Deep waves: The corporate and household debt wave

Foreword

In our Deep Water Waves publication,¹ we identified several powerful, connected and long-duration factors that will have a significant impact on investment returns over the next decades. One of these is the debt wave, driven primarily by a combination of economic, geopolitical and demographic pressures. We observe that the debt wave is at a historic peak in terms of the US dollar value of the debt in issue and appears set to continue growing. This was sustainable with low inflation and plentiful liquidity. These factors have both reversed, leading to a heightened urgency to raise capital. As a result, the traditional view on “fiscal responsibility” seems to have moved from the mainstream of political and economic policy debate to the fringes. Given several secular trends in place, this “wave” is apt to grow in depth and breadth. This process drives an increasingly structural polariza­tion between those countries that can easily continue to issue debt and refinance and those that cannot.

This paper focuses on household and corporate debt, assessing the “quality” of investments and the implications of high inflation and high interest rates on investment risk and returns.

Executive summary

• Global financial conditions have shifted rapidly, from a low- to a high-interest rate regime. This looks structural. Importantly, high debt-to-GDP ratios and high interest rates are now the starting point for the next decade. While there are expectations of rate cuts over the next year, interest rates will probably remain higher than in the past decade. Existing (high) levels of indebtedness exacerbate the challenge.

• The off-balance-sheet US dollar debt of non-banks outside the US substantially exceeds their on-balance sheet-debt and has been growing faster. These contingent liabilities have the potential to trigger a liquidity shock, implying the need for stringent banking regulation. Risk assessments would broaden to include insurance, pension payments, guarantee schemes and contingent liabilities.

• Debt restructurings are likely to become more frequent. Companies may deleverage too, and that could weigh on economic growth, requiring government intervention, meaning that deleveraging of private debt leads to higher public debt.

• Debt sustainability is even more crucial than before. Companies need to earn at a faster rate than their cost of debt to remain sustainable. Our assessment of selected countries’ earnings growth and cost of debt shows that Italy, Australia and the UK have a slower growth rate of earnings as against the cost of debt.² Investors need to be even more selective in their investments in such countries.

• Supply chain recalibration to diversify and avoid dependency on China is expensive and could result in more borrowing, to finance capital expenditures. Theoretically, the cost of this debt needs to be less than the earnings growth rate, but the current environment suggests this will be a significant challenge. There is a direct link to the Sovereign, as companies’ cost of borrowing indirectly depends on the country’s credit rating.

• Retail banks traditionally think of mortgages as a “core” product that facilitates cross-selling opportunities. In some countries, like Canada and Australia, household debt is the largest category of the loan book. We measure the vulnerability of households on multiple parameters, including mortgage rate, share of variable rate mortgages, debt service ratio, housing costs, affordability, and real wage growth. Our assessment shows that the households are most vulnerable in Australia and Canada in comparison to the selected countries.³

• Typically, private investments flourish during economic slowdowns. Private companies seem to be increasingly avoiding public offerings, reducing the likely flow of exit opportunities for private equity and impacting venture capital, while the secondaries market looks attractive. Distressed assets and private credit may appear more attractive with more investment opportunities, but they imply specialist risk assessment. Active investment management with scrutiny on corporate debt quality and documentation/covenants are increasingly crucial and differentiating when debt servicing costs stay high (and higher for middle- and low-income countries). Additionally, within fixed income there are opportunities in Asian bonds, higher yield and leveraged loans that offer higher yields, while having lower duration.