One of the many shattered expectations post-2008 was the idea that we will see a period of debt de-leveraging, as would have been expected in the aftermath of a serious financial crisis. In fact, global debt has been growing at a rate of about 5% per year since 2007, while the global economy has been growing by about 3% per year. According to McKinsey, global debt was $87 trillion in the year 2000. It grew to $142 trillion in 2007, just before the financial crisis hit and then it hit $199 trillion by the middle of 2014. Latest reports suggest that it reached $217 trillion last year.
The rate of growth in global debt in the 2000-07 period was higher compared with the 2008-2016 period. It grew by about 7% per year, but global GDP, not adjusted for inflation grew by an average of about 8% per year, from $33.55 trillion to $57.8 trillion. In other words, the rate of nominal economic growth measured in U.S. dollars was actually higher compared with the rate of growth in global debt measured in U.S. dollars. The fact that the rate of growth in global debt has slowed compared with the 2000-07 period which preceded the global financial crisis is in no way a reason to celebrate, given that we have now entered a new era where the rate of growth in global debt, far exceeds the rate of growth in global GDP. The economy expanded from $57.8 trillion in 2007 to $72.2 trillion in 2015. Given that this is a non-adjusted measure in current dollars, it is very troubling, as is the fact that there is nothing on the horizon aside from a major economic crisis, which is likely to cause a change in the trend.
Note: The above forecast is based on global GDP and debt trends from 2008-16, which shows a non-adjusted rate of global GDP growth in U.S. dollars of 3% per year and U.S. dollar equivalent growth of 5% per year.
The sustainability factor that obviously comes into play here is the need to service all that debt. For simplicity's sake, in order to illustrate the effect it will have on the economy, I decided to apply a uniform average global interest rate of 5%.
As we can see, in the 30 year period between 2020 and 2050 the percentage of global GDP which will have to go to servicing the debt will almost double. Compared with 2014, when McKinsey puts total global debt at $199 trillion and global GDP was worth $78.63 trillion, it will more than double, given that interest on global debt took up 12.7% of global GDP, if we are to assume the same global interest rate was 5%.
It is hard to pinpoint a level of debt-servicing load which might be considered to be a breaking point. If I had to guess, we most likely already reached that point in 2007, which is why we had the financial crisis. Back in 2007, the interest rate on global debt was much higher, somewhere in the 8% range most likely, therefore the carrying cost of the 142 trillion in debt was most likely about 20% of the global GDP level of $58 trillion. If this is true then the current low interest rate environment since the great financial crisis, most likely bought us about two or three decades, before we will have a day of reckoning. If the global interest rate were to rise at any point along the way, we will most likely experience another significant economic shock, perhaps of a similar intensity as we did in 2008. I wrote a series of articles last year, which explained why global interest rates are likely to remain low for the foreseeable future, even though we are currently talking about a tightening Fed.
It is also true that our interest rate carrying capacity may have been altered somewhat since 2007, therefore it is entirely possible that the time of reckoning may come sooner, or it may be pushed out further in time if our ability to cope with a higher interest servicing load increased or will increase in time. I personally do not believe that our ability to cope with higher interest payments on the economy has improved. The fact that the rate of growth in debt is higher than the nominal growth of global GDP as measured in U.S. dollars means that we are in fact finding it harder to cope with our current obligations and desired spending, leading to the world taking on more debt than the growth in global GDP allows for. In effect, we are increasingly borrowing in order to service past borrowing, not so much because we want to spend or invest more than we did in the past.
Probable end-game scenarios
For the purpose of illustrating the effect of the current trend of global debt growing at a significantly higher rate than nominal global GDP, I assumed that the relationship will be steady. Returning to the real world, I believe that there is a very strong possibility that the process will speed up. In other words, global debt will continue to increase by a growing gap compared with global GDP growth. This ought to be intuitive because after all we are dealing with a situation where the debt servicing burden is growing faster than our ability to cope. This means that we need to borrow at an ever-faster rate just to keep pace with that borrowing. This means that the amount of time we may have gained from the dramatic drop in global interest rates in the aftermath of the 2008 financial crisis, may have bought us less time than my calculation based on the assumption of constant trends would indicate.
Scenario Number One: Facilitate the debt bubble
Global average interest rates do not have much lower to go from current levels in my view, so there is no more help coming from that direction. The best we can hope for is for interest rates to remain near current levels. That may not necessarily end up being the case as the growing total debt/GDP is likely to lead to a gradual and constant increase in defaults at consumer, business and government level. This in turn will push the cost of risk up, causing an increase in interest rates.
With interest costs moving up, the likely scenario is that we will see the rate of accumulation of debt out-pacing nominal global growth. My guess is that central banks as well as governments and other institutions such as the IMF will continue to do what it takes in order to facilitate the growth in debt, even as it continues to accumulate at an accelerating rate compared with nominal GDP. It is the most likely scenario, given that it is politically the most convenient. It will also have arguably the most damaging outcome when the debt bubble will burst. It could potentially bring down the entire global financial system.
Scenario Number Two: Inflation
There is a reason why most developed world central banks target 2% inflation. It is not so high that it poses a risk of taking on a life of its own and getting out of control. At the same time, it helps a great deal with keeping our debts serviceable by increasing the nominal growth of the economy. Global inflation seems to have dipped bellow 3% in the past two years, and it is forecast to remain relatively low going forward. An obvious solution to coping with the gap between nominal growth as measured in US dollars and the growth rate in total global debt is to increase global inflation. Currently it would have to be increased by about 2 points and then it would have to be further increased as needed. The obvious risk with this path is that it can easily get out of control, with more and more countries falling into a hyper-inflation trap.
Scenario Number Three
The last likely scenario is the least likely to occur by choice, because it is politically the least appealing. There is the option of accepting even lower growth rates in exchange for narrowing or even eliminating the growth gap between economic growth and the growth in debt. Current yearly global economic growth has averaged about 3% since 2007. For developed world countries this has meant an average growth rate ranging between 0%-2% in most cases. We are therefore already on the edge of what the masses in the developed world will find to be unacceptable. We are seeing this discontent manifesting itself in the form of increased support for formerly fringe political movements on the right and the left, while the center is increasingly being abandoned. Any further deterioration in economic growth is likely to cause political dysfunction, which would exacerbate things, which is why no country would choose to do this willingly.
There are some factors which may cause an economic slowdown, which may not necessarily come as a result of public or central bank policies and will most likely fail to close the gap between economic growth and the rate of growth in debt. The automation trend that is currently starting to go after manufacturing as well as white collar service jobs may be one of the those factors. Productivity may improve a lot as a result of the trend, but consumer demand which in the end drives the economy will suffer as jobs will become more scarce. A recent study suggests that each new machine employed is causing a net loss of 5.6 jobs. The study also suggests that the number of machines employed will quadruple between now and 2025, meaning that we are about to feel the effects rather intensely. If this is indeed how things will go down in this respect, chances are that it will take even more debt in order to keep the economy going in order to make up for lost wages.
Bond yields indicate we are at the beginning stages of this crisis
Starting with the 2008 crisis, interest costs as a percentage of the world's economy mostly declined. This trend most likely came to an end when government bond yields bottomed.
As we can see, U.S. 10-year bond yields bottomed last summer. Similarly low rates were seen before, most recently in 2012, but that is the level where I think we can say with relative certainty that it is not likely to go much lower for a prolonged period. If we look at other important bonds around the world, we see a similar trend, where a recent bottom has been set in, which looks unlikely to be breached for a prolonged period. It is only as of a few months ago therefore that the continued gap between the growth rate in global debt and the growth rate in nominal global GDP will start to lead to an increase in interest rates as a percentage of global GDP. A number of factors may push bond yields down going forward and we may re-visit those 2016 lows, but I think that is about as far down as interest rates can go for a sustained period, therefore we can say with some certainty that the beginning stages of this crisis started already.
Implications for investors
The big story in the U.S. in the past few months has been the rising trends in interest rates, in large part thanks to the Federal Reserve commitment to raising rates. One of the obvious beneficiaries has been the financial sector. If one looks at financial ETF's such as iShares US Regional Banks (NYSEARCA:IAT), Vanguard Financials ETF (NYSEARCA:VFH), or Fidelity MSCI Financials Index ETF (NYSEARCA:FNCL), we see that all of them have been doing quite well in the past year or so. Continuation of this trend for the longer term will depend on continued willingness by the Federal Reserve to continue raising rates and then holding them at a higher level.
Source: St. Louis Fed
As we can see from the Fed Funds Rate chart above, interest rates have flat-lined since the financial crisis of 2008, which is part of a longer-term trend of declining rates which has been in place since the early 1980s. Each time rates were taken higher, a new high was made each cycle that was lower than the previous one, all but just one time. This time around, I doubt we will spend much time above 1%. It is currently at .79%. With total debt/GDP rising in the U.S. and globally, we can hardly afford a prolonged increase in interest rates. What this all means for the banks is that they will not benefit from the current trend of rising rates for much longer. The trend will last far less than many might expect.
Rising interest costs also means that consumer spending on certain items may start to soften. For instance, car sales, home renovation might all become less-desirable for many families as recent and future home buyers find that mortgage costs are going up. In these conditions, taking out new car loans or home equity loans in order to finance home renovations will seem less desirable.
Looking at the specifics of where the accumulation of debt is occurring in the U.S., it is clearly happening at government level.
Source: Money & Markets
Today the total debt held by the public is 77% of GDP (excluding intra-governmental debt), as we can see from the chart, the CBO seems to think that it will rise to 150% of GDP before 2050. This means that if we are to assume a low average interest rate of 2% on that debt, today it is costing us about 1.7% of GDP to service the debt, while by 2050 it will cost us 3%. This of course is under the assumption that interest rates will not go up, which I believe to be unrealistic. Even if central banks around the world will continue to try to push interest rates down, the sheer volume of new debt will make it more and more likely that interest rates will go up, because investors will want a risk premium. We are currently seeing this with bonds deemed more risky around the world. I believe the demand for risk premium will creep up the food chain and eventually it will reach the U.S. sovereign bond market. Rising interest costs at government level will mean that other investments will eventually be squeezed out.
From a global perspective, we have to understand that this in effect means that given a global population of about 9.5 billion and debt of about $1,140 trillion, we are looking at each and every human being on this planet carrying an average of $120,000 in debt by 2050. The average global per capita GDP is currently about $10,000. If we assume nominal economic growth will average about 3% per year, then by 2050, it will be about $25,000. I personally do not believe we will get there on debt or on per capita GDP. Both will be much lower.
We in fact have already witnessed a downshifting since the 2008 crisis, which will not be reversed, but rather further shift down in my view. What this means is that company revenues and profit growth all over the world will be greatly challenged, and people's investments with it. Within this context, one has to be very careful in regards to investment choices. The days of the diversified portfolio, which more or less mirrors the trend of the market, but people hope to outperform it, are over in my view. It may seem out of place to claim this, given that we are currently overcome with the Dow 20,000 euphoria. We should keep in mind however that it is just 70% higher compared with the high reached at the beginning of the century. When adjusting for inflation, it is not such an impressive gain for a 17-year period. Investment returns will become even less impressive going forward. Revenue growth will be a challenge, and so will profits as price competition is likely to become very fierce.
Success in investing going forward depends on identifying market bottoms within the economic cycles, in other words picking up investments near the bottom, as was the case in 2009-10. Individual sectors that see a selloff along the way, as was the case with oil in 2014 also present an opportunity. In this particular case it is a logical matter of identifying the longer term price needed to provide the world with the incremental barrel of oil. Once the price dropped significantly bellow that level, it became an opportunity to buy and hold for a few years and ride the recovery back above that oil price level needed to facilitate production growth in the longer term.
I recently also identified uranium miners as a potential opportunity to ride a market turnaround after a whole decade of decline. While it may be impossible to perfectly time such investments, given a flexible timeline measured in years, there are very good odds of such investment strategies beating the market in the longer term. I bought Ur-Energy (NYSEMKT:URG) last month as a first step toward building a position in the uranium sector. I will most likely continue to build this position this year and next, with the goal in mind to ride along what I believe will be a recovery, which either already started, or will do so in the next few years.
The challenging times that await us may not be entirely clear at the moment, given that we are very deep into an economic recovery, with the 2008 crisis now an increasingly distant memory. The Dow at 20,000 also set the mood for an overwhelming collective trend towards optimism. It will take many more years before the trend we are stuck in will become obvious, even though we have been stuck in it for a while, with only constantly declining interest rates masking the effects to a large degree. I believe that we will come to realize it in the aftermath of the next recession, as we will watch the global economy struggle to mount some sort of a recovery. It will be a recovery which will not feel like a recovery at all, but rather a permanent state of stagnation, with correspondingly stagnated investment opportunities. No matter how we look at it, the outsized rate of growth in global debt can only mean that hard times are ahead for most of us.
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Disclosure: I am/we are long URG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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