The rising level of corporate and government debt across the global economy is going to lead to a debt-deflation trap, according to RWC manager Clark Fenton.
Central banks around the world have taken interest rates to historic lows in recent months as they try to shore up economies for the impact of the coronavirus crisis and the widespread lockdowns caused by the pandemic.
However, Fenton – who manages the RWC Diversified Return fund – said:
“When rates are kept very low artificially, this enables more debt, delaying the problem and creates this debt overhang, hence why it’s called the trap.”
The manager noted the effect this has on growth leads to significant underinvestment and hinders future recovery.
It’s been argued in recent weeks that rising debt was not an immediate concern because of low interest rates and modest levels of inflation. However, amidst this backdrop, limited discussion has been given to the potential implications of higher levels of debt and falling prices.
“The biggest thing right now is debt and the debt-deflation trap,” Fenton said. “It’s high at a corporate level and high at government level.”
Quantitative easing programmes have helped to increase the volatility of money across economies, but whether it will be enough remains to be seen.
Private individuals and businesses are saving rather than spending, realising that the best strategy to withstand the next pandemic or a potential second wave of coronavirus is to increase savings and reduce levels of household debt.
“Households need to save, which is also deflationary,” the manager added.
Consumers have not been spending as governments would have hoped, which will decrease prices. But should this coincide with increasing levels of debt, there could be a wave of both consumers and corporations defaulting on their debts.
Businesses that are making a loss will reduce levels of output and unemployment will rise, sending more negative ripple effects through the economy. Once in this spiral, it can take a while to recover.
However, Fenton noted that this time of saving and austerity could prove to be a useful period for balance sheet repair and the increased pricing power of the businesses that emerge from the crisis.
“While there will be a lot of bankruptcies, this is part of the harsh capitalist reality,” he said. “But for those who make it they’re now in a better position.”
As well as the debt-deflation trap, a liquidity trap is emerging due to low interest rates and the high savings rate.
Bonds and interest rates have an inverse relationship and news in May that the UK sold its first ever negative-yielding government bond is noteworthy.
Bonds are unappealing with little to negative return, leaving investors to choose primarily between precious metals and equities.
Central banks have been praised for injecting much needed liquidity into the system, but these efforts to support the market can create a false sense of security.
Performance of MSCI ACWI since 2007
Source: FE Analytics
There can be certain successes taken from the performance of the stock market. At the end of Q1 this year, the MSCI ACWI returned 124.89 per cent from its 2007 peak. This equates to more than three times the growth in GDP and 6.5 times the increase in corporate revenue.
“Quantitative easing doesn’t create inflation other than in asset prices,” said Fenton.
While the markets are supported but economic growth looks sluggish, the reason can’t be because of short-term monetary policy but rather ongoing increases in debts and deficits.
Economic slowdowns have hinged on the fact that a debt-burdened economy can't support higher rates of interest.
This has resulted in a situation where it has taken an ever-increasing amount of debt to generate economic growth.
Debt growth outpacing GDP
Source: Real Investment Advice
While deflation is seen as the long-term threat, central banks also can’t discount the short-term inflationary concerns.
Most predictions of a V-shaped recovery, which would see the economy revert to pre-recessionary norms, operates under the assumption that there’s no second outbreak of Covid-19.
Policies of quantitative easing are enshrined in monetizing the deficit to support economic growth. However, if the recovery is swift and economic growth leads to decreases in unemployment, there will likely be an inflationary surge.
Reopening economies across the world carries its own inherent risks because of the various initiatives which have sent money directly to businesses. Historically, increases in the money supply tend to lead inflationary pressures by about nine months.
Fenton is clear that away from this traditional method of inflation, there is a more insidious kind at play: currency debasement.
“Countries try to get more competitive by debasing their currency, which in turn reduces purchasing power,” he said.
The combination of fiscal and monetary stimulus will lead to currency debasement, which historically means good news for gold but bad news for traditional currencies.
“Money losing its worth is still a form of inflation, but it does unfortunately mean people lose confidence,” the manager said.
This is reflected in the multi-asset RWC Diversified Fund, which is invested in gold and copper.
Performance of fund vs sector YTD
Source: FE Analytics
The $63.6m fund has returned 8.67 per cent year-to-date, whereas its average peer in the offshore FO Mixed Asset – Flexible sector made a loss of 0.94 per cent. It has an ongoing charges figure (OCF) of 0.8 per cent.