It is often said that the Global Financial Crisis (GFC) was caused by defaults on sub prime loans in the United States. Such defaults were merely symptoms of the underlying problem, rather than the cause, which of course was the over accumulation of debt by both businesses and consumers alike. Although investment markets have since seen significant appreciation since March 2009, it is now perhaps timely to review what, if any, improvements have really been made in the battle against the pernicious debt burden.
Household Debt in Australia
From an Australian perspective, household debt has only continued to increase, buoyed by a combination of first home buyers grants (now concluded), favourable domestic economic conditions and relatively low interest rates (now increasing). It is clear then that the Australian consumer has not really learned any lessons from the GFC and has not yet started to deleverage in any shape or form.
In fact personal credit continues to grow, exacerbated by rising asset prices. House prices in Australia remain among the highest in the world. In the short term this trend appears unlikely to change as housing demand in major capital cities continues to exceed supply. Further, the labour market remains buoyant. Nevertheless, US housing prices before their housing collapse were far lower in relative terms but still fell heavily as the recession, and the subsequent hike in unemployment, led to mass foreclosures. Should Australia enter a deep recession at some stage later this decade then it is not implausible to suggest that a similar experience could unfold. A recession can lead to high unemployment which would face severe pressure on the ability of mortgage holders to continue to meet loan repayments. Under this scenario, it is perhaps inevitable that forced sellers would exceed demand and lead to moderate, to potentially heavy, price falls (depending on the extent of unemployment).
The consumer's inability to deleverage is in stark contrast to the corporate sector, which is much advanced courtesy of the enormous capital raisings and asset sales that transpired during the GFC. In this sense the corporate sector (outside the banking sector which continues to lend voraciously to over indebted consumers) has perhaps learned the lessons from the GFC. This is a positive for investors as the corporate sector is in better shape to weather another downturn should one arise.
Nevertheless, a large proportion of the corporate sector remains hostage to the frailties of the consumer. A large proportion of economic growth since 1960 has been driven by the increase in credit. Incomes dictate the degree of expenditure possible but, when combined with debt, expenditure (and therefore economic growth) can multiply. If household debt is reaching a crisis point then the ability to continue to fund further growth via debt is reaching a limit. At some stage consumers will have to reign in debt, which will reduce consumption and impact upon corporate profitability.
Critics would perhaps argue that we have overblown the potential risks as housing prices and the domestic consumer emerged relatively unscathed from the GFC. The reality of course is that a disaster was averted in Australia by virtue of the rapid and synchronised global response to the GFC. The flood of liquidity helped lower interest rates (where banks otherwise would have been forced to ration credit causing a large hike in interest rates) and fiscal stimuli assisted upholding demand (preventing much higher unemployment). So, in the face of escalating household debt, household income actually improved due to the lower interest rates. Despite much higher mortgages, individuals were able to meet repayments.
Clearly though we are reaching a tipping point. The ability for individuals to service loans is now severely curtailed should interest rates rise even modestly (defaults are likely to rise significantly should home loan rates rise above 8%), let alone if unemployment rises. Yet the timing of the tipping point remains difficult to predict. Debt levels have been very high now for the best part of decade. It is possible for growth to continue against this backdrop while asset prices continue to rise and employment prospects remain sound. Yet the warning bell has been rung. A period of high unemployment and/or high interest rates is all that is needed to convert this warning to a harsh reality.
Private Sector Debt in the United States
At first glance, the chart below represents the parlous state of the United States economy, showing private sector debt to GDP approaching an astonishing 300%. Private sector includes both business and household debt.
We contend that this chart is somewhat misleading because household debt to GDP in the United States is around 100% of GDP (and decreasing, albeit slowly, as the US consumer has started to deleverage) and therefore the balance must be attributed predominantly to the business sector.
But here is the distinction. Outside the finance sector, we know that the average balance sheet in corporate America is in reasonable shape. We also understand that debt in the finance sector (investment banks, hedge funds, banks) roughly doubled between 2000 and 2007. So the majority of private debt can be attributed to the finance sector, large parts of which have already succumbed to the financial crisis (banks and hedge funds have failed and much of the toxic debt has been dealt with or written off). Once figures are adjusted for these failures then actual private sector debt may no longer look quite as daunting.
Sovereign Debt - Australia
So far we have focussed on private sector debt. Much has been reported about the huge amount of borrowing undertaken by the government to spend our way out of the GFC. While public debt in Australia has increased, it is unlikely to exceed 10% of GDP at its peak which means that the actual cost of servicing the debt is unlikely to exceed 1% of GDP. This is not only relatively low in a historical context but also very low in a global context.
This means that the Australian Government is on a strong position to be able to fund further initiatives should they be required in the event of another crisis.
Sovereign Debt - Global
Contrast this with the position in the United States and Europe where public debt levels are significant.
Public debt in the United States and Europe has exploded since the onset of the GFC due to massive stimulus packages and plummeting tax receipts. By bailing out the banking system and selected corporates, governments have simply shuffled the debt from the private sector to the public sector, creating new and arguably more hazardous policy challenges.
As of early 2010, US public debt to GDP has been estimated at 63% of GDP. If we assume an average interest cost on this debt (over the longer run) of roughly 4% per annum, then the annual cost of servicing this debt equates to 2.5% of GDP. On the face of it this does not sound too high. However, tax receipts only equate to around 15% of GDP which means that 17% of all tax receipts are effectively applied towards debt servicing. Compare this against the actual 2009 budget data where interest repayments on government debt equated to only 9% of all tax receipts due to the very low interest rate environment.
Sovereign debt problems are not a new phenomena. There have been some 87 defaults over the past 200 years. However, the number of countries experiencing financial difficulties (including Portugal, Italy, Ireland, Iceland, Greece, Spain and much of Eastern Europe; not to mention the United States and Japan) would suggest that a tipping point has been reached. The situation becomes much worse if we take into account unfunded liabilities (assets required to fund existing retirement, health care and education liabilities into the future) as shown below:
The only sustainable way forward is for the public sector in much of the developed world to start to deleverage. Deleveraging will require a combination of the following:
- reducing expenditure
- increasing taxes
- initiating reforms (such as user pays systems that transfer costs from the public sector to the private sector)
Such actions reduce private sector incomes and are politically unpopular. Further, such measures typically detract from economic growth and so, at least in the short run, reduce tax receipts making the task of reducing debt even more onerous. Yet the risk of inaction (defaulting) is greater so the countries concerned have little or no choice. The imbalances must be addressed if there is any hope of providing sustainable future growth
What is going to be the likely impact on financial markets?
It is clear that the much of the economic growth since the 1960's has been fuelled by the global debt boom. It also clear that the necessary deleveraging that needs to take place to provide sustainable future growth is, outside the corporate sector, not very advanced. Individuals and government alike have much work to do.
The risks for governments over this period are large and the prospect for enhanced social instability over these times is likely to be elevated. Further, the necessary reductions in government and consumer spending are likely to lead to below trend growth prospects over the coming decade. On balance, enhanced uncertainty as countries work their way through their financial problems is likely to generate greater volatility and the prospect of sub par growth is likely to result in more subdued returns. Under such circumstances the need for prudent stock selection (stocks with comparative advantages, high earnings certainty, strong cashflows and reasonable dividends) and asset allocation has perhaps never been so important.
Conclusions
To conclude:
- Australian household debt levels are at unprecedented levels (not dissimilar to US household debt levels). While the US consumer has started to repair its balance sheet, the Australian consumer has not.
- Having survived the GFC, the Australian and United States corporate sector (excluding the finance sector) balance sheets are in reasonable shape. "Public debt in Australia is low by global standards.
- Public debt in the United States and much of Europe remains high. The policy challenges for these countries in coming years are immense.
- Necessary reductions in government and consumer spending are likely to lead to below trend growth prospects over the coming decade. In turn, we would expect increased sharemarket volatility and more subdued shareholder returns.
For more information please do not hesitate to contact one of the members of our Wealth Management team.
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