Billionaire hedge fund manager Paul Tudor Jones worries we are amid a global debt bubble and headed for some ‘scary moments.’ Sen. Elizabeth Warren sees parallels with today’s high debt levels and conditions existing just before the Great Recession. Former Fed boss Janet Yellen is concerned deteriorating corporate lending standards might be posing systemic risk. So, just how bad are things in the debt markets?
Debt falls into the category of never being a problem until, seemingly out of nowhere, it becomes a bad thing. A family might be over-extended financially, but so long as the monthly payments are on time, they can go about their lives impervious to the risks. Until of course the breadwinners lose their jobs and creditors show up at the door, demanding ‘their pound of flesh.’
Warnings about the national debt go at least as far back as the Reagan years, when the national debt ballooned from about 32% of GDP to 55%. Using the same Bureau of Economic Analysis data, the national debt is now about 74% of GDP.
Corporate debt has nearly doubled in the past decade, and now stands at about half of GDP. Globally, the ratio of debt to GDP is as high today as it was prior to the Great Recession. According to the FT, the composition of this debt has moved towards governments and non-financial corporations, and away from households and the financial sector.
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High debt loads are not just an American or European thing. According to the Institute of International Finance, emerging markets now represent more than half of the global economy and its debt has ballooned to 175% of GDP. Desmond Lachman of the American Enterprise Institute blames the Fed’s zero interest rate policy for exacerbating this recklessness.
The economy continues to chug along and worrying about debt can make one feel like a modern-day Cassandra. The deficit rose by 17% in the fiscal year just ended, and CBO projections show a trillion-dollar deficit this year. Yet even the Tea Party/Freedom Caucus, with claims of fiscal rectitude, seem unfazed by deficits, as most of their politicians voted for unfunded tax cuts. Apart from a few places like the Peterson Institute, being worried about debt mostly seems like a contrary position.
Nonetheless, I believe the global debt market is in a bubble and investors should be worried. Ever increasing government and corporate debt will eventually cause disruption. No one knows what series of events will serve as a catalyst for debt becoming a problem, but likely candidates include rising interest rates and a weakening economy, perhaps exacerbated by an Italian default?
A thought experiment: what if government bonds yielded 5%, instead of the current 3 ¼%, as the Head of JP Morgan believes will happen within a few years? Among many implications, the annual cost of simply meeting interest payments on the U.S. national debt would surpass the American military budget. Funding for other government programs would be crowded out by the need to service the debt.
In the corporate world, the BIS recently published a report showing that something like 12% of all companies in the developed world have difficulty servicing their debt. These ‘zombie’ companies remain active mostly due to low interest rates.
This is how debt can end badly for the corporate sector. If interest rates increased significantly, at some point the number of zombie firms might be reduced to late 1980 levels. In that hypothetical example, 10% of all publicly traded companies would go bankrupt. This is not a prediction, and interest rates may not rise meaningfully, but a combination of an economic downturn and rising interest rates could spell disaster for investors. Many non-zombie firms would also face difficulty in honoring their financial commitments.
Debt presents other potential problems. Studies show nearly all the growth in the developed world during the past 15 years has been fueled by debt. What happens when we reach our maximum capacity to take on more debt? It does not seem like demographics will bail us out? This is all within the backdrop of the Fed becoming less intrusive and pulling back from managing the economy. They are somewhat letting the free market take over and explains why interest rates have been rising.
Finally, the U.S. stock market is in the top 5% of most expensive stock markets since the Civil War. And even after a 10% drop year-to-date, government bond prices remain in the top decile of most expensive ever. Assets are certainly priced as if debt is not a problem.
Now, problems have a way of getting resolved over time, little by little. As a society, our strategy in dealing with intractable problems is to ‘kick-the-can-down-the-road’ and things often work out fine. Nonetheless, prudent investors should prepare for the worse and hope for the best. What does that look like? Start with asset allocation. Think in terms of risk-off assets such as money market instruments, short term government and investment grade bonds and fixed annuities. As a rule, the percentage of your assets in this category should comport to your age, or more. A 57-year-old should have at least 57% of her assets in this category, for example. The remainder of your assets should include risk-assets such as stocks, private equity, real estate and so forth.
Investors should become very picky and gravitate in the months ahead to the highest quality, lowest risk assets. In the stock market this can mean companies whose debt is rated in the AA to AAA range, or perennially profitable companies with little or no debt that earn more than their cost of capital.
Two companies with high credit ratings that are good long-term bets include Berkshire Hathaway and Johnson & Johnson. Berkshire is nearly as well diversified as many Index Funds, but without the zombie companies. J&J is well diversified in the health care sector and pays an attractive and growing dividend.
Two perennially profitable small cap companies with conservative finances are National Presto Industries, the munitions and small appliance manufacturer, and restaurateur Cracker Barrel Old Country Stores. Both are purely domestic firms with high dividend yields.
Stock market investors should avoid highly indebted companies and firms that have lost money in the past decade. The rising tide of the past decade has lifted nearly all firms, but it is unlikely this trend will continue indefinitely. Remember the period from September 2000 until May 2013? If you were invested in an index fund, you experienced a zero rate of return for those nearly 13 years.
In the bond market, it is time to take advantage of the yield curve and favor short term instruments. Yields are above inflation for the first time in a decade. Investment grade short-term corporate bonds yield about 3 ½%. The iShares 1-3 Year Treasury Bond exchange traded fund (SHY) yields about 2.8%. Inflation protected bonds guaranteed by the U.S. government are attractive. An easy way to own them is through an ETF such as the Schwab Strategic U.S. TIPS fund.
It is time to avoid owning low quality debt of any kind. If you own High Yield funds or ETFs, you should plan on liquidating them. Closed-end junk bond funds should be sold either now or later in January, as they might be subject to tax loss selling in December, thereby widening their discounts further. Finally, if there is a sovereign default in the developed world, de facto or not, gold will come back into vogue. Within your risk allocation, own some gold streaming companies that are debt-free such as Franco-Nevada Corp.