The age of debt

The admonishment reflects a deep repudiation of debt, echoing the European protestant ethic of the Middle Ages. Much like modern Islamic Finance, Christians in the time of Shakespeare forbade lending with interest. Interestingly, they didn’t forbid borrowing. So, when they wanted to obtain capital, they would either take an interest-free loan from a rich friend or seek out borrowing from a different faith. And still, being in debt was demonised. The person who owed was often portrayed as a profligate Oscar Wilde-type or a failed businessman. The person who was owed to, a merciless Scrooge or Shylock. When it was the crown that owed, woe to the lender. 

Times have moved on of course. The Enlightenment brought with it the gradual removal of strict adherence to Christian scripture, but borrowing was still frowned upon. Twentieth century finance, especially after WWII, taught humanity that some debt can actally be good. Debt is the lifeblood of the economy. It takes idle deposits and turns them into productive capital. As such, it democratises capital, by taking it from the elite and giving it to business. Debt allowed the middle class, another creation of the twentieth century, to rise, and claim its place in the world. Those who, for the first time in two millennia, had acquired the right to vote for government, would also be empowered with some capital which would allow that choice to be meaningful.

However, both in terms of ethics and practice, excessive debt is frowned upon.

In principle, no amount of debt is prohibitive. I can borrow a few Pounds, throw them away in the pub, and default on my obligation to the lender. Or I can borrow 10x times my present capital and then go on to build a business that produces enough to pay off the debt and make a profit.

However, in practice, debt has natural limits. Once it reaches a certain point, it can’t be repaid, without the borrower suffering significant cutbacks which would prevent them from generating enough income to make their debt payments. Interestingly, this is only the first level of critical indebtedness. As interest payments are only a fraction of the total debt, often borrowers are compelled to borrow more, not less at this stage. This allows them to keep going. An entity like a corporation can keep refinancing its debt obligations as long as rates are low and borrowers have reason to trust it. Governments, who are allowed to print money to pay their debts, have an even bigger leeway. Eventually, though, there comes a point where financing dries up. Again, there’s a pecking order. An entity with an ‘Investment Grade’ bond is allowed more room to manoeuvre than one in the ‘Non-Investment Grade’ space. A company is more scrutinised than a government, as it can’t print money to pay off its debts. A country that can’t print its own money or owes a lot in foreign currency is also scrutinised hard versus a country whose currency is strong. A developed market, for the time being, has an advantage over an emerging market. The less one entity is judged harshly, the more incentive to accumulate debt, as it helps to grow without having to suffer the pain of cutbacks.

The problem with debt is that it’s highly addictive and tends to pile up. This, all economists agree upon.

But how much debt is ‘too much’?

For governments, a generic level is 60%-90% of GDP, at least according to the seminal work by Karmen Reinhard and Kenneth Rogoff ‘Growth in a Time of Debt’. They argue that when "gross external debt reaches 60 percent of GDP", a country's annual growth declined by two percent, and "for levels of external debt in excess of 90 percent" GDP growth was "roughly cut in half."

For corporations, a rule of thumb is that interest payments should be no more than a quarter of Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA). Mature companies with EBITDA lower than their interest payments are called ‘zombies’.

However, the answer to the question is much more complicated.

For one, it is a moving goalpost. It depends both on external factors, like the cost of debt, and a series of internal factors such as:

• a) Who the lender is. Is it a country, or a company?
• b) Who the borrower is
• c) The number of lenders for each borrower
• d) How the capital is deployed
• e) In what currency is the debt in?
• f) What are the covenants surrounding that debt?

Let us touch upon the tectonic change in the external environment.

In the past year and a half, we experienced a fundamental shift in the global inflation and interest rate regime. Lending rates, which we once, naively, thought would stay very low for decades due to the crushing amount of global debt, have risen significantly, as global inflation surged.

After 14 years of ultra-low interest rates and nearly 30 years of subdued inflation, price rises made their most dynamic comeback in over four decades. Markets, who hate instability, are finally realising that the era of geopolitical convergence is over, and in that respect, the world now resembles the 1970s. While it will probably not be as bad (the 1970s also featured a departure from the Gold Standard), the inflation and growth backdrop is much more uncertain than before the pandemic.

The first wave came after the first phase of the pandemic, in early 2021. Global lockdowns threw global supply chains into disarray. This happened at a time of two major shifts in the backdrop: the world’s transition towards sustainability, and China’s geopolitical drift away from the West which has compromised its position at the heart of the global supply chains. That first wave was deemed ‘transitory’ by central banks. By December 2021, however, it was becoming apparent that this inflation would take some external effort to break, forcing central banks to end the zero-rate regime and promise rate hikes. Before they fully embarked on that effort, the war in Ukraine caused a spike in global commodity prices, causing a second wave of inflation on top of the first one. With the labour market tight, with participation rates falling during the pandemic, and consumption strong due to pent up savings from the pandemic, it didn’t take long for supply pressures to turn into demands for higher wages and thus more persistent demand-side pressures. Inflation in developed markets peaked at around 10%, a level unheard of for decades. Interest rates rose at the fastest pace since 1981, crossing the 5% level in the UK and the US.

At the time of writing the wave is subsiding, as consumers are running out of the extra pandemic savings and unemployment has marginally ticked up, especially in the UK. All other things being equal, this would lead to inflation subsiding. However, fresh tensions in the Middle East are threatening a third wave of inflation. The Pax Americana, forged after the demise of the Soviet Union, has effectively collapsed, the world is unbalanced and thus inflation has become unpredictable.

This means that interest rates are also unpredictable. In a world laden with debt, interest rate unpredictability can be especially damaging.

So the answer to the question ’how much debt is enough’,  is ‘less than it used to be’.

The question is far from theoretical. The world of investments and the global economy consist of two fundamental financing materials. Debt and Equity. Equity, stocks, are considered the riskier asset class. They give out better investment returns but they are also riskier. A stock will, typically, offer a nearly double return than bonds for triple the theoretical risk. Bonds, on the other hand, are considered the ‘safe’ asset class, as they come with other advantages:

• Their risk/reward profile is typically better versus equities
• Their return, if held to maturity and with no default, is perfectly predictable

73 percent of bonds issued are sovereign, issued by nations rather than corporations. After 1971, when the global currency regime was liberalised, countries were allowed to print as much money as they wanted. This, in practice, means that most countries can’t go bankrupt directly, as they can, in theory, print enough money to pay off their debts.

That’s why government bonds are called the ‘risk-free’ asset. As such, they are the cornerstone of global portfolios. Organisations such as pension funds and central banks are limited to mostly buying local debt. Even private investors, who from 2000 to 2016 saw bonds outperforming equities (5.2% against 4.6% per annum on average), and who generally are more conservative than in the past, have become more prone to debt.

The pre-pandemic years were special, if not unique, in the history of debt accumulation. As capitalism came near the brink of collapse in 2008, central banks floored interest rates and started buying government debt in the open market, suppressing yields. The ZIRP (Zero-Interest-Rate-Policy) period lasted for almost 12 years, from 2009 to 2021, with a brief -albeit failed- attempt to hike rates in 2018. This led to a significant debt binge. While the world ‘learned a lesson’ and deleveraged quickly following the Global Financial Crisis, after 2012-2013, it started loading up on debt, especially in the United States. Overall, US large caps are $1.2tn in debt, almost at the 2008 levels. And while banks deleveraged, sectors such as healthcare, utilities, consumer staples and consumer discretionary loaded up on debt in the past few years. The rest of the world was slower to catch up, starting from 2015 onwards (at the time when the EU would follow the Fed’s example and print money). Since 2015 global large cap debt levels have risen 42%, but just half that if we exclude the US.

However, the more serious debt accumulation happened at a national level. Despite European debt woes, zero-percent debt is difficult to resist. Since 2009, debt-to-GDP in the US has risen from 90% to 120% and is projected to rise further to 137% by 2028 according to the IMF. In the UK it has risen from 76% to 106% and is projected to rise to 108% in the next three years. France was at 80% in 2008 and is expected to reach 110% by the end of the decade. All of these are certainly above the 60%-90% government debt-to-GDP level Reinhart and Rogoff have set.

In terms of total debt-to-GDP (including household debt), this has gone up from 225% in 2000 to 340% in 2023. At the height of the pandemic (when GDP was crushed) the figure was as high as 360%. It is clear that the developed world has passed into the second phase of debt accumulation, the part where debt accelerates to pay for debt. At this stage, borrowers are judged more harshly. Stronger currencies, such as the US Dollar, can afford to borrow more, whereas eurozone countries, contained by the Stability Pact, are facing higher scrutiny from the bond vigilantes. When the borrowing happens outside the government, the government can step in. But when it is the government that has overborrowed, then where does that leave debt markets?

Since the end of 2020, the bond market has been coming off a 30-year rally. US Treasury bonds (for which we have ample data) lost over -24% from peak to trough. This is by far the worst performance in their 200-year history. The second worst was a drop of -19% during a 12-month period ending in May 1861, when the South attacked Fort Sumpter and the US was on the brink of dissolution. Most of the bond bear markets, in fact, were marked by historic events. The end of the Spanish Dollar as a commonly accepted currency in 1835, the Iranian Revolution in 1791, the Wall Street Crash in 1931, the War of 1812, when British soldiers burned the White House, Black Monday in 1987. And none of these ever came close to the bear market that we experienced when, after 14 years of Federal Reserve intervention, the US central bank took its hand off the scale.

The longer the bull run, the more overpriced long-term assets become. But this didn’t happen to tech stocks, NFTs and cryptos or even real estate. It has happened to the Risk Free, including the US 10-year Treasury, the bedrock of modern portfolios.

And it’s not just inflation and interest rates driving the drop. Global geopolitical entropy is increasing, leading to an unbalanced world. Incidents which were isolated may now have wider and more unexpected repercussions.

The US 10Y is reaching the 5% yield mark. It was not long ago when we all agreed that we would begin looking at the US 10Y it when it crossed the 2.5% mark. A generation that hasn’t seen a yield is now enticed by it. Sage investors will of course go for the yield, which means they will only be concerned for the amount of time they are willing to part with their money. They already acknowledge that bonds are very volatile right now, and are well-warned by JP Morgan’s Greek boss Jaime Dimon that yields could hit 7%.  

This is not bad news for bondholders, per se. Many are locking in high yields, especially at the shorter end, as the yield curve has been inverted (short-term bonds yielding higher than long-term bonds). Many are also locking in high yields over the longer term, hoping for not just the yield (they can get it higher at the shorter end), but also capital appreciation if yields fall (and prices rise).

At the back of most investors’ heads, however, the Fed is still in control of the yield curve. After all, with Quantitative Tightening it can control the demand of shorter-term issuance. And if it decided to buy long bonds again, as Gavekal’s Louis Gave suggests might eventually happen, in order to monetise the huge debt, it could control both ends. So when purchasing a bond, many think that the yields will stop rising when the Fed wants them to.

However, the US central bank has changed its rhetoric. The moral of the story is that when inflation is not under control, the central bank is not in control of yields.

The Fed’s lack of control is not difficult to substantiate:

1. Inflation in the US is creeping higher for the third straight month. And even though the super-core inflation (ex food, gas, housing) is stable, we could be faced with a third inflation wave that has yet to translate into renewed demand-side pressures.
2. At the long end, especially where the Fed is absent, the US government is present with an increasing supply of debt, possibly more than the market can digest. Every month, US government institutions are price-insensitive sellers of debt worth $220bn. $21tn of Federal debt needs financing from someone else other than the Fed, which is contracting its own balance sheet at the pace of $60bn per month. A recession can cause an additional need for $1.5tn of debt per annum. Can the market digest all this debt issuance?
3. Presently, there are two major wars, in Eastern Europe and Israel, that affect energy and food prices. The geopolitical backdrop is as unstable as the 1970s, if not more so. Wars are inherently inflationary.

The beauty of bonds is that they promise an exact return if held to maturity. But those who buy with thoughts of capital appreciation must be very careful. They need to remember that the central bank is now a seller, not a buyer. They face a hawkish Fed and unpredictable inflation. The yield they get is hard-earned. Investors need to be prepared to hold the long bond to maturity, 10 or even 30 years, to get the return promised and hope that inflation will not diminish the capital.

Meanwhile, the US yield curve, which had been inverting for over one year, is now in the process of disinverting. This is usually the precursor to normalisation. What does normalisation look like in the post-QE world?

It definitely signals a world of higher rates. We have entered an era of higher inflation due to rising geopolitical tensions, as East and West have stopped working together towards a globalised future. Additionally, the world is gearing up for further capital expenditure due to the green transition.

So, as debt has entered the second phase of accumulation and with the need for additional capital expenditure, all in an uncertain inflation environment, it is easy to imagine the world going forward as a higher-interest rate place. The Federal Reserve, which can monetise debt by reverting to Quantitative Easing, has shown no inclination to put its hand so heavily back on the scale. It would take a 2008-like catastrophe to change that position.

The bigger question though is not rates, but rather the amount of debt accumulation. What is the debt endgame. Especially in the US which has been running high deficits for a long time. Rising debt, which is already eating severely into growth, has an eventual limit.

The answer, historically, is that ’this time is different’. In the past few centuries, excessive debt accumulation has led to episodes of wide debt forgiveness. However, in the twentieth and the twenty-first century, debt has become so ingrained in overall business, that wider debt forgiveness is unthinkable.

This means that the debt endgame will be complex, and it will ultimately come down to sheer power. Countries with strong currencies will be able to withstand higher debt. Countries that are important geopolitically will still be able to sell their debt as the risk-free asset. On the other hand, countries that are weaker will be judged more harshly by bond vigilantes. Like Greece and Italy, others will have to curtail expenditure, even lose part of their GDP, and even risk internal defaults.

George Lagarias, Chief Economist

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