The U.S. is a role model in navigating the debt supercycle
August 10, 2016
Navigating a path through the accumulation of global debt known as the debt supercycle can be challenging in its own right. That’s because this global debt — assumed by governments, businesses, and consumers worldwide — has reached historic levels, with some advanced economies at their highest debt-to-gross domestic product (GDP) ratio ever. Also, as we have seen in an earlier Insight, Global imbalances: Root cause of the debt supercycle, this particular debt cycle is characterized by a globalized economy and interconnected financial markets — so much so that events and developments in one country, region, or market have tended to reverberate in other areas. Structural imbalances — ranging from fiscal deficit crises in Greece, to excessive housing prices in places such as Spain, Ireland, and China — have often been part of cascading events resonating globally, and that have given rise to the debt supercycle.
However difficult it has been to right these imbalances, it might be helpful to look at how one major economy addressed a number of issues and imbalances in the wake of the global financial crisis of 2008–2009. We use the example of the United States. The US not only tackled many of its financial crisis–related problems effectively, but it seems to be on a firmer track than many economies to find a way out of the debt supercycle.
Attempts to address imbalances and the supercycle
With imbalances contributing to this seemingly endless cycle of debt, it’s understandable to ask: Is anything being done about it? The answer is, yes, quite a bit has occurred since the financial crisis, much of it in the form of fiscal and monetary policy responses, and some of them unprecedented. In addition, some situations were policy responses that were coordinated among major countries in an effort to minimize severe downside risks.
But the question remains how effective these policy responses have been. Most have been regarded as temporary fixes. Long-term economic expansion would have to be supported by real growth in multiple sectors of the global economy, which in large part has not yet occurred. Some countries’ fiscal stimulus programs resulted in a sudden increase in the total debt level. In the realm of monetary policy, central banks have tried a number of easing efforts, in some cases venturing into negative interest rate territory, where the long-term effects are still relatively unknown.
What’s past could possibly be prologue
By their nature, these policy efforts tend to be reactionary, as governments and policy makers respond to specific problems or crises — that is, the structural imbalances. We believe that addressing these imbalances, restoring normal growth to affected countries, and ultimately navigating the debt supercycle all require a certain degree of political will as well as appropriate, effective policies. None of this is easy to achieve. However, it can be instructive to look at past policy responses that were seen as successful. The primary example of this is the US reaction to the subprime mortgage crisis, an event that is considered to have triggered the larger financial crisis that followed.
The US navigation through the crisis
As a starting point for the US journey through the global financial crisis, we chose late 2007 — just before the crisis began, but a period when there were many structural issues in the financial markets and the overall economy.
One critical issue that was developing in the US at the time was the housing market problem. Housing had seen a long-term trend of booming prices and increasingly risky mortgages. When prices began to drop and interest rates rose, defaults and foreclosure activity increased, evaporating demand for mortgage-related securities. This culminated in the collapse of several funds at the investment bank Bear Stearns. At that point in 2007, Bear Stearns’ balance sheet was overleveraged with heavy exposure to mortgage-backed securities (MBS), which included subprime mortgages that carried low credit quality and high likelihood of default. By 2008, market stresses led to a merger of Bear Stearns with JPMorgan, in a stock swap valued at only $10 a share. Bear Stearns stock had been trading at $93 a share just a month before its collapse.
The Bear Stearns event can be considered the key catalyst for the market disruption that followed, which included turmoil after companies considered “too big to fail,” such as Lehman Brothers, filed for bankruptcy.
In the US, the crisis prompted swift responses from policy makers. Just some of the policy and governmental reactions included:
- In September 2008, federal officials took over the government-sponsored mortgage giants Fannie Mae (FNMA) and Freddie Mac (FHLMC) — just two of the institutions or companies receiving bailout money from the Troubled Asset Relief Program (TARP), a program established to shore up the financial sector.
- Initially, TARP was authorized expenditures of $700 billion from the federal government, but by 2014 when the US Treasury Department ended the program, TARP’s total disbursements were less than $430 billion, and many institutions had repaid the program, including Fannie Mae and Freddie Mac.
- In October 2008, six of the world’s leading central banks, including the Federal Reserve, announced a coordinated monetary easing policy to help steer economic activity to a more solid footing.
- The Fed also officially initiated its quantitative easing (QE) policy in 2008, which included purchasing bonds in an effort to inject liquidity and stimulate the economy. After three consecutive QEs, the Fed gradually phased out the program in 2014.
- Fiscal stimulus was initiated, including tax reductions for corporations and individuals, and spending programs both public and private.
- Structural reform focused on banking and the financial sector with the Dodd-Frank legislation, targeting reforms and improvements in an effort to prevent future similar crises.
Effects of the temporary fixes of the US response
Since 2008, the US has gone through the subprime mortgage crisis and bank overleveraging problems, as well as many other issues amid the financial crisis. The result of all the efforts and policy responses? Generally, they’re viewed as having worked. The financial sector in the US has improved in leverage ratio and appears to have achieved overall improvements in managing risk exposures, in our opinion. However, the QE efforts and fiscal policies did have a price. They helped push total debt levels to historical highs. In this way, the temporary solutions of the financial crisis have contributed to the severity of the debt supercycle in the long term.
US government debt increased $4.4 trillion between 2007 and 2010, making up more than 25% of the US GDP, even as total outstanding debt has declined in the home mortgage, nonfinancial corporation, and financial sectors. US Treasury yields have remained near the historical lows reached in 2012. The overall economy is running at well below full steam — the US economic growth rate has ranged between 1.5% and 2.5% for the past six years, and was reported by the US Commerce Department at a lower-than-forecast 1.2% annualized rate for the second quarter of 2016. In light of this, the overall return on investment, as represented by Treasury yields, is unlikely to match the levels seen prior to the financial crisis. We would suggest that fixed income investors may need to adjust their investment return targets to reflect this unusual reality. Historical risk-reward profiles also may need recalibrating in order to balance interest-rate and credit risks.
Turning point for the US?
An important turning point may have been reached in December 2015 when the Fed raised interest rates by 25 basis points — the first time since the onset of the unprecedented monetary easing. This year, in light of unsettling global economic considerations and uncertain domestic jobs reports, the Fed has pulled back from previously indicated plans for several rate hikes throughout the course of 2016. Nonetheless, the Fed generally appears inclined to a more forward direction with rates, especially compared with some other central banks, and in light of the new reality of negative interest rates in many countries.
Despite an inclination to tighten monetary policy, the turning point of US financial markets has not been reached yet. Investment returns continue to be subject to factors such as the restructuring of the global commodity sector following the collapse in many commodity prices in early 2016. While additional improvements are needed in some economic conditions, such as a return to normal growth, the US appears better positioned to emerge from the debt supercycle, even if the pace is somewhat slower than anticipated.
Similar impacts around the world
The global financial crisis and resulting debt cycle had monetary and fiscal policy reactions in many other areas as well. Some programs that were set up to address these concerns continue to the present day.
In Europe, for example, a big concern has been policy efforts to address the banking sector. Since 2008, real estate bubbles in Ireland and Spain drove banks into difficulty and dragged their economies into further recession. In some cases, stressed banks were nationalized to deal with balance sheet issues, such as the Royal Bank of Scotland in the United Kingdom. But overall banking recapitalization in Europe was delayed, with a banking union under the European Union (EU) only officially launching in January 2016. This banking union is considered just the beginning of banking reform, which in turn is only one piece of the structural reforms needed.
As with the US, European fiscal stimulus policies that were initially introduced to respond to the financial crisis may have reduced the severity of the impact, but the policies also eventually helped raise total debt levels to unusual highs. Some feel that in order to deal with the resulting stress on economies and financial markets, the only tool left is monetary policy, and a number of central banks have responded in kind.
While the Fed’s December 2015 rate increase was a small step toward normalizing monetary policy from near-zero interest rates, other central banks have gone in the opposite direction. In March 2016, the European Central Bank (ECB) reduced its deposit rate further into negative territory and ramped up its asset purchase stimulus program. Earlier in January, the Bank of Japan had decided to dip below zero with a negative deposit rate. The effects of the central banks’ actions can be striking. In June, for example, ECB monetary policy led to the 10-year German government bond yield slipping below zero for the first time.
The US relatively ahead despite soft growth
In the past two economic cycles, the US has been a leader in recovering from downturns and recessions. In navigating the current debt supercycle and its residual economic effects, we see the US as relatively ahead of Europe and Asia. The interest rates of a number of major countries continue to trend lower and may stay low for a protracted period in our view, despite the central banks’ efforts to use every tool they have to rev up the world economies. In theory, we would expect these kinds of unprecedented steps, such as the QE efforts and movement into negative rates, to serve as an economic stimulus. Yet global growth has continued to be soft and growth expectations remain muted at best. The International Monetary Fund (IMF) stated in its global outlook published in April that it expects global growth to remain modest in 2016 at 3.2%, a growth rate two percentage points below the average of the past decade.
The US has had a stronger GDP growth rate, but still not robust
Chart shown is for comparison purpose only.
A challenging environment
All of this contributes to a challenging investing environment at times, which we believe also means that fixed income investors may need to consider adjusting their expectations to the different phases of imbalance reforms, including credit fundamentals, within different countries and regions. Other key factors for investors to consider are the prospects of protracted slow growth, continuing low inflation, and low interest rates.
The globalization of the financial markets could constrain the longer-term returns of US fixed income investments, at least until most of the other economies catch up in addressing their structural imbalances, and make the necessary reforms. For investors in any region, such conditions make evaluating the credit fundamentals of a country or a company even more important than in prior cycles, in order to achieve their investment goals.
The views expressed represent the Manager's assessment of the market environment as of August 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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