A debt crisis is coming

Newsletter by Belal Mohammed Khan
Published on 12th October 2022

A new geopolitical equilibrium is fast evolving in a novel era of secular inflation, higher rates, and slow growth. All of this is occurring against a backdrop of a historic global debt burden. As the global order comes under intense contestation and transformation, the investment landscape will likely be dramatically transformed.

Our portfolio strategy remains conservative and defensive; however, at the same time, we are allocating to pockets of opportunity across regions and markets.

To start, in the near term, we expect the Q3 corporate earnings reports to (finally) reveal the challenging operating environment we have been talking about and writing about for the last three quarters. Since October 2021, our view has been that the combination of inflation and slower growth will eat into corporate margins and that only quality companies will prevail .

“High debt levels beyond the debt–growth thresholds begin to work as a constraint on countercyclical fiscal policy, which leads to greater policy uncertainty, increased volatility, and lower growth rates.”

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This month we highlight the debt burden countries are carrying and the risks to growth, especially in a time of rising rates. Empirical evidence shows that large government debt has a negative impact on economic growth potential, and in most cases, as debt grows, the negative impact increases. The evidence also shows that the debt-growth relationship threshold sits between 75% – 100% of GDP. High debt levels beyond the debt–growth thresholds begin to work as a constraint on countercyclical fiscal policy, which leads to greater policy uncertainty, increased volatility, and lower growth rates. Since we do not foresee any material reduction in debt for most developed and emerging market economies over our investment horizon, we expect debt servicing costs will weigh heavily on many such economies. Meanwhile, a handful of next energy exporters with improving or strong external account positions should weather these storms better.

In a slowing economic environment with rising rates due to inflation-fighting efforts of central banks, debt servicing as a share of government spending will increase, creating a crowding-out negative feedback loop. Macroeconomic shocks, local or global, can have a disproportionately larger impact as debt-ladened countries may not be able to put in adequate countercyclical policy support. In addition, sovereign ratings could increasingly be at risk. Risks get more complicated when high government debt levels accompany high private-sector debt. Our growing concern is on burdens of debt and the possibility if growth slowdown gets further entrenched, it will likely result in sovereign and corporate downgrades.

“In such a complex and dangerous environment, only quality companies in select sectors will weather such headwinds…”

Regarding global debt, it has reached new historic hard-to-comprehend levels of over $300 trillion. Debt in an era of rising rates and slowing growth will continue to impact all levels of society negatively. Recent IMF data show about 30% of total external debt is variable rate debt. Also keep in mind Covid-19 related debt moratoriums, and debt service suspension initiatives ended at year-end 2021, just as growth was beginning to slow, and rates were beginning to rise. In such a complex and dangerous environment, only quality companies in select sectors will weather such headwinds better than others. Our portfolio equity strategy has had a quality bias since October 2021 and mostly a defensive sector allocation since April 2022. Discover our asset class views .

In this complex investing environment, we believe a more expansive investment universe & a more nuanced investment strategy/asset allocation is required to achieve needed returns. It is critically important to avoid regions and companies with debt burdens that are getting too large to bear. Such an investment environment also brings with it elevated market volatility and more frequent volatility spikes. Our investment strategy includes long overweight positions in select regions, commodities, and volatility.

Unless headwinds fade and positive forces surface, a debt crisis will surface, first in some pockets of the market, but given the interconnectedness of the global financial system, the reverberations from one region or asset class can quickly create a mass exodus as investors rush to safety. We’re watching carefully, and are ready to respond.

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