The Next Ten Years: It’s All About Debt
Podcast & Views - 14th May 2020
It is a strange time. On lockdown days and weeks blend into each other. One line doing the rounds on social media last Friday was: ‘in case you’ve completely lost track of the days, this Friday is the Bank Holiday Monday.’
For investors in these periods of crisis the sharp movements in the value of portfolios means we can become fixated with the short-term. The short-term does matter. We are likely to see the economy and stockmarkets move through various phases in the coming months. Anticipating how to invest through these changes is crucial.
However, the long-term also matters. In reality it is often these major events which shapes how the next decade unfolds.
Ten years ago, the Global Financial Crisis set the scene for a period where governments were working to cut spending, banks were being shrunk and the very innovative or very strong companies on stockmarkets became utterly dominant.
Throughout this period central banks were trying to reduce support to economies and governments were trying to reduce their deficits. Ordinary people bore the pain of this process with public sector workers – including our heroic NHS nurses – experiencing pay that was often falling in real terms. After this crisis the electorate’s willingness to put these workers in this position is going to be very low. Justice will be demanded for those who got us through this.
One of the most frustrating aspects of this crisis is that all that pain was experienced and now – in a matter of weeks – our debt levels are back up to where we started. Likewise, the steroids economies are receiving from central banks are even greater than in the Global Financial Crisis. In fact, in five weeks central banks spent as much money to support the economy as they spent in the first five years after the Global Financial Crisis.
The debt we carry now though is of a different character to that which we had in the run-up to the Global Financial Crisis. Now we are loading our debt not onto households and consumers but onto the government.
Here in the UK our deficit could well be above £300 billion a year after this crisis. For comparison, in the year before it was around £48.7 billion.
Clearly, this will shrink rapidly as people are pulled off the furlough scheme. But debt levels will still be huge.
The single biggest issue for investors in the next decade will be how governments choose to tackle this debt. This will determine what happens to interest rates, to inflation and to economic growth. The three things that have the biggest long-term impact on stockmarkets.
It is common to say that there are only two ways to tackle debt; with taxes or with spending cuts.
This sounds true, but it’s not. Actually, the government has at least four options. The first two are straightforward.
- They could default on their debt. We hope they will not choose this route!
- They could tighten conditions for ordinary people either by raising taxes or cutting spending. However, the size of the debt we now have means that getting it down through this method alone is likely to prove politically impossible. This approach also slows growth. Indeed, most countries have already given up. In 2012 some 25 advanced economies were squeezing their electorates through this ‘fiscal tightening’. By 2020 this had fallen to none.
The next two options are a bit more complicated, and not understood by the vast majority of taxpayers. To understand them we need to remember that what governments work to do is reduce their ‘debt to GDP.’ This is the amount of debt we have relative to how big our economy is. And there are two ways to reduce our debt to GDP that do not involve taxes or spending.
- Reduce the cost of government debt by driving down interest rates. This makes the total debt we have cheaper and means that when old debt needs to be re-paid it can be transferred into newer cheaper debt. The debt we have then weighs less on our ability to grow our economy.
- Get our growth up either through creating inflation or by genuinely doing innovative things that create real wealth in the economy.
The second two approaches have been what has been attempted alongside austerity over the last ten years. However, now there is clear evidence that both political parties are largely giving up on austerity. Yes there might be some cosmetic attempts by the chancellor to put in place a ‘Covid tax’ after this crisis but in reality the size of our debt is so vast that it will be these second two tactics that will have to carry most of the load.
So how do governments get down those interest rates? They can get their central banks to buy their own debt and they will do a lot of that. If they can do this without sending inflation sky-high then it is an incredible way of eating our own debt. Many people say this will end in tears, but it is worth noting that we are ten years into trying this and so far, it is working. Secondly, they can force others to own the debt. They do this principally by forcing banks and pension funds to own government debt in order to be deemed ‘safe’.
How do they boost growth? They can do this through infrastructure spending and actually reducing taxes. They are also likely to do this through spending a huge amount of money on environmental policies.
So, what does this mean for investors? Firstly, governments are going to push interest rates lower and lower and they have a lot of techniques still to deploy to achieve this. Secondly, they are going to work hard to get growth up – meaning that ultimately, they are likely to create inflation.
Investors can position for this reality by investing in those companies that rise the most when interest rates are falling – quality growth stocks. They can also position by owning bonds that are of a longer-duration (meaning are long-term) which will rise in value when interest rates fall. This pattern is largely what was in place before this crisis, but it is now turbo-charged.
Of course, in order to get to this new reality, we have to move out of this initial period of crisis for markets. There will be some important and specific trends in investments for us to tackle before we get to it.
But ultimately, we can expect governments to force down interest rates and try to force up growth. They need that growth to grow faster than the cost of their debt – it’s the only way out of this situation. Our priority is to be clear-headed about the sorts of investments that will thrive when that happens, and those that won’t.