Many investors are wondering when the United States will finally emerge from the economic version of high school detention: being stuck in a slow growth mode. Opinions on this topic typically range from later this year to perhaps as late as 2015.
But in a recent paper, “Debt Overhangs: Past and Present,” authors and economists Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff suggest that the correct answer might be closer to 2030. Given their previous work on the aftermath of credit bubbles and the impact of public debt, investors have every reason to take their prediction seriously.
According to the paper, the United States and much of the rest of the developed world are now contending with debt levels unprecedented since the aftermath of World War II. Historically, excessive public sector debt – defined as gross public debt in excess of 90% of gross domestic product – has resulted in slower growth for a very long time. Episodes of excessive public debt are associated with GDP being about 1% lower per year than in other periods, and – here is the catch - the paper concludes that episodes of excessive public debt have an average duration of 23 years.
In many developed countries, including the United States, it would appear that we are already living with the consequences of our ever-growing debt burden. For instance, growth in the United States remains anemic nearly three years after the recession ended. Since mid-2009, the United States has averaged 1.8% annual growth, roughly half of its long-term average. This is in contrast to previous post World War II recessions, when the public debt level wasn’t so high. In those recessions, the deeper the downturn, the more robust the recovery was that followed.
What does this mean for investors?
1) Consider rethinking earnings estimates for certain companies. While many investors worry about margin compression, the real risk to long-term U.S. earnings may come from overly optimistic revenue projections, particularly for companies focused on the United States. The biggest determinant of U.S. earnings growth is U.S. economic growth. If economic growth is modestly slower going forward, investors should lower their long-term earnings estimates as well.
2) Consider raising allocations to emerging markets. Equity multiples are influenced by investor expectations for growth. All else equal, countries with higher expected growth tend to trade at a premium. If the United States, Japan and large parts of Europe experience slower growth thanks to their high public debt levels, they are likely to trade at slightly lower multiples in the future. And to the extent that emerging markets are not weighed down by the same debt baggage, they are unlikely to experience the same headwind as developed markets and are likely to trade more in line with developed markets than they have in the past.
A slow growth world does not necessarily mean the death of equities or the absence of opportunities. It does, however, suggest that investors need to have realistic expectations for the U.S. economy, and for most of the developed world. Slower growth, lower interest rates and lower multiples are arguably consequences of higher public debt. And if the authors are right, this may be an issue we’re still contending with in two decades' time.
Sources: “Debt Overhangs: Past and Present” by Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff.