The most important question hanging over the market is, “When will we see severe government funding problems?” The downturn in global growth has been widespread among developed countries. Although the downturn was caused by high debt levels, the resulting problem is that the higher debt levels have been transferred into government institutions. US Federal debt in the hands of the public was $5.3 trillion 2 years ago. As of March, 2010, it was $8.3 trillion. And in 2020, the Congressional Budget Office estimates that it will be $20.2 trillion. Previous crises were mostly local or regional, allowing an escape mechanism through devaluation to increase exports. Canada solved its debt crisis in the 1980s by devaluing 16% and increasing exports as a percentage of GDP. Sweden, Asia (ex-Japan) and Mexico followed a similar formula (devaluing 25%, 46% and 48% respectively) in the 1990s in order to significantly increase exports. This time around, it is more difficult to devalue because essentially everyone is affected, and everyone faces lower trend growth rates (and lower demand) in export markets.
During WWII, the US Treasury capped the 10 year rate at 2.25%. Inflation averaged close to 6%. By 1952, US Government debt to GDP dropped from 120% to 66%. Back then the US ran a trade surplus. Capping yields and allowing inflation to rise are difficult solutions when you need to raise foreign capital.
Coincidently, now that the Federal Reserve is no longer buying mortgage backed securities and agencies (quantitative easing) and China is running its first trade deficit, it begs the question, “Who is going to buy additional US Government debt?” The answer is commercial banks. Banks currently hold only 2% of the US Treasury market. Back in the 1960s, they owned approximately 25% (admittedly, when the US Treasury market was much smaller in proportion to GDP). Although banks are reducing the size of their balance sheets, US Treasuries require no capital. Over the next year, expect US banks to fund most of the deficit.
As discussed in our February commentary, it is now widely accepted that high levels of debt to GDP actually slow economic growth. Nonetheless, there is little political will to restrict government spending to reduce debt levels. That would likely change when the US Government faces a funding problem. That problem may occur when private credit demand returns. The net margin on corporate and consumer loans is approximately twice that of government debt. Increasing private sector debt may crowd out the government because private credit is 2 ½ times government debt. When demand picks up, the Fed will drain liquidity and increase short-term rates, pushing up interest rates across the yield curve.
So when should we expect this to happen? Probably not for a while. Although we have seen some encouraging consumer data, high unemployment and slow economic growth will tamper consumer appetite for borrowing. US consumers are still in the early stages of a multi-year delevering cycle. In fact, we expect the savings rate to rise.
Corporations, on the other hand, have stronger balance sheets than consumers. Their increased borrowing requirements will probably be comfortably met by banks. And, should rising rates start to affect housing, expect authorities to reconsider some form of quantitative easing, perhaps directing banks and insurance companies to purchase more government bonds. While this would not be a formal interest rate cap, it would reflect a policy bias toward inflation and away from deflation.
High debt levels will be a cloud on the investment horizon for some time to come. But, don’t expect a cloud burst any time soon. Apart from normal market volatility, low rates should support equity values. That does not mean, though, we are in a structural bull market. Should the government have a funding issue and rates increase suddenly, expect a meaningful market decline. More likely, rates will remain subdued. Inflation protection, however, should be part of every portfolio.