Investors should weigh hit of high government debt on markets
History shows previous waves of rapid escalation have ended in financial crises
After a big decline between February and June, consensus forecasts for global growth have stabilised, recent data suggests. Global equity markets have therefore continued their recovery path, fuelled by central banks lowering rates and the gradual reopening of some economies after lockdowns.
Though the pace of central bank monetary policy easing has stabilised, unprecedented fiscal support and falling government revenues have led to sharply wider fiscal deficits in several economies. The world is now awash with debt issued mainly by governments. It is tempting to believe that these high debt levels are sustainable indefinitely due to the current record low-interest rates.
Like most other economies, SA is expected to accumulate debt at a significant pace over the next 18 months. The debt to GDP ratio is forecast to reach 85% by 2022 — a level last seen in 1935, according to the IMF chartbook. The rise in government debt has been a necessary consequence of Covid-19, but do high government debt levels have an impact on the performance of financial markets? Unfortunately, yes. History tells us that previous waves of rapid debt accumulation have only ever ended in financial crises. Therefore, investors may have to start thinking of ways to insulate their portfolios against such a dreaded outcome.
The general lack of concern is caused by the belief that the authorities can successfully manage excessive government debt levels through innovative policies. In 1947 world-renowned economist Abba Lerner argued that very high government debt does not have to end in default. The interest burden that government incurs can be met by ... printing money. If inflation becomes a problem, the government can raise taxes!
A slightly modified version of this framework is being applied nowadays in modern monetary theory (MMT), which holds that the higher interest burden governments must pay can be met by the central bank significantly reducing interest rates. If investors, or banks, start fearing a government default and this prompts a sell-off of government bonds, the central bank can buy those bonds, thereby maintaining debt service cost at low levels.
Like nowadays, the three waves of debt began during periods of low real interest rates
Investors and banks will be left holding money instead of government bonds. The theory holds that the newly acquired money will not lead to a rise in inflation because investors will not invest, and banks will not lend into a weak economy. Therefore, without a sharp increase in inflation interest rates can remain lower for longer, and very high levels of public debt can be sustained.
History tells a different story, but due to selective memory modern theory is more likely to be given more weight when making investment decisions than the facts that transpired five decades ago. This is one reason it is essential to study long periods of history — to understand what can happen. According to the recent World Bank publication “Global Waves of Debt” there have been three major debt waves in emerging markets since 1970, and all three ended in financial crises.
Like nowadays, the three waves of debt began during periods of low real interest rates. They were often facilitated by financial innovations that promoted borrowing. These were the Latin American debt crisis of the 1980s, the Asia financial crisis of the late 1990s, and the global financial crisis of 2007-2009. Of particular concern for SA investors is that the countries that fared worst during these crises were those that had inefficient sectors with poor corporate governance, poor revenue collection, widespread tax evasion, public wage indexing and monetary financing of fiscal deficits.
While we cannot offer a crystal ball for assistance on the actions the authorities can take to manage the situation, we do believe there are ways investors can navigate this highly uncertain period. Investing is a challenging exercise when faced with unchartered waters, particularly for benchmark-cognisant domestic equity investors. However, the most important thing is to focus on getting a few basics right.
- Success in investing is driven by the ability to detect patterns in a noisy world and use them in investment decisions to deliver better returns. In our SA Equity Fund we continue to focus on the selection of growth companies. The growth factor performs better during the latter part of economic expansions or during early to mid-slowdowns (risk-off). During these risk-off periods investors are more cautious and safer assets such as US treasuries and the dollar benefit from a flight to safety. The value factor tends to perform well during an economic recovery or early expansion period (risk-on) when investors are likely to pay up for riskier assets.
- A comprehensive risk management framework is critical to an investment process. While we all want perfect forecasting models, most investment decisions are based on models that have low forecast power. We should thus not only consider the probability of being wrong but the consequences as well. We use scenario analysis to estimate the value of the investment portfolios we manage given changes to certain critical factors. Our portfolios have been positioned to ensure big changes in the oil price, gold price or currency do not lead to a substantial difference in the portfolio’s return compared with the returns of the benchmark.
Managing portfolios in a risk-controlled manner while pursuing a growth strategy is critical if we are to deliver the best outcomes for our clients in this season of darkness.
• Rabali is chief investment officer at Lima Mbeu Investment Managers.
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