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Dan Vrabac
Co-Portfolio Manager
Ivy Global Bond Fund
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ONCE AGAIN, global markets are being forced to face the reality of an over-indebted world. For most of the past decade, debt in the private sector – especially consumer and financial debt in the developed world – grew at alarming rates and reached unprecedented levels of gross domestic product (GDP). The debt-fueled growth led many to believe we were in some kind of new era of prosperity. However, when the subprime canary dropped dead in its cage, markets rolled over, and by late 2008, the global economy went to the brink of collapse.
Early in 2009 governments around the world began to act – with an unprecedented loosening of monetary policy and tsunamis of fiscal spending. By March 2009, markets had bottomed, as investors began to smell a government spending-induced recovery. Equity and bond markets rallied across the globe, and GDP growth rates were pushing into positive territory by year-end.
The problem, however, was that the debt had not gone away – it just moved to another borrower.
Many governments were already running budget deficits prior to the current economic crisis. Unfortunately, those same loose government policies that brought us back from the economic brink carry their own demons – in the forms of record-high budget deficits and an incredible jump in government borrowing. Even before 2009 ended, many were wondering how in the world governments could sustain such spending and borrowing.
Initially, the U.S. received most of the attention. But the U.S. was not alone. Similar problems surfaced in the United Kingdom, which had an even larger debt-to-GDP level than the U.S. The Baltic countries, especially Latvia, were forced into draconian fiscal actions to correct their borrowing spree. At the end of 2009, the debt difficulties of Dubai came into sharp focus, and that principality had to be bailed out by its Emirate neighbors.
Other countries had even worse bankign and mortgatge problems. Attention soon focused on the European PIIGS - Portugal, Ireland, Italy, Greece and Spain. Ireland alrady essentially has nationalized its banking system.
Basically, four ways exist for a sovereign entity to reduce its debt burden:
1. Use future revenues to pay it down;
2. Generate inflation so that the currency used to repay the debt is worth less in the future than it is worth today;
3. Devalue or depreciate its currency (same effect as inflation); and/or
4. Default.
The first method limits future debt issuance and also reduces an economy’s potential growth – although setting it up for better growth in the future. It also is the method that requires the most belt-tightening in the near term. The other three methods are anathema to investors, who therefore appropriately begin to require higher interest rates, shorter debt maturities and possible bailouts from stronger sources.
This is precisely what is happening with Greece today. The concerns are many:
1. As a member of European Union, will Greece be allowed to default on its debts? What would that do to other members of the EU? Should the EU or the International Monetary Fund (IMF) provide bailout funds or guarantees of Greek debt?
2. Contagion: If Greece can’t pay (or refuses to pay), who else out there can’t pay (Latvia, Ireland, Spain…) or will follow Greece’s lead? And if the EU or IMF bails out Greece, won’t those other countries seek a bailout, too?
So, although extremely generous government policies brought us back from the brink of economic depression, the corresponding growth in government debt and deficits those policies have spawned is similar to the Trojan Horse – an apparent gift to the markets, but in reality the seed of a potentially different type of destruction.
Getting out of debt built up over many years will extract a tremendous price in terms of current and potential economic growth, not to mention reduced standards of living – often for the citizens who can least afford it. The greatest impact will be felt in the developed world, where most of the debt debauchery occurred. But emerging markets will not go unscathed.
This is not to say that markets won’t have occasional rallies. But until the developed world comes to grips with the true size and implications of its debt problem, we can expect continued uncertainty and volatility in the years ahead. The current calling into question of various sovereign states’ ability to repay debt in a timely manner is simply one manifestation of a multi-year debt binge gone out of control.
Past performance is not a guarantee of future results. The opinions expressed are those of Dan Vrabac and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through February 4, 2010, and are subject to change due to market conditions or other factors. Investment return and principal value will fluctuate, and it’s possible to lose money by investing. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets.
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Past performance is no guarantee of future results. The Ivy Funds are managed by Ivy Investment Management Company and distributed by its subsidary, Ivy Funds distributor, Inc.