Last Stages of the Debt Supercycle - October 2022 Update
He who is quick to borrow is slow to pay.
Issues to be addressed in this paper
When we published our very first megatrend paper in September 2019, I committed to providing an update every three or so years, so time is up. It would probably go down as the understatement of the year to suggest that nothing meaningful has happened on the debt front since 2019, so I should have plenty of interesting stuff to share with you.
Allow me to start with a brief quote from the 2019 paper, which introduced the concept of debt supercycles. I wrote “Most importantly, I will argue why interest rates are likely to stay low for many years to come.“ Ha! In the department of getting things wrong, this must be top shelf. I have made many dubious predictions over the years, but rarely have I made one which turned out to be further away from the truth.
Or maybe not? As I began to dig deeper in preparation for this paper, I noticed that those who understand the concept of debt supercycles the most (for example Ray Dalio of Bridgewater) actually refer to real interest rates – not nominal rates – and real rates are indeed exceptionally low at the moment.
For reasons I will explain below, we have now arrived at the panic stage of the current debt supercycle, and I will explain the implications of that. In this paper, I will repeat parts of the 2019 paper, as it is important that you fully understand the concept of debt supercycles, but you could certainly learn a lot more by reading the 2019 paper in full. You can find it here.
Common characteristics of late-stage debt supercycles
Debt supercycles have always behaved quite similarly – particularly towards the end of the cycle. Low bond yields, low risk premia on risk assets, decelerating productivity growth, anaemic GDP growth and plenty of misallocated capital are all powerful indications that we are approaching the end of the current debt supercycle.
If economic agents choose to address the 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. Real bond yields will continue to decline, and economic growth will continue to slow and may eventually come to a complete stop.
In the latter stages of all past debt supercycles, the mountain of debt has been such a burden on economic growth that new tools have come into play – tools like debt monetisation, financial repression and, more recently, quantitative easing (QE). Given how low (negative) real interest rates are at present, it is tempting to conclude that we are already engulfed in financial repression.
Towards the end of all past debt supercycles, economic agents have increasingly suffered from debt fatigue. The appetite for borrowing has dropped and, consequently, economic activity has come to a virtual standstill. It is a hard nut for policy makers to crack, when traditional monetary policy tools no longer work. All past debt supercycles have ended with a rather brutal collapse, but there is no recognisable pattern as to what has caused the collapse. In the early 1870s it was an overleveraged rail network; in the early 1940s it was World War II.
The status of the current debt supercycle
As you can see in Exhibits 1A and 1B below, debt, both in absolute terms and when measured as a % of GDP, is higher than ever. (Global data for 2021 have not yet been made public, hence why 2020 is the end-year.) A few observations to be made on the back of those numbers: Total global debt now exceeds $300Tn, and the IMF recently warned that debt levels are now “dangerously high”. Total global debt includes government, business and household debt from all over the world.
Although we do not yet have full visibility post 2020, we know that, in 2021, debt levels continued to grow fast because of the COVID-19 outbreak. We also know that debt levels have continued to rise in 2022, at least partially because of the war in Ukraine.
In the early stages of a debt supercycle, there is plenty of borrowing, and most of it is actually quite healthy. However, eventually, the borrowings turns 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. That part of the debt supercycle is called 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.
Not that long ago, all four conditions were in place in the current supercycle, but the bubble has now burst, and we have instead entered the panic stage. In this last stage of the supercycle, 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 is 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.
How debt destruction through inflation works
When you enter the panic phase, you are at the very end of the debt supercycle, which always ends with plenty of debt destruction. The slate needs to be wiped clean, so to speak, and an extended period of debt destruction begins. Debt destruction can take place through default or inflation. There is no benign way out of a debt supercycle. All evidence suggests that we are ‘lucky’ this time. Inflation is doing the job for us, and I can assure you that debt destruction through inflation (think c. 1980) is less disruptive than debt destruction through default (think c. 2008).
Therefore, it is perhaps not so puzzling that some central banks appear to be behind the curve on raising interest rates. Knowing that there are powerful disinflationary forces in place which are likely to prevent a repeat of the early 1980s, where inflation peaked around 20%, being behind the curve could very well be a deliberate tactic, even if you will never get a central banker to admit it.
Let’s assume the annual rate of inflation settles around 5% for the next 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, for which we have paid £1 million, which we have financed 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 £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 late 1970s and early 1980s and think of all the negative implications of inflation being out of control for a while. The challenge for central banks now is to destroy as much debt as possible without losing control of inflation.
For every megatrend we have identified, we have uncovered a number of investable themes. In the case of the megatrend in question, three investment themes have been identified so far, namely:
- Out-of-Control Public Deficits;
- Regulatory Arbitrage; and
- The Productivity Conundrum.
Out-of-Control Public Deficits
Public deficits almost always get out of control towards the end of debt supercycles, as governments try to maintain economic growth by launching various public spending programmes. A good example more recently is Biden’s ongoing infrastructure programme, which is now in excess of $3Tn (almost 15% of US GDP).
The ageing of the populace can only increase the need for further spending. This poses a serious problem for many countries, which are more indebted than ever. When debt is high, you need the economy to grow briskly to service existing debt and, with rising interest rates, servicing that debt becomes a bigger and bigger challenge. Governments will therefore resort to all sorts of tactics to improve economic activity, as it becomes increasingly obvious that the private sector on its own won’t be able to deliver the necessary growth.
Given the growing reliance on electricity to fuel our cars and heat our homes, an obvious place to start would be to improve the reliability of the electricity grid which is sub-standard – both in the US and in parts of Europe (Exhibit 2). Having said that, as I noted in another recent paper, there is simply not enough green metal in the world to go 100% green. An obvious investment opportunity is therefore to invest in a mix of those green metals which are most likely to be in short supply in the years to come.
Infrastructure is also likely to offer a major investment opportunity over the next few years. Rising interest rates are putting a strain on public budgets, forcing more and more governments to think out of the box on its spending programme.
As debt continues to grow faster than income, it is only a question of time before all wheels come off. Regulatory authorities around the world have attempted to address the problem by forcing commercial banks to reduce the size of their loan books, which has led to a re-shaping of the lending industry. All but the largest corporates now have to look elsewhere, if they wish to borrow.
Consequently, commercial banks no longer own the corporate middle market (SME market). Particularly in the USA, increasingly in Europe, and beginning in Asia, SMEs have to look elsewhere for their borrowing needs. In the US, we estimate that about 90% of all lending to SMEs now takes place away from commercial banks.
Although that number is lower in Europe, as you can see in Exhibit 3 below, the gap is closing rapidly, and that is an opportunity investment-wise. The European banking regulator’s desire to bring European loan books down to levels in line with those in the USA will drive non-bank finance in our part of the world much higher in the years to come.
Investment strategies that stand to benefit from this trend would include Regulatory Capital Relief (RCR), 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 an RCR transaction that the buyer’s risk is quite modest. Even better, this is far from the only opportunity in the Regulatory Arbitrage basket. Plain Middle Market Lending, Trade Finance, Aviation Leasing, Specialty Finance as well as various forms of Structured Credit are all investment strategies that benefit from this trend and offer attractive opportunities.
The Productivity Conundrum
All else equal, increased international trade should lead to higher productivity, as most business is conducted where prices are the sharpest, and those prices will, to a significant degree, be dictated by the underlying productivity of the company in question. Right? Wrong! Precisely the opposite has happened. As international trade continues to grow (even if it is taking a pause at present), productivity growth continues to fall. Why is that?
It is indeed a paradox that productivity growth has slowed throughout the digital age, i.e. over the last 25-30 years. Could it be that advanced robotics have actually had a negative effect on productivity? No. There is plenty of evidence to suggest that companies that have deployed industrial robots are, on average, much more successful than non-adopters (Exhibit 4). That would hardly be the case, if robots had a negative impact on productivity.
Despite the rapid advance of robots, there are plenty of negative productivity agents in society these days. Productivity is hampered by an ageing workforce, by excessive amounts of debt, by outdated infrastructure, etc., etc. I believe those countries that suffer the least from all the negative factors will benefit the most from the digital revolution. From an investment point-of-view, one therefore needs to embrace new technologies like advanced robotics, AI, etc. This is, for the time being, more easily accomplished by investing directly in various listed companies than by investing in funds.
Final few words
The obvious question to ask, but also the most difficult one to answer, is the following:
What will most likely be the ultimate fallout in this debt supercycle?
A collapse of the DB pension system, which is grossly underfunded in many countries, is one possibility. A nuclear war between NATO and an increasingly desperate Putin is another possibility, although I (rather naïvely?) continue to rate it the most unlikely fallout. Another Lehman-like moment, starting in one of the most indebted countries, probably the USA or China, is a possibility I would assign a much higher probability to, but how high? It is impossible to put a number on.
This doesn’t imply you can’t take any precautions, though. Only days ago, I wrote a piece called The Implications of Declining Wealth-to-GDP and, in it, I discussed how I would structure a portfolio in a changing (highly inflationary) investment regime. The conclusions in that paper, which you can find here, can, almost word for word, be applied to this paper as well. The only asset class I would allocate dramatically different to, if I knew for certain that the endgame was up, is equities. In that case, I would allocate virtually nothing to that asset class.
Niels C. Jensen
19 October 2022