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DEBT, GROWTH AND
INVESTMENT RETURNS
The Inconvenient Truth
Lior Jassur, DBA
Fixed Income Research Analyst
IN BRIEF
• Growth, inflation and rates — Economic growth and inflation have fallen
short of expectations, and long-term interest rates remain remarkably low.
Current yields on global 10-year government bonds suggest the markets
expect that both low inflation and low real interest rates will persist for
many years.
Erik Weisman, Ph.D.
Chief Economist and
Fixed Income Portfolio Manager
• High levels of public debt — High global public debt may be a
contributing factor in the growth shortfall, along with unfavorable
demographics, slowing productivity growth and underfunded pension and
health care obligations.
• Debt and growth — Research indicates there is a bell-shaped relationship
between debt and growth: Rising debt spurs economic growth; however,
beyond a certain point, additional debt has a negative effect on growth.
• Lower investment returns — The combination of low growth and low
bond yields for extended periods of time could lead to relatively low
nominal investment returns for both equities and bonds.
• Real returns —It is paramount that investors guard against mispricing risk
that chasing yield would produce and focus on real rates of return rather
than nominal return assumptions based on historical conditions.
The economic recovery from the global financial crisis (GFC) and the
ensuing recession has confounded most economists and market
observers. Growth in the United States and across the globe has
fallen significantly short of expectations, and short-term interest
rates have remained near zero for more than six years. In the United
States, for instance, annual GDP growth has been about 3.2% since
the Second World War but is now tracking in the 2% to 2.5%
range. Inflation remains stubbornly low — below 2% in the United
States, Europe and Japan — despite the highly accommodative
monetary policy measures undertaken by central banks in the
aftermath of the GFC.
JUNE 2016 / DEBT, GROWTH AND INVESTMENT RETURNS: THE INCONVENIENT TRUTH
Long-term rates are also remarkably low, notwithstanding the
significant liquidity provided by central banks: Yields are
currently (Q2 2016) around 1.85% in the United States, 0.15%
in Germany and -0.10% in Japan for 10-year government
bonds. Rates at these levels suggest the financial markets
currently expect that both low inflation and low real interest
rates are likely to continue for many years. Almost seven years
into the recovery, markets are not considering a return to precrisis levels of growth, inflation and interest rates in the
developed economies. The reasons for the growth shortfall are
not easy to parse, but frequently cited factors include
unfavorable demographics, slowing productivity growth,
underfunded pension and health care obligations and high
public debt levels.
Rates at these levels suggest the financial markets
currently expect that both low inflation and low real
interest rates are likely to continue for many years.
The challenges posed by high levels of public sector debt can
be categorized into two areas:
•Effect on economic growth: High debt levels result in
high debt servicing costs at the expense of government
spending in other areas, like infrastructure and
education. If higher taxes are required to cover debt
servicing, private sector investment and spending
decisions are also impacted.
•Risk management: Governments often borrow more in
the face of an external or internal shock to shore up
stressed financial institutions or provide fiscal stabilization
during a recession. If debt levels are already high,
additional borrowing can lead to a sovereign debt crisis.
In effect, a government’s ability to provide insurance for
its economy diminishes when it carries high levels of debt
during relatively benign periods.
In this paper, we focus on public debt and growth rates in the
G-7 economies1 and discuss the implications for investors of a
low-growth, low- return environment. The significant rise in
public sector debt in the developed economies is a trend that
predates the GFC. High and rising public debt-to-GDP ratios
are often associated with low economic growth rates.2 While a
lower-growth environment virtually eliminates the latitude of
countries to grow their way out of indebtedness, higher debt
levels also constrain governments’ policy options in response
to new crises, increasing the likelihood of future shocks to
the economy.
Growth trends lower
Rise in public sector debt
As shown in Exhibit 1, a marked uptick in public debt-to-GDP
ratios has occurred in all of the G-7 countries, barring Germany,
since the GFC. In France and Japan, the ratio of debt/GDP rose
during most of the pre-crisis period as well as in the aftermath
of the GFC.
Economic growth rates have trended lower during the period
examined, from 1985 to 2015. Exhibit 2 shows the rolling
five-year average changes in GDP for the G-7 countries.
Although the growth picture is complicated by the fluctuations
of the economic cycle, the trend is downward; post-crisis
growth rates are lower than during the pre-crisis period. GDP
per capita, a common measure of national well-being, has
similarly trended lower.
Exhibit 2: GDP — five year average year-over-year
change %, at constant prices
Exhibit 1: Government net debt-to-GDP
Net debt-to-GDP (%)
120
United States
United Kingdom
Japan
100
Italy
Germany
80
France
Canada
60
40
6
Italy
5
Germany
4
France
Canada
3
2
1
0
20
0
1980
7
United States
United Kingdom
Japan
8
GDP change (%)
140
-1
1985
1990
1995
2000
2005
2010
-2 1985
2015
1990
1995
2000
2005
2010
2015
Source: International Monetary Fund, World Economic Outlook Database,
April 2016. Data Jan 1985–Dec 2015.
Source: International Monetary Fund, World Economic Outlook Database,
April 2016. Data Jan 1980–Dec 2015.
—2—
JUNE 2016 / DEBT, GROWTH AND INVESTMENT RETURNS: THE INCONVENIENT TRUTH
Exhibit 4: Net debt-to-GDP and growth rates
120
100
2.5
3.0
2.7
2.5
1.8
80
60
100
40
68
Exhibit 3: The velocity of debt, G-7 average
20
5.0 x
0
GDP/Debt
21
Q1
35
Q2
Avg. Debt/GDP%
4.0 x
2.0
1.6
47
Q3
0.6
1.5
1.0
GDP Growth Rate (%)
Another way of examining the relationship between debt and
growth is to consider the “velocity of debt,” i.e., how much
GDP is generated per unit of debt. This concept is not unlike
the velocity of money, which measures the frequency with
which a unit of currency is used to purchase goods and services
within a given time period. The velocity of debt in the G-7
countries, measured as the ratio of nominal GDP to nominal
public debt outstanding, is clearly trending down (see Exhibit
3). In other words, less economic growth is being generated
per unit of debt.
relationship between debt and growth: Rising debt from low
levels helps spur economic growth, but beyond a certain point,
additional debt has a negative effect on growth.
Gov’t Debt/GDP (%)
Velocity of debt
0.5
Q4
Q5
0.0
Avg. GDP Growth Rate
Source: International Monetary Fund, World Economic Outlook Database, April
2016. Data Jan 1980–Dec 2015.
3.0 x
2.0 x
1.0 x
1990
1995
2000
2005
2010
2015
Source: International Monetary Fund, World Economic Outlook Database,
April 2016. Data Jan 1990–Dec 2015.
The period after 1980 in the G-7 is characterized by the
growth of debt markets, increased international trade and
globalization and new regulation and tax policies, as well as
acceleration in the aging of the population. These factors
fostered higher debt that initially supported GDP growth;
however, as the velocity of debt slowed, the debt became
growth detracting and increasingly unsustainable.
Debt and growth
In order to examine the relationship between debt levels and
GDP growth, we divide all the available combinations of debtto-GDP and GDP growth rate of the G-7 countries between
1980 and 2015 into quintiles.3 Exhibit 4 shows the average
debt-to-GDP rate and average GDP growth rate for each
quintile. These data show that GDP growth initially increases
when debt-to-GDP increases from an average of 21% to an
average of 35%, but as the debt ratio continues to rise, the
associated level of GDP growth declines. This supports the
findings of Clements, et al, 2003,4 who found a bell-shaped
At present, most G-7 countries have a very high debt burden,
along with an aging population and a declining labor force
growth rate. Consequently, the number of employed that can
help sustain the debt burden is rising at a slower rate or even
falling, a trend that is expected to continue, compounding the
problem of high borrowing. During the 1960s and 1970s, not
only was the debt burden less onerous, it was supported by a
proportionately larger labor force and a younger population.
The demographic trends in Japan and Germany are such that
their debt sustainability appears particularly strained.
Prior to the GFC, governments pursued policies that helped
offset some of the effects of unfavorable demographics. These
included tax cuts, deregulation and lower barriers to trade.
Many of these policies have been reversed amid a rise in
protectionist sentiment and regulatory oversight and a need to
fund ballooning debt burdens.
Long-term interest rates
Exhibit 5 shows the long-term interest rates (based on 10-year
bond yields) for each of the G-7 countries since the 1980s.
Although debt-to-GDP ratios have increased during that period,
the long-term interest rates in these economies have been
declining, reflecting the slowing rates of economic growth and
falling rates of inflation, as well as the liquidity provided by
central banks in the aftermath of the GFC.
—3—
JUNE 2016 / DEBT, GROWTH AND INVESTMENT RETURNS: THE INCONVENIENT TRUTH
Rise in interest rate risk
While nominal quantitative easing (QE) can buoy the financial
system during crises, QE is unlikely to lead to higher real
economic growth rates. This can only be achieved if QE funds
are productively invested in the economy. Failing this, the longterm effect of QE is simply a deteriorating debt-to-GDP ratio
and slower long-term growth rates. It is also unrealistic to set
inflation targets on the basis of historic growth and inflation
rates in the current context (e.g., the 2% inflation targets of
the European Central Bank and the Bank of England). The
probability of achieving these targets is likely hampered, given
the increased debt burden associated with QE.
A further consideration is that as yields have fallen, the
duration (interest-rate sensitivity) of bonds has increased,
with the effect that investors are now taking more interest
risk than they were during the global financial crisis in 2008.
Exhibit 6 charts the duration relative to yield for 10-year
government bonds for five of the G-7 economies, revealing
a fall in the yield per unit of duration. The decline in yield per
unit of duration indicates that investors are receiving lower
compensation per unit of interest rate risk for their bond
investments. In effect, the risk-reward relationship has become
less favorable for investors.
The limitations of monetary policy to address the growth
shortfall in the developed economies is becoming more
apparent with time. Along with this realization, there is a
growing sentiment that fiscal measures will need to play a
larger role in the overall growth policy mix. However, the high
debt levels in many cases place a very real constraint on fiscal
policy options. There is little room to maneuver.
The limitations of monetary policy to address the
growth shortfall in the developed economies is
becoming more apparent with time.
Exhibit 5: Long-term interest rates (yield on 10-year bonds, %)
United States
18
United Kingdom
16
Japan
Italy
14
Germany
Yield (%)
12
France
Canada
10
8
6
4
2
0
1980
1985
1990
1995
Source: OECD, data Jan 1980–Dec 2015. Data unavailable for Italy and Japan for full time period.
—4—
2000
2005
2010
2015
JUNE 2016 / DEBT, GROWTH AND INVESTMENT RETURNS: THE INCONVENIENT TRUTH
rate when estimating the weighted average cost of capital. The
equity risk premium — the excess return that stocks provide
over a risk-free rate like 10-year government bonds — has
historically been of the order of 4%.
Exhibit 6: The problem of low yields
Yield per unit of duration — global sovereign markets
United States
United Kingdom
Italy
Germany
0.14%
0.12%
Yield (%)
0.10%
While interest rates are expected to slowly normalize after a
period of exceptionally accommodative monetary policy, yields
are likely to remain low for the foreseeable future, given the
high levels of indebtedness and the effect this has on growth
and the inflation outlook. Nominal investment returns across
the board will likely fall short of those realized over prior
decades. The combination of low growth and low bond yields
for extended periods of time will lead to relatively low nominal
investment returns for both equities and bonds.
France
0.8%
0.6%
0.4%
0.2%
0.0%
-0.2%
2006
2008
2010
2012
2014
2016
Current estimates of annualized returns over the next few
decades are around 7% for U.S. large-company stocks and
around 4% for 10-year Treasury bonds, assuming 2% inflation
(i.e., a real interest rate of 2%).5 While some prognosticators
may differ a bit, most investment professionals expect returns
in the years ahead to be well below the long-term historical
annualized returns reported in the Ibbotson Stocks, Bonds, Bills,
Inflation 2015 Yearbook: 10.1% for large-company stocks and
5.3% for intermediate-term government bonds. If we take the
7% return expected for large-cap stocks and a 4% return for
bonds, it is unlikely the 7.5% return assumption used by many
investors will prove realistic.
Source: Barclays, data Jan 2006–April 2016.
Nominal investment returns across the board will
likely fall short of those realized over prior decades.
The inconvenient truth: Lower return expectations
Government bond yields are the basis for pricing most other
investable assets, as they are viewed as risk free. For instance,
corporate bonds are priced with a spread over government
bonds, interest rate swap rates are derived from government
bond yields and equity valuation takes account of the risk-free
Exhibit 7: Lower yields beget more risk-taking
Increasing complexity
Private
Equity 4% Real Estate
5%
Fixed
12%
Cash
27%
Private
Equity 12%
Non-US
Equity 14%
Fixed
73%
Fixed
52%
US Small
Cap 5%
Real
Estate 13%
US Large
Cap 33%
Non-US
Equity 22%
US Large
Cap 20%
US
Small
Cap 8%
1995
2005
2015
Expected return: 7.5%
Standard deviation: 6.0%
Expected return: 7.5%
Standard deviation: 8.9%
Expected return: 7.5%
Standard deviation: 17.2%
Increasing risk
Source: Callan Associates: 2016 Capital Market Projections
—5—
JUNE 2016 / DEBT, GROWTH AND INVESTMENT RETURNS: THE INCONVENIENT TRUTH
Conclusion
Investors will need to make a choice: Accept a wider range
of risks to obtain a target nominal rate of return or reduce
nominal return expectations for a given set of risks. In 2006,
a 5% yield on investment could have been achieved by
buying 10-year US Treasury Bonds; in 2015, a 5% yield
required investing in high yield bonds. In a high-debt, lowgrowth, low-interest rate environment, seeking absolute
returns based on historical results requires taking additional
risk: default risk, increased volatility of returns, liquidity risk,
duration risk, currency risk, subordination risk, etc.
This is illustrated by analysis conducted by Callan Associates
shown in Exhibit 7. Compared with two decades ago,
achieving a 7.5% return today requires that investors assume
three times the risk (based on the standard deviation of returns)
and manage a larger number of portfolio allocations. This may
provide beneficial diversification; however, each segment of the
asset allocation pie requires its own expert monitoring and may
not actually improve returns.
The current low-growth, low-yield economic environment will
likely persist for quite some time given the structural nature of
the factors underpinning these trends. At a time when the
limitations of accommodative monetary policy are readily
apparent, the high debt levels of most G-7 countries is a real
constraint on these governments’ ability to use fiscal policy to
address weak growth. Low growth, combined with low bond
yields for a protracted period of time, will lead to relatively
lower investment returns for both equities and bonds. Investors
may be tempted to chase yield and unwittingly take on more
risk in an effort to achieve historical rates of returns. Rather
than choosing this path and mispricing risk in the process, we
suggest investors focus on real rates of return on a relative
basis — and, where appropriate, reduce return expectations in
line with the current economic conditions. It is an inconvenient
truth: investment returns will almost certainly be lower going
forward than they have been over the prior decades.
Investors will need to make a choice: Accept a wider
range of risks to obtain a target nominal rate of
return or reduce nominal return expectations for
a given set of risks.
Against this backdrop, it is paramount that investors guard
against mispricing risk that chasing yield would produce and
focus on real rates of return rather than nominal return
assumptions based on historical conditions. Investment analysis
needs to be considered in relative terms. When government
bonds yield less than 2%, the relative value of a corporate
bond yielding 3% should be assessed on the basis of whether
the extra 1% yield compensates investors for the additional risk
rather than on historical corporate yields. Similarly, when using
a discounted free cash flow model to value an investment,
future growth rates and discount rates need to reflect a highdebt, low-growth environment rather than long-term rates
based on the last few decades, when growth was higher.
—6—
Endnotes
1
The Group of Seven (G7) refers to Canada, France, Germany, Great Britain, Italy, Japan, and the United States.
2
E xtensive academic research has focused on the macroeconomic implications of varying levels of government debt and GDP growth. Krugman, p., 1988. “Financing vs. Forgiving
a Debt Overhang.” Journal of Development Economics, 29(2), pp. 407–437; Pattillo, C., Poirson, H. & Ricci, L., 2002. External Debt and Growth. IMF Working Paper, Issue 02/69;
Reinhart, C. M. & Rogoff, K. S., 2010. “Growth in a time of debt.” National Bureau of Economic Research, May, 100(2), pp. 573–578; Ostry, J. D., Ghosh, A. R. and Espinoza, R.,
2015. “When Should Public Debt Be Reduced?” IMF Staff Discussion Note.
3
T he analysis is based on all the data points available between 1980 and 2015 for each of the G-7 countries. Each data point comprises the ratio of net government-to-GDP and the
year-over-year GDP growth in the same year, resulting in a total of 190 observations. The data points are arranged in order from lowest to highest debt-to-GDP and grouped into
quintiles, each quintile containing 38 observations. The average debt-to-GDP and the average GDP growth rates are calculated for each quintile.
4
Clements, B., Bhattacharya, R. & Quoc, N. T., 2003. “External Debt, Public Investment, and Growth in Low-Income Countries.” IMF Working Paper, Issue 03/249.
5
J.P. Morgan Long-Term Capital Market Assumptions 2016.
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