with reasonable certainty. A confluence of factors contributed to the global 40 Debt as % of GDP debt accumulation7: 20 0 • In many economies, robust real GDP growth and booming real estate markets and construction led to 1800 1809 1818 1827 1836 1845 1854 1863 1872 1881 1890 1899 1908 1917 1926 1935 1944 1953 1962 1971 1980 1989 1998 2007 fast increases in credit. Source: Reinhart, Reinhart and Rogoff (2012). Data through 2012 for advanced economies and through 2011 for emerging economies. • The liberalization of the financial sector over the last three decades opened up major financial markets, and innovative ways to engineer debt instruments with risk profiles Emerging economies alone contributed 47% to the growth in perceived to be suitable for specific classes of lenders global debt since 2007. China, whose government launched an fueled a self-reinforcing increase in credit availability. ambitious stimulus program in late 2008, in response to the global financial crisis, played a leading role6, with its debt more • A savings glut, mainly in emerging economies, and than quadrupling since 2007 (see Exhibit 3). China’s debt is declining real interest rates across the world made mostly domestic, held by banks, and has been used primarily to credit cheaper and more available. finance real estate and other investments. Continued on next page. Global Debt: Challenges and Opportunities | 3 Debt accumulations are historically associated with slower Continued from previous page. future GDP growth, systemic instability, and economic and 9 • Credit use increased as both lenders and borrowers financial-system vulnerability . The faster the debt build-up, felt more comfortable in a relatively stable the worse the ensuing contraction has tended to be. In the macroeconomic environment. years leading up to the global financial crisis, major advanced economies saw household debt spiral upward to unsustainable • The 2008 global financial crisis caused governments to levels along with housing prices, until real estate collapsed and increase their borrowing steeply to offset tax revenue domestic spending slowed, with more-leveraged households declines and stimulate their economies. experiencing larger spending slowdowns10. Faster private- sector deleveraging and quicker balance-sheet recognition of Debt levels can increase in both good economic times and losses have resulted in more robust recoveries11. bad. When growth is too weak, governments may attempt to The economic slowdown following debt accumulation is well stimulate economic growth by investing or spending borrowed understood by those familiar with the aftermath of the lending funds, as well as adopt policies that encourage businesses booms in the U.S. in the 2000s and Japan in the 1980s, and and households to invest or spend using credit. Several prior research findings corroborate it12. Exhibit 4 outlines an illustrative periods of debt accumulation were followed by severe economic example. When domestic demand is fueled entirely by credit, $1 contractions8, and what we are experiencing now may have of borrowing generates $1 of spending, and the stock of debt similarities to past cycles. The current secular debt cycle is now increases by $1, all else being equal. To keep demand at the same more than five decades long, with deleveraging pauses in the level through credit, debt needs to keep increasing. When the 1980s and 1990s. It intensified in the last few years, raising flow of credit stops, demand goes back to what it was before some critical questions: borrowing, and the stock of debt remains at a high plateau. To • Should we be concerned? decrease debt, we need to reverse the credit flow, which causes • Does this pose any risks? If it does, is there a way out? a contraction in demand. What is more, weak demand leads • Do we need to deleverage at any cost, or should we rather to disinflation or even deflation, which, in turn, triggers easier focus on learning to manage the debt and its growth trends? monetary policy, currency depreciation, and increased vulnerability of the banking system to crises. • Could it be that it does not matter as much as we fear? What if debt has become a structural element of the modern global Since debt overhangs have often happened during or after deep economy, with its deep financial markets, sophisticated risk recessions, wars, or other crises, it is not clear whether anemic or management tools, and steadily declining interest rates to negative growth can all be blamed on high debt. Also, the impact historically low levels that make debt servicing as easy as it on growth depends on each economy. Emerging economies, has ever been? as well as countries that lack inclusive political and economic • Finally, how should investor portfolios be positioned in this institutions, are considered to be more adversely affected13. environment? Some deleveraging has been taking place since the crisis14, but it has been uneven across economies. Global Debt: Challenges and Opportunities | 4 Exhibit 4: Debt would rise perpetually in an economy Exhibit 5: Corporate bond issuance and S&P 500 relying solely on credit to sustain demand (depicted by buybacks have been increasing at similar paces dotted lines). If credit stopped flowing, demand would S&P 500 buybacks Bond issuance stagnate while the stock of debt stabilized, and it would contract if the credit flow reversed in order to deleverage. 3,000 2,500 PERIOD 1 PERIOD 2 PERIOD 3 PERIOD 4 2,000 +$1 -$1 1,500 USD Billions $0 CREDIT 1,000 -$1 500 0 +$1 2009 2010 2011 2012 2013 2014 2015 $0 DEBT STOCK Source: Strategas Research Partners and Chief Investment Office.