Destabilising, dangerous debt or ‘new normal’?

We are still living with the fallout from the financial crisis that started in 2008-9. In the years that followed the crisis, expansionary monetary and fiscal policy injected unprecedented levels of cash into the financial system, helping to sidestep an economic depression. The secondary effect has been to swell corporate debt and inflate asset prices, exacerbating social and political tensions. Investors are now trying to spot the tipping point as monetary policy changes course.

It is easy to look at debt’s headline figures and worry. Global debt rose from USD115.9 trillion in 2007 to a record USD184 trillion in 2017, equivalent to 225% of Gross Domestic Product, according to the latest data from the International Monetary Fund. That, says the IMF, is the equivalent of USD 86,000 per person, or 2.5-times the world’s average per capita income. Most of the increase in debt over the decade 2007-17 was in the form of government debt with non-financial corporate debt accounting for another 41% of the rise, according to McKinsey data. The fear is that debt might tip economies into another recession.

It is worth remembering that global growth depends on global debt. The key issue, as Japan’s economy proves, is the capacity to finance that debt.

Rising debt levels and lower growth over the past twenty years or so have also increasingly limited central banks’ ability to tighten interest rates. Over time, the US Federal Reserve’s interest rates have peaked successively lower, as US total debt has expanded (see chart 1). While the correlation is not exact, the chart nevertheless points to a ‘new normal’ relationship between high debt, low rates and low growth.

When the financial crisis began, central banks printed money and cut interest rates into low-to-negative ranges, creating the conditions for cheap credit and allowing investors with access to loans to buy assets, which look expensive by historic standards. This has driven a more than 350% boom in the S&P500, for example, over the past decade.

Cheap money, narrowing options

Since 2015 central banks led by the Fed have been promising to phase-out liquidity and normalise monetary policy. Last week that policy path took a new turn.

Faced with market volatility and lower inflationary pressures, the Fed signalled that it does not plan to raise rates this year. The announcement simultaneously reassured investors that there is no risk of choking off market growth with a premature rate hike, while scaring them by cutting the growth forecast for 2019 from 2.3% to 2.1%. The difference between the Fed’s growth expectations and the White House’s forecast of 3.2% did nothing to reassure investors.

The European Central Bank’s guidance has already put rates on hold for 2019, lowered GDP forecasts and re-launched its liquidity injections.

How much is too much?

The last decade saw public debt levels fall in the wake of the financial crisis, and rise again in response to the availability of cheap money. On the corporate side, liabilities owned by non-financial companies have reached record levels as they have used cheap credit to invest in marginally profitable projects. One reason that public debt has risen is that governments bailed-out private debt in the wake of the financial crisis.

Now that record debt is with us, there is no consensus among economists on how much public debt is safe for an economy, nor at what point debt begins to undermine GDP growth. Indeed, there is an argument that the world is not suffering from too much government debt because, as long as economic growth outstrips the interest rate available on sovereign bonds, governments won’t have to impose higher taxes and can print money to finance spending.

Household debt, the US trigger for the global financial crisis more than a decade ago, is now more or less stable despite a decade of stagnant wages in developed economies. The subsequent increase in inequality means that a crisis caused by household debt might trigger a social problem, but is unlikely to be the catalyst for another systemic financial crisis.

Populism and contagion

Corporate debt may be different. Complicating the calculation for investors on the eve of 2019’s first quarter earnings season, are this year’s falling corporate earnings projections, which will inevitably make it harder for companies to service their debts.

This makes corporate debt a more likely candidate for the next tipping point. The problem may not be the quantity of debt, but its quality. Most of the growth in non-financial corporate debt has been at the ‘BBB’ level, the lowest end of investment grade quality. Outstanding ‘BBB’ debt in the run-up to the financial crisis accounted for around one-third of the corporate credit market. It is now more than half of the total. That makes markets vulnerable to a loss of confidence, which is then capable of pushing the lowest investment grade credit into ‘fallen angel’ territory, forcing many institutional owners to sell, making it more difficult for corporate borrowers to refinance, triggering a collapse in the price of credit.

One of the lessons of the financial crisis was that the contagion spread further and faster than most watchers anticipated.

While financial institutions have profited from cheap credit, allowing them to afford expensive assets, many consumers have not benefitted from the market boom, priced out by their inability to borrow. At a social level, rising debt and increasing asset prices have exacerbated inequalities, undermining trust in the financial system and contributing to political extremes in the name of populism. The question for markets then is, can conventional policy remedies still help economies in the face of profound changes in our societies? It looks increasingly likely that central banks might need to reinvent quantitative easing and create new monetary tools that will encourage both financial and social returns.