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The End of the Debt Supercycle

According to Deutsche Bank, about $15 trillion of government bonds worldwide now trade at a negative yield (Exhibit 1), encouraging debtors to increase their borrowings further but, at the same time, creating massive problems for investors around the world – particularly defined benefit (DB)  pension plans which rely on bonds to provide a reasonable level of income to honour their obligations.

Exhibit 1: Total negative government bond debt, worldwide
Source: Deutsche Bank Research, August 2019

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As a consequence, we have decided to launch an offshore investment fund that will focus on private credit opportunities, which should result in annual income streams to investors of 5-7%. In the following, I will not discuss the new fund, though. That will be covered in a separate paper, to be published over the next few weeks.

In this paper, I will explain the nature of debt supercycles and why we are coming to the end of the current supercycle. I will also go into some of the implications of that, for example the fact that more and more credit is provided away from commercial banks. Most importantly, I will argue why interest rates are likely to stay low for many years to come.

Examples of ‘recent’ debt supercycles

Debt supercycles last on average about 60 years (Source: Ray Dalio, Bridgewater Associates). In the West, the last debt supercycle prior to the one we are currently in came to a crescendo with the panic on Wall Street in 1929. The Federal Reserve system had been established not that many years earlier and unwisely stood by as access to credit was too easy throughout the 1920s.

In the years following the Wall Street collapse in 1929, economic conditions gradually deteriorated, and it all culminated with the breakout of World War II in 1939. In the years following the war, a new debt supercycle was formed – the one we are now at the tail-end of.

In the West, the debt supercycle before the one that ended with World War II came to an abrupt end in 1873 when the US financial system collapsed. A massive build-up of debt in the 1850s and 1860s to finance the expansion of the US railroad system led to overconsumption and asset speculation. It all culminated in 1873 – an event that is now known as the railroad crisis.

Debt supercycles are necessarily global in nature. The debt supercycle collapse best known to the current generation of investors is probably the one in Japan in 1989 which resulted in a catastrophic decline in equity and property prices. Now, 30 years later, the Japanese economy is still reeling from the consequences of that debacle.

Neither are debt supercycles anything new - they have existed for thousands of years. They even get a mention in the Old Testament, which described the need to wipe out debt every 50 years. In the old book, it is referred to as the Year of Jubilee.

In the following, I will take a closer look at those three debt supercycle collapses – 1873, 1929 and 1989 respectively – and I will go into why present conditions are uncomfortably similar.

The DNA of debt supercycles

All debt supercycles start with (many) years of healthy borrowings which stimulate economic growth. It actually makes perfect sense that, as the overall economy grows in size, so does debt.

In that context, I should point out that, in the early stages of a typical debt supercycle, a dollar of added debt leads to approximately a dollar of GDP growth – the two always grow hand in hand in the early stages of a supercycle.  

The healthy borrowings in the early stages eventually turn unhealthy. Excesses begin to creep in as borrowers assume the good times will continue forever. As a result, they continue to borrow, even if they cannot always afford to do so. Let’s call that the bubble stage.

Four conditions are typically prevalent during the bubble stage:

1. Debt grows faster than income.

2. Equity markets rally.

3. The yield curve flattens.

4. Monetary policy is too lenient.

What is particularly worrisome is that all those four conditions are prevalent at present. Allow me to zoom in on the first one which is not very well understood. As I pointed out earlier, during the early stages of a debt supercycle, GDP and debt grow more or less 1:1.

The ratio drops fairly steadily as the supercycle matures and is typically below 0.5 in the bubble stage. When you approach the end of the debt supercycle the ratio is usually below 0.3. In that context, I note that Chinese and US GDP have both recently grown less than $0.25 for every dollar of added debt.

Eventually, the bubble bursts. Economic agents (mostly consumers and corporates) no longer react to central bank policies the way the theory books prescribe. Consequently, monetary policy becomes inefficient. This was a condition first recognised by central bankers in the 1930s, and they even coined a phrase to describe it - Pushing on a String, they called it.

You are now at the very end of the debt supercycle. When that happens, a very painful phase of debt destruction begins (more on that later).  Debt destruction can take place through defaults or inflation. There is no benign way out of a debt supercycle.

The behaviour of interest rates in debt supercycles

Interest rates behave similarly in debt supercycles – particularly towards the end of the supercycle where they always fall significantly. In the aftermath of the three panic years mentioned above (1873, 1929 and 1989), bond yields dropped to about 2% in all three instances (Exhibit 2).

Exhibit 2:	10-year government bond yields following the panic year
Exhibit 2: 10-year government bond yields following the panic year
Source: Hoisington Quarterly Review and Outlook, Second Quarter 2012

In that context, it is quite telling that interest rates continue to drop and that $15 trillion of government bonds worldwide now trade at negative bond yields (see Exhibit 1 again).

Longer term, the pattern is also quite similar across debt supercycles. As you can see from Exhibit 2, 20 years after the panic year in those three debt supercycles, 10-year government bond yields were only 2-3% and had on average risen only 1% from the panic year (Source: Hoisington).

Common characteristics of late-stage debt supercycles

Low bond yields, low risk premia on risk assets, plenty of misallocated capital, decelerating productivity growth despite being in the midst of a digital revolution and anaemic GDP growth despite interest rates being so low, are all powerful indications that we are in the very late stages of the current debt supercycle.

If economic agents choose to address this problem by taking on even more debt (as they have done so far), the higher level of debt will only serve to perpetuate the problem. Bond yields will continue to decline, and economic growth will continue to slow and may eventually come to a complete stop.

In the later stages of debt supercycles, central banks always resort to monetisation - see Exhibit 3 below as far as the last two US debt supercycles are concerned. At the very end of a debt supercycle, the mountain of debt is such a burden on economic growth that new tools come into play – tools like debt monetisation, financial repression and, more recently, quantitative easing (QE).

Exhibit 3:	US 3-year money growth (% of GDP annualised)
Exhibit 3: US 3-year money growth (% of GDP annualised)
Source: Principles for Navigating Big Debt Crises, Ray Dalio

Having said that, towards the end of all debt supercycles, economic agents (whether households or corporates) increasingly suffer from debt fatigue. The appetite for borrowing drops and, consequently, economic activity comes to a virtual standstill. It is a hard nut for policy makers to crack when traditional monetary policy tools no longer work.

The meaning of debt destruction

Debt supercycles always end with plenty of debt destruction. The slate needs to be wiped clean, so to speak. As mentioned earlier, there are only two ways debt destruction can be accomplished – either through inflation or through defaults. There is no benign way out of a debt supercycle.

The big challenge for investors now is to identify which path this supercycle is most likely to follow – default or inflation? I have had a few conversations with people on the inside – people with detailed knowledge of central bankers’ preferences - and the response has been the same every time. Central bankers prefer inflation over default – any time!

In the context of that, it is no longer so puzzling that some central banks appear to be behind the curve as far as interest rates are concerned. Knowing that there are very powerful disinflationary forces in place which are more than likely to prevent a repeat of the late 1970s / early 1980s where inflation approached 20%, perhaps they don’t mind letting inflation run a little bit?

How debt destruction through inflation works

Let’s assume inflation gathers momentum to 5% per annum and stays at that level for five years. Let’s also assume that property prices rise in line with the underlying rate of inflation. Finally, let’s assume we have bought a property worth £1 million which we finance with an interest-only mortgage. For simplicity’s sake, we’ll assume we can finance 100%.

After five years of property prices rising by 5%, the house is now worth about £1,276,000, but we still owe only £1,000,000 to the mortgage provider. From the lender’s point of view, in inflation-adjusted terms, the £1,000,000 he lent to us at the outset is only worth £783,500 after five years. That is essentially debt destruction through inflation.

Now, I wouldn’t for one second argue that debt destruction through inflation only has positive implications. In the example above, think of one person’s gain being another person’s loss. Or think back to the 1970s and think of all the negative implications of inflation being out of control for a while. Having said that, central bankers seem to know what they would prefer.

Precisely where are we in the current debt supercycle?

I am often asked the question why I don’t think 2008 was the panic year in this debt supercycle and why the phase we are going through now is not the extended period of very low interest rates that all debt supercycles go through? Those are indeed good questions. Could it be that the panic year in this debt supercycle is already behind us and that we are now going through the unwinding of all the excesses?

Looking at Exhibit 4, that would be the most obvious conclusion to draw. After some 60 years of rising debt when measured as a % of net worth, at least in the US, household debt peaked in 2008 and has since fallen meaningfully.

Exhibit 4:	US household debt as a % of US net worth
Exhibit 4: US household debt as a % of US net worth
Source: Principles for Navigating Big Debt Crises, Ray Dalio

I am not convinced, though. If all four economic sectors are included - not just the household sector - a very different picture emerges. In 2006 - the last year before the Global Financial Crisis began to damage the global economy - total global debt stood at $128 trillion. Ten years later, total global debt had risen to no less than $160 trillion (Source: Institute of International Finance). That sort of rise in debt levels has never happened before post the crisis year in a debt supercycle.

Financial instruments are more sophisticated today than in prior debt supercycles, and it is obvious that monetary authorities - and their associated governments - have taken upon them to shield the private sector from the worst implications of the Global Financial Crisis.

One implication of that is how debt has shifted around. Whereas total private sector debt in advanced economies has fallen since 2008, public debt has risen further. All other equal, that makes it more likely that the coming fallout from this debt supercycle is quite likely to be very different from any previous debt supercycle.

What could be the ultimate fallout in this debt supercycle?

At this stage, nobody knows precisely how we will unwind all the excesses of the current debt supercycle. In other words, what is to follow is pure speculation on my behalf.

We do know a few things, though:

In most OECD countries, the public sector is far more leveraged than at any other point in time. This is occurring at a time where more people than ever before are retiring from the workforce. In other words, in the years to come, the growth in income tax revenues will slow down and may even decline in the worst affected countries.

This will happen at a time where public sector budgets are likely be under immense pressure from the growing populace of old people. Here in the UK, according to the NHS, a man aged 80 is about seven times more expensive to them than a man aged 30. The public sector will simply be forced to cut back somewhere.

By far the biggest liability item on the public balance sheet is underfunded and entirely unfunded pension liabilities. I note that state pensions in the UK are 100% unfunded.

If we eliminate underfunded private sector occupational schemes from the equation, according to my source, total unfunded / underfunded pension liabilities (i.e. the money that can only come from UK tax payers) amount to more than £8 trillion - more than four times UK GDP.

That number has “accident” written all over it. It is obviously not a vote winner, so politicians won’t touch it with a barge pole but, sooner or later, somebody will have to. Otherwise unfathomable amounts of debt will be passed to future generations.

My guess is that the concept of state pensions will change dramatically, and that private sector workers with robust pension savings will lose the entitlement to a state pension altogether.

Furthermore, all members of underfunded DB schemes – whether public or private sector schemes – will at some point have to take a haircut, and the DB pension model will cease to exist.

Could that be the ultimate fallout of the current debt supercycle? Unless they can get inflation going again, so debt destruction through inflation becomes a viable escape route, I think so.

Niels C. Jensen

2 September 2019

Appendix A

The impact of excessive debt on GDP growth

In a famous study from 2012 (Source: Institute of International Finance), Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff concluded that, once public debt exceeds 90% of GDP for five years or longer (five-year periods were chosen to avoid any cyclical impact), debt becomes a barrier to GDP growth. In summary, they concluded that:

1. excessive (90%+) debt overhangs are associated with 1.2% lower annual GDP growth rates when compared to low-debt periods;

2. the negative impact on GDP growth is long-lasting – the cumulative difference after 23 years is 24%; and that

3. the implications on GDP growth are significant even when the countries in question are able to secure con¬tin¬ual access to cap¬i¬tal markets at relatively low real inter¬est rates.

As the authors concluded in the 2012 paper:

… our read of the evidence certainly casts doubt on the view that soaring government debt is as non-issue simply because markets are presently happy to absorb it.

In a world of rising indebtedness (Exhibit A1), much of which is public in nature, one should indeed worry about the longer term implications. In alphabetical order, the list of OECD countries suffering from more than 90% public debt-to-GDP includes Belgium (99%), France (96%), Greece (182%), Italy (128%), Japan (234%), Portugal (118%), Spain (95%), and the United States (109%) with the UK hovering just below the critical level at 86%) (Source: Institute of International Finance). I wonder whether all those countries will be able to dig themselves out of the hole again?

As regular readers of my work will know, at the most fundamental level, only two factors drive GDP growth, and that is workforce growth and productivity growth. Excessive indebtedness holds back GDP growth as it affects productivity growth negatively.

Governments (mostly) service their debt. Record low interest rates make them believe they can afford more debt than they actually can but, in reality, servicing all that debt siphons capital away from productivity-enhancing investment opportunities like education and infrastructure. And, over time, a poorer education system and an inadequate infrastructure will slow down GDP growth.

As Reinhart, Reinhart and Rogoff demonstrated in their 2012 paper, the impact on GDP growth is meaningful, and I don’t think it is a coincidence that the modestly indebted Scandinavian countries (36-39% public debt-to-GDP) continue to perform relatively well.

Exhibit A1:	Gross central government debt as % of GDP (advanced and emerging economies)
Exhibit A1: Gross central government debt as % of GDP(advanced and emerging economies)
Source: IMF, January 2019

Appendix B

Megatrend #1 and its associated sub-trends

The End of the Debt Supercycle was one of the first megatrends I identified when, years ago, I began to zoom in on the various megatrends that will impact the world as we know it.

Exhibit B1:	The End of the Debt Supercycle and associated sub-trends
Exhibit B1: The End of the Debt Supercycle and associated sub-trends
Source: Absolute Return Partners

Having said that, I quickly realised that investing in a megatrend is not that simple; one needs to identify the more investable sub-trends that are a direct result of the megatrend in question.

In the case of The End of the Debt Supercycle, over the subsequent years, I have identified no less than four sub-trends, all of which are a direct consequence of ‘our’ megatrend #1 (Exhibit B1).

Regulatory Arbitrage

As debt continues to grow faster than income, it is (most likely) only a question of time before all wheels come off. Regulatory authorities around the world have addressed the problem by forcing commercial banks to reduce the size of their loan books, which has led to the lending industry being re-shaped in recent years. All but the largest corporates now have to look elsewhere if they wish to borrow.

Consequently, as far as the middle-market is concerned, whereas commercial banks historically owned this market, that is no longer the case – particularly in the US which is ahead of Europe in terms of re-shaping the lending industry (Exhibit B2).

Given the European banking regulator’s desire to bring European loan books down to levels in line with those of the US, in the years to come, hundreds of billions of euros will have to be lent by direct lending funds and other non-bank sources of finance.

Exhibit B2:	Lending to middle-market corporates
Exhibit B2: Lending to middle-market corporates
Source: BlueBay Asset Management

Investment strategies that stand to benefit from this trend would include Regulatory Capital Relief, where parts of a bank’s loan book are sold to long-term investors like pension funds. The good news from the buyer’s point-of-view is that there are so many strings attached to these transactions that the buyer’s risk is quite modest. Regulatory Capital Relief also happens to be one of our favourite ways to invest in this megatrend.

Other investment strategies that stand to benefit from this trend would include Aviation Leasing, Music Royalties, Middle Market Lending, Trade Finance, Specialty Finance as well as various forms of Structured Credit.

Escalating Public Deficits

Economic theory prescribes that GDP = C + I + G + (X-M), but if neither C (consumer spending) nor I (corporate investments) will grow much in the years to come, governments may need to act. They can directly impact both G (government spending) and X-M (net exports).

There are (at least) two reasons why public deficits will escalate as a result of this megatrend. Firstly, populists (and the political arena is overloaded with populists these days) always spend loads of public money, and populists will most likely gain in popularity for as long as the middle classes struggle but more about that in megatrend paper #3 – Declining Spending Powers of the Middle Classes.

Secondly, when GDP growth is low or negative, even responsible governments increase public spending. It is called fiscal policy, and one shouldn’t expect government not to use fiscal policy ‘just’ because we are already drowning in debt – at least as long as interest rates are as low as they currently are.

Currency Wars aka QE

The first country to experiment with QE (Quantitative Easing) was Japan in the early 2000s. In the West, QE was first applied in late 2008 by the US Federal Bank in response to the Global Financial Crisis.

These days, QE is an active part of monetary policy in both Japan, Europe and the US. More recently, governments around the world have been criticised for not bringing QE to an end, potentially even replacing it with QT (Quantitative Tightening) as the Americans have done to a limited degree.

Governments have noticed the German export success story and believe it is based on a very competitive currency – the euro – which is held back by the weaker members of the Eurozone – particularly Greece and Italy.

All other equal, QE weakens the currency in question, but governments are facing the dilemma now that nearly everyone is doing QE; i.e. governments/central banks are afraid of putting a stop to it as the currency could rally and make the country in question uncompetitive. It is also worth pointing out that Germany has benefitted, not because of QE, but because the dodgy behaviour of one or two other Eurozone members has held the euro back.

As we approach the End of the Debt Supercycle, GDP growth continues to slow, and that’s where it becomes quite handy to manipulate your currency. Governments all over the world want to replicate the German export model and export their country out of trouble; hence the reluctance to end QE any time soon. In other words, QE has become (sort of) a currency war in disguise.

The tricky part is to identify investment strategies that stand to benefit from this sub-trend. In principle, CTAs should be able to benefit, but their systematic approach has not worked very well more recently – mostly due to low volatility in financial markets. Consequently, I think this sub-trend is most effectively adopted at the tactical level, i.e. how currency risk should be managed (i.e. hedged or not).

Structural Oversupply of Commodities

For all the reasons mentioned already, GDP growth will continue to slow and may ultimately come to a complete standstill.

Demand for most commodities is very sensitive to the level of economic activity – fossil fuels more so than most. As I make my way through the eight megatrends, you’ll see that there are other reasons why fossil fuels will be phased out over the next couple of decades, leading to a major investment opportunity.

Coal and gas prices will be worst affected. Both may go to $0 in our lifetime. Oil prices will be less dramatically affected, as a significant amount of oil is used by the chemical industry every day – mostly to manufacture various plastic products, although I note that a war on plastic products is also coming.

Other commodity products could also be negatively affected, assuming GDP growth remains pedestrian for an extended period of time. On the other hand, rising living standards in most EM countries should at least partially compensate for the slow growth across the developed world. In other words, I don’t expect other commodities to be as negatively impacted as fossil fuels.

In terms of suitable investment strategies, if you can afford to close your eyes now, only to reopen them 10 years later, I would go short all fossil fuels, but few investors can afford such a strategy. Adding to that, fossil fuels prices could quite possibly rise further in the near term, as supply problems continue to pester the industry.

Consequently, the most appropriate investment strategy seems to be one where one can go both long and short the various fossil fuels, but investment managers who specialise in fossil fuels tend to have a rather mixed track record (to say the least), so it is not as simple as it sounds.