Market update
It is all about debt
By Stephen Merlicek, Chief Investment Officer
December 2011
Debt can be our best of friends and worst of enemies. In some ways it is like alcohol consumption, where low to moderate consumption used in the right way is usually not an issue, for example with a meal. But large amounts used in the wrong way, like binge drinking, can have dire consequences.
Most of the problems that occurred in the GFC and the subsequent crisis in Europe has emanated from excessive levels of debt.
Years of easy money and credit growth has led to excessive amounts being borrowed by individuals, some companies and governments. Basically people and organisations have borrowed from future generations and overseas countries to fund consumption or lifestyles which are not sustainable in the long term. It has taken years to build up these excessive levels of debt and it is naive to assume that it can be solved in a year or two. Thus the volatility in markets and depressed markets are a reflection of the debt situation.
What are the implications of high debt levels?
Some economists say debt is not an issue in a worldwide sense, because for every borrower there is a matching lender. But this ignores the fact that in times of stress, lenders lose money or go under, which has real economic impact (classical economic models are not good at modelling depression and the role of debt).
A high level of debt means that future consumption is being brought forward. By definition, consumption must reduce at some point, for many borrowers that point is now.
It is similar to someone borrowing a lot to buy an expensive house. The result usually is that most of that person’s income goes towards paying off the mortgage for a number of years which leads to reduced consumption on other items for years to come.
We are now seeing cutbacks by governments all over the world as they try to rein in large deficits. This leads to unpalatable cuts in government services which people are not used to, thus the demonstrations and riots we have seen in many countries.
It can also lead to increased taxes to raise government revenue, which is dangerous when economies are already depressed.
What is the solution?
The solution is likely to come from a number of fronts:
- It takes time to pay down debt, so creating a payment plan is the first step in reducing debt.
- Some debt will need to be written off, this is already happening in countries such as Greece.
- There will be cuts to government expenditure in Europe, the US and other countries. In some cases there will be increased taxes to increase government revenue.
- In the past, a traditional way to reduce debt has been to print money. This mechanism works by inflating one’s way out of debt, thus making the real value of debt less. The downside of this is that inflation is generally regarded as a negative influence and most central banks have devoted significant energy to keep it under control. In addition, most European governments cannot print money due to the single currency controlled by the European Central Bank.
Of course, individuals do not have all of the above mechanisms and generally will have to reduce expenditure in order to be able to pay off their excessive debt levels.
The biggest potential issue from an investment perspective is that the transition phase to a lower debt future can be difficult and volatile. The returns for most asset classes are likely to be substantially lower than in the past and sustainable income yield will become a lot more valuable going forward. One of the few positives is that astute cashed-up investors may find some great opportunities in the future