“The inexorable trend of rising debt-to-gross domestic product (debt/GDP) ratios is becoming the single biggest risk factor in investment portfolios. High and rising peacetime debt levels are unprecedented, so much so that the next decade may look very different from recent history and long-term averages.”
The quote above introduces Unsustainable Global Debt, the white paper recently published by our Global Asset Allocation research team, which takes a deep dive into the causes and consequences of high and rising global debt levels (see Chart 1).
A short summary of the work might be “debt is fine until it isn’t”. Rising debt is what’s keeping both markets and the economy going, particularly in today’s COVID-impaired world with ballooning levels of public sector debt. But this cannot continue forever. There are only three ways to get out from under an excessive debt burden – grow your way out, default your way out or inflate your way out. The last looks like the path of least resistance over the long run.
While these debt-driven dynamics will play out fully only over a secular horizon, they are relevant to our investment decisions today. Below we discuss three elements of the active asset allocation positioning in our Canadian multi asset class funds that are being influenced by these dynamics.
1. Can’t be underweight equities
The wall of worry is high. Equity markets look expensive by most metrics. Tech stocks in particular may be frothy with retail investors crowded in. COVID19 may resurge and knock the economy back. The US election poses multi-dimensional risks.
But it’s not clear how much any of that really matters much to the broad market trend at this point. Governments around the world are spending and borrowing aggressively and central banks are effectively monetizing this. That money has to go somewhere. And equities don’t have much competition for those funds.
Through this lens, it is largely irrelevant where in the alphabet of growth trajectories we end up. The important point is the level of economic activity – which is what is mostly closely correlated to the unemployment rate – is almost certain to remain weak for a very long time. Official projections from the United States Congressional Budget Office, which incorporate a ‘V-shaped’ recovery, still see the US economy taking nearly three years just to get back to where it was at the end of 2019, nearly six years to recoup the output lost through that period and a decade or more to restore ‘full employment’. It is that level of GDP that matters above all to policy makers. And there appears to be no immediate barrier to them trying to lift that level through aggressive monetary and fiscal stimulus. In our view, that’s the basic story behind the market’s furious rally off the March lows. So long as the stimulus keeps up, equities have room to run.
What’s going to stop the stimulus? In a word: inflation. Governments have little incentive to rein in spending as long as borrowing appears to be cost-free. And central banks, acutely aware of both the limitations of traditional monetary stimulus and the necessity of fiscal spending to combat significant cyclical and structural headwinds, will do all they can to ensure this remains the case. Only when inflation forces central banks to respond with higher interest rates will the stimulus likely stop. This is true regardless of whether one adopts the established macroeconomic framework or the increasingly popular Modern Monetary Theory approach. But even then, recent central bank communications, including the first change to the Fed’s mandate in decades, suggest a longer runway for monetary stimulus even if inflation does start to pick up. So while inexorably rising debt levels mean that the inflation constraint should eventually bind, that doesn’t look like a major risk over the nearer term.
So for now, with all this money being pumped in, we think one simply can’t be underweight equities. There will be the inevitable corrections; turmoil surrounding the US election or a resurgence of COVID are identifiable risks in coming months. We will be looking to take advantage of fear-driven corrections to add equities in our funds.
2. Diversifying away from nominal bonds
In a world with too much debt and not enough output, interest rates must be kept very low for very long. Government and investment-grade corporate bonds can thus be expected to offer meagre returns. Moreover, the defensive role they can play in a multi-asset portfolio is diminished for three reasons. First is just arithmetic – with yields at low levels, there is less room for them to fall, thus limiting the scope for capital gains to offset capital losses in riskier assets. Second, nominal bonds are vulnerable to higher inflation, which would turn meagre nominal returns into sizable real losses. Third, higher inflation volatility would threaten the negative correlation between stocks and bonds that have made the latter such a useful hedge in a 60/40 portfolio in recent decades. As Chart 2 shows, that negative correlation is an historical exception, matching the historically exceptional period of low and stable inflation which may soon be nearing its end.
As a result, we are diversifying away from nominal bonds in the defensive components of our multi asset class funds in favour of the real assets that should be better able to provide both appreciation and protection in a world of near-zero interest rates and prospectively higher and more volatile inflation. These include inflation-linked bonds (TIPS in the US and Real Return Bonds in Canada) as well as gold.
3. Staying tilted outside of Canada
The debt dynamics holding sway globally are clearly at play here in Canada. Household and corporate debt has been rising steadily for years. Government debt is now joining the ‘party’ in trying to fill the massive hole blown by COVID19 in the economy. Borrowing across all levels of government in Canada spiked to 22% of GDP in the second quarter of 2020, contributing to a surge in total debt in the economy to nearly 450% of GDP (see Chart 3). Put in context, these deficit and debt figures are double what they were in 1992 – the year that Canada’s credit rating was cut for the first time by S&P. While borrowing will come down somewhat as the economy recovers, it can be expected that the level and trajectory of debt in the Canadian economy will be durably higher.
Does it matter that Canada is gorging on debt when everyone else is doing it too? Yes it does, because countries are not all doing it equally. Canada’s situation is worse than most. As of the end of 2019, even before the most recent splurge, Canada had an aggregate debt burden higher than in any G20 country other than Japan and France. The relative debt position of Canada vis-à-vis the US in particular has been an excellent leading indicator of the USD/CAD exchange rate, with Canada’s debt excesses of the 1980s and 1990s ultimately weighing heavily on the Canadian dollar (see Chart 4).
We have long been expecting Canadian dollar depreciation on the basis of excesses in housing and consumer spending in Canada, but the more important element may turn out to be the funding of those excesses through higher debt accumulation. You borrow from the future, you pay in the future. As such, we retain an overweight to foreign assets in our portfolios.
To summarize, the global trend towards higher debt may be necessary in the short run but looks unsustainable in the long run. As the resulting dynamics unfold, we will continue to evolve our tactical and strategic allocations, with the unwavering goal of maximizing return while managing risk in our Canadian multi asset class funds.