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WhiteCapability MFS Paper Series Focus Month June 2016 2012 ® Authors 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. The views expressed are those of the author(s) and are subject to change at any time. 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