Got Fiscal Austerity

 

Mark Beischel, CFA Dan Vrabac

Mark Beischel, CFA
Dan Vrabac
Portfolio Managers
 

 

 

Ivy Global Bond Fund - July 2010

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Market uncertainty continues as investors seek to understand the implications of the alarming rise in U.S. debt and the deficit, the ongoing financial crisis in Europe and the risk of a slowdown in China. In recent weeks there has been a flood of research, news stories and opinions regarding the merits and demerits of fiscal austerity programs, and what their presence or absence might imply for economic growth and market performance. In this issue of our Portfolio Perspectives Newsletter we highlight the different sides of this debate, discuss our opinion and reflect on what it means for the markets in general and the Global Bond Fund in particular. 
How did we get here?
The primary cause of the global financial crisis was the excessive leverage (debt) built up in the consumer and financial sectors in the developed world over the past few decades — especially in the first several years of the 21st century. It’s enlightening to review the assumptions behind the idea that we could continue to add to the private sector debt burden without worrying about the consequences. In essence, the debt binge was predicated on irrational assumptions: 
  1. Housing prices would rise forever;
  2. There would always be liquidity in all markets;
  3. Central bankers had figured out how to engineer low interest rates and inflation (while maintaining solid economic growth);
  4. Banks were well-capitalized and had robust risk monitoring methods;
  5. Savings from income were unnecessary as gains in asset prices (especially housing) would more than compensate, and capital gains obviated the need for income;
  6. Highly risky mortgage borrowers would never be a problem — see point 1;
  7. Investment bankers could turn junk debt into AAA securities — see 1 and 6;
  8. Securitization reduced the concentration of risk by distributing it throughout the system;
  9. Equities should be held for the long term (Japan and the 2000 tech wreck notwithstanding);
  10. There are lots of uncorrelated assets, and;
  11. Rising debt levels did not matter because asset values were growing too.
Well, we know how that worked out. Starting in late summer 2007, and eventually plumbing the depths in October of 2008, the crumbling private sector was leading us to the precipice of another depression. A government response became imperative; the monetary authorities moved first, followed eventually by fiscal stimulus. Although we can debate the size or form of the government-backed rescue, most of us would agree that some government intervention was warranted. However, there are significant costs involved with crisis-induced government stimulus programs. One cost comes in the form of startling increases in government debt. The second cost is in the form of slower potential growth. As the bill for the financial crisis continues to rise, investors have begun to question whether certain governments will have trouble paying all that interest and principal in a timely fashion. The global financial crisis has grown into a sovereign debt crisis. 
How much debt is too much?
There are certain levels of government debt to gross domestic product (GDP) that economists monitor as a sign of elevated risk. The trigger level for alarm is also dependent upon how fast the debt is growing. Debt of 60 percent of GDP is considered about as much as a country can take on without disturbing the markets. However, even lower debt-to-GDP levels can become problematic, e.g. if the country has a history of debt problems or it is experiencing a large uptrend in deficit spending.1 Sixty percent is also the maximum debt-to-GDP level in the European Maastricht Treaty to which all members of the Euro zone are supposed to adhere (they don’t). As the level of debt-to-GDP moves from 60 percent to 90 percent, economists and investors become very nervous about a country’s ability to access debt markets and therefore to meet its financial obligations. Remember, nearly all governments are dependent upon their ability to access markets to roll over maturing debt and to raise new debt. A rising level of debt-to-GDP at any point in time might lead to higher interest costs, which feed back into the deficit, which adds further to the debt level. Levels consistently at or above 100 percent have been associated throughout financial history with slower potential economic growth, as well as subsequent debt restructurings and or defaults.2 Counting all types of debt (including what’s owed to Social Security), the United States is at 87.5 percent of GDP today.3
 
Economists use a debt sustainability equation to help them determine if a country is getting into or out of trouble. To determine debt sustainability, there are two factors that influence the debt-to-GDP ratio: The primary fiscal balance, and the relationship of the rate of interest on government borrowings to GDP growth. The primary fiscal balance is the budget surplus or deficit excluding interest payments on debt; in other words, a government’s ability to generate enough revenue to pay its bills before having to pay interest on the debt. If this is a positive number — a primary fiscal surplus — the government can use the surplus to reduce outstanding debt. If it is a negative — a primary fiscal deficit — then the debt increases by the amount of the deficit.
 
The second part of the debt sustainability equation addresses the importance of economic growth. Studies have demonstrated a strong relationship between the interest rate a sovereign pays on its debt and the rate of GDP growth. If GDP is growing faster than the interest rate, it means debt as a percent of GDP will shrink. If GDP is growing slower than the interest rate, then debt as a percent of GDP will rise.
 
During the latest phase of the global financial crisis, governments everywhere dramatically increased their borrowings at the same time economic growth plummeted. Therefore, many developed countries are getting socked by both parts of the debt sustainability equation. Fiscal stimulus measures mean growing deficits, and private sector retrenchment means lower economic growth — often lower than the interest that governments are paying on their debt. As you can see in Table 1, the outlook is poor. For at least the near-term, it appears to us that primary fiscal deficits will deteriorate or remain high and debt-to-GDP levels will continue to rise. This is why the ability of certain governments to meet their fiscal obligations is being called into question.
 
Now look at the last column in Table 1. The numbers represent how big a primary surplus each country would need to run each year, for the next 10 years, to bring their debt-to-GDP ratio back to the level that existed at the end of 2007. To provide perspective, let’s take the case of the United States. We would have to go from more than a $1 trillion deficit this year to 10 straight years of $600 billion primary surpluses. That should give you some idea of how difficult it will be to attain debt sustainability, and how extreme was the debt build-up! 4 This has led to the dilemma du jour — what, if anything, should governments do? Is it time to try to reduce deficits in order to stabilize or reduce debt-to-GDP ratios? Or is it too soon — after all, we’re not out of the economic crisis yet — will we need more stimulus to avoid a double-dip recession? This is the current heated debate — austerity now, or later? What are the economic and investment implications of the decision?
 
Table 1.
  Primary Balance-to-GDP (%) Debt-to-GDP (%)  
Country 2007 2010 2011 2007 2010 2011 Adjustment
Greece -4.5 -6.9 -6.8 104 123 130 2.8
Ireland -1.3 -9.0 -9.0 28 81 93 5.4
Portugal -2.8 -6.1 -6.8 71 91 97 3.1
Spain 1.6 -5.2 -4.5 42 68 74 2.9
Italy -2.2 -2.6 -2.8 112 127 130 3.4
Japan -3.4 -7.4 -9.0 167 197 204 6.4
U.S. -3.1 -9.2 -8.2 62 92 100 4.3
United Kingdom -3.4 -10.5 -9.9 47 83 94 5.8
Germany -0.8 -4.0 -3.7 65 82 85 3.5
 
Source: BIS Working Paper No. 300, The Future of Public Debt: Prospects and implications, March 2010. Note: The “Adjustment” Column is the annual primary surplus a country must run to stabilize the Debt-to-GDP ration at 2007 levels.
What is Fiscal Austerity, and how important is it? 
Fiscal austerity addresses the first part of the debt sustainability equation — attacking the primary fiscal situation through reduced spending and/or higher taxes. At some point, every government will embark upon a fiscal austerity program (just like the private sector is now being forced to do), or else it will risk permanently reducing potential growth.5 The real debate is the timing — austerity now, or austerity later? Complicating this matter is the second part of the debt sustainability equation — economic growth and interest rates. If implementing austerity measures now results in lower growth, the second part of the equation may overwhelm the first part, causing debt-to-GDP levels to continue to rise. If austerity is delayed, the market may become more concerned about a sovereign’s ability to pay. Then, not only will deficits keep rising, but lack of investor confidence could cause higher interest rates and reduce growth prospects. 
Here, in a nutshell, are the two sides of the debate. 
Austerity Now: There has been a rise in popularity for this view over the past several weeks. The Greek crisis has frightened Europe and the United Kingdom into taking a hard look at their debt sustainability situations (the United Kingdom announced a draconian budget in early July 2010). To support the “austerity now” view, references are made to a few countries in the 1990s that faced fiscal crises and successfully used fiscal austerity as the way back to growth and debt sustainability. 6 The idea behind “austerity now” is that cutting budget deficits will demonstrate to investors that governments are serious about their problems. Budget cuts reduce the size of government in the economy, allowing room for the private sector to grow and eliminating the possibility of crowding out. This favorable development supposedly raises Keynesian “animal spirits” in the private sector, i.e., instills greater confidence in the future. Greater confidence should result in companies increasing employment and capital expenditures. 7 Therefore, both components of the debt sustainability equation are addressed. First, fiscal surpluses automatically reduce debt. Second, economic growth accelerates faster than the interest on the debt, aided by reduced government borrowing.
 
Austerity Later: This camp argues that the global economy and especially a number of individual national economies are still too weak from the global financial crisis to withdraw government stimulus. 8 The argument is essentially that a withdrawal of stimulus now — which the “austerity now” camp supports — risks propelling us toward a double-dip recession, or worse — a debt deflation that would severely cut global growth for years. This would lead to continued sovereign debt problems, and likely result in debt defaults and restructurings. In contrast, the “austerity later” camp argues that further stimulus measures are needed today, precisely because the private sector is still deleveraging and will not be a growth driver for the foreseeable future. The “austerity later” camp does recognize the need for fiscal austerity down the road.9 However; it believes that the ramifications of withdrawing stimulus today are too terrible to risk austerity programs at this juncture. 
What do we think? 
If you have followed our commentaries in the past, you are well aware that we have demonstrated a serious concern over the amount of leverage in the system and the implications of deleveraging on the economy (slower potential growth) and the markets (greater uncertainty and volatility). Given the high degree of underutilization of resources (labor and capital), our view tends to be closer to that of the “austerity later” camp. The examples of successful “austerity now” programs (see footnote 6) are not applicable to today’s situation. Furthermore, it’s a Pascal’s wager — it’s not just the risk of being wrong, it’s the consequences of “austerity now” being wrong that are of the greatest importance. We are, however, in full agreement with the International Monetary Fund (IMF) and Bank for International Settlements (BIS) (see footnote eight) on the importance of strong fiscal programs to reduce government debt-to-GDP levels over the medium term. We have discussed in prior commentaries the importance of putting together a credible fiscal exit strategy.
  
Although the current debate focuses on the primary balance, economists agree that we cannot address that in isolation without considering the impact on growth. Without growth, fiscal austerity will be insufficient in obtaining debt sustainability. Over the medium term, the growth factor is more important than correcting the primary balance in the near term. The usual recommendations for engendering growth are structural changes, such as labor, pension and health care reforms. Stronger banking systems are also important. More efficient tax structures also improve growth prospects. In some countries, less corruption, better tax collection and stronger rule of law will also add to growth.
 
There is no magic level of debt-to-GDP that will trigger problems. As you can see from Table 1, Japan has by far the highest ratio, but it also has the lowest interest rates in the world. No one believes Japan is on the verge of defaulting. Furthermore, no one truly believes that if the U.S. breaks the 100 percent debt-to-GDP level that defaults is imminent. Therefore, deferring austerity — while putting into place a credible medium-term fiscal adjustment — is certainly possible. It’s also possible that with economic growth so anemic, further fiscal and monetary stimulus will be necessary. There is a tipping point, however, particular to each national economy. There are consequences of high debt-to-GDP ratios. No country can raise its debt-to-GDP forever. Japan may not be in default, and may have low interest rates, but it suffers from extremely low economic and income growth.
 
There are a great number of other important factors, but the discussion could run into volumes. As we stated at the beginning, fiscal austerity is Topic #1 in the financial and economic press — as it should be. Let’s just bullet point some of the other items for which investors need to account in the fiscal austerity debate:
  • Central bank reaction to fiscal austerity — will they tighten in the face of potential growth and inflation, or remain stimulative?
  • Contingent liabilities — government guarantees (explicit and implicit) are not counted in debt-to-GDP measures; if they were, debt-to-GDP ratios would be multiples higher than the current ratios.
  • Foreign liabilities — the degree of foreign ownership of government bonds may influence policy decisions.
  • Rapidly ageing populations complicate the fiscal situation.
  • How much will positive developments in emerging markets offset the reduced growth in developed markets?
  • Will export surplus countries (especially China and Germany) take the necessary steps to stimulate domestic consumption and help the global economy, or will they continue with mercantilist policies that will move the world closer to a deflationary result?
  • Global imbalances remain, and a lack of global growth could manifest itself in trade wars.
  • Social tension — how will populations react to fiscal austerity?
  • Political tension — will governments have the guts to take the right medium-term fiscal steps?
Market Implications 
Uncertainty is the bane of markets and economic growth. Think of it as a chain:
 
Uncertainty--volatility--risk aversion--higher cost of capital--reduced capital investment--lower economic growth.  
 
Unfortunately, the fiscal austerity debate is just one factor (albeit a very big factor) creating uncertainty in the markets. Another driving factor will be the ongoing deleveraging in the private sector. As this is a multi-year process, we expect high market volatility to be with us for some time. On the positive side, many emerging market countries do not have the dire fiscal situations of developed nations. China, however — although it will have a growth rate well in excess of developed countries — faces its own fiscal dilemma and debt problem. The authorities in the last few months have indicated a willingness to slow the economy in order to rein in the property sector and unprecedented loan growth. Furthermore, even though emerging markets should have better economic growth, they are not immune to what’s going on in developed markets. Opportunity is good in emerging markets, but it doesn’t come without a healthy dose of risk. Investors must be paid appropriately for emerging market investments, as they are not a one-way street.
 
As long as the United States is viewed as a safe haven, it will be allowed plenty of rope with regard to its deficits and debt-to-GDP ratio. This can be observed in the low level of U.S. Treasury rates currently. But this should not be taken as a right; inability to address the long-term debt situation could reach a tipping point for investors that would result in interest rate spikes and dollar depreciation. We believe that lower potential and nominal growth in developed countries will impact the profitability of corporations as well as the revenue-collecting ability of sovereigns. Borrowing costs will go up, and taxes will be raised. Companies can only cut costs for so long. Capital investment is required for long-term growth. Higher employment is needed for growth. Until these are forthcoming, the economic outlook remains grim. 
The Global Bond Fund 
Given the uncertainty and volatility in the current environment — partly due to the unknown outcomes of the fiscal austerity debate — what are we doing with the Global Bond fund?
 
There are two keys to our approach — the risk management process and the fund’s flexibility. Regarding risk management, it is more than just a marketing claim with us. As we’ve noted in the past, the Fund focuses on corporate bonds (more than 60 percent of the Fund is invested in corporate bonds in the United States and throughout the world). We emphasize investments in companies with strong balance sheets, solid cash flows (proven through economic cycles) and leadership in their industry and/or country. We also typically keep exposure to any one corporate issuer to two percent or less of the fund’s assets — this keeps the Fund from being dramatically impacted by a poorly performing issuer. Diversification is another key to risk management. There are more than 100 issuers representing more than 20 countries in the Fund. The Fund is also maintaining a low duration (a low average maturity). This allows us greater visibility in uncertain times and reduces the negative impact of potentially higher interest rates and wider yield spreads. Finally, in the current environment, we are keeping plenty of liquidity in the Fund. We believe it is preferable to give up some yield now for better opportunities ahead. We believe market volatility in the quarters ahead will provide numerous opportunities to bring good value investments into the fund. May 2010 is a perfect example. During that time, corporate yield spreads widened dramatically due to the crisis in Europe before settling down in June. We used that opportunity to add bonds that were on our watch list.
 
Linked closely to the risk management process is the flexibility of the fund. Unlike other global bond funds, this Fund isn’t tied to an index, which means our sovereign (government) bond exposure is far lower. It also means we don’t always need to have non-dollar currency exposure if we don’t see a benefit. In fact, we are able to move the currency exposure in a range of 100 percent U.S. dollar to zero percent. The Fund typically has a lower non-dollar exposure than other global bond funds because using foreign currencies is not the primary road to performance. The fund’s primary objective is the provision of income through interest-bearing securities. Capital gains, and by association, currency gains, are a secondary means of obtaining performance. That said, if government debt and deficits continue to grow, the Fund has the flexibility to gain nondollar exposure to help protect investors’ purchasing power should the U.S. dollar decline. 
 
1 Prior to Argentina’s default in 2001, debt to GDP grew from 35 percent in 1995 to 65 percent in 2001; Federal Reserve Bank of San Francisco, “Learning From Argentina’s Crisis,” October 18, 2002. 2 Kenneth Rogoff and Carmen Reinhart, “This Time Is Different: Eight Centuries of Financial Folly.” 3 As of March 31, 2010. U.S. Treasury Department, “Monthly Statement of the Public Debt”, U.S. Bureau of Economic Analysis.
4 Brazil has been running primary surpluses since 1999 to reduce its public debt burden. Only after several years of fiscal prudence — suffering low potential growth and high interest rates — have the markets recognized the achievement. 
5BIS Working Paper No. 300, March 2010 states that persistently high levels of public debt will drive down long-term potential growth.
6 Sweden is the poster child for this view. However, it needs to be stated that the circumstances were very different at the time. Sweden’s problem was isolated. The rest of the world was in a growth phase. Sweden’s debt was mostly domestically financed. Finally, Sweden was able to depreciate its currency to boost exports and growth. These circumstances are vastly different today, especially given that practically the entire developed world is in or barely out of recession caused by the global financial crisis. Furthermore, not all countries can depreciate their currencies at the same time to grow their way out of their debt problems. Finally, economic growth was more important to solving Sweden’s crisis than fiscal austerity.
7 George Akerlof and Robert Shiller discuss the importance of confidence in their book “Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism”. They also mention other factors which affect animal spirits, such as fairness, corruption, and money illusion.
8For the best descriptions of this view, see Martin Wolf’s columns in the Financial Times of London and Paul Krugman’s columns in the New York Times.
9 Both the IMF and the BIS have recent research on the importance of long-term fiscal credibility and austerity. They argue that it is much more important to deal with structural issues such as pension (social security) reform and health care reforms, better tax structures, and growth-oriented programs in a multi-year plan than to drastically cut fiscal programs today in the hope of stimulating “animal spirits”. BIS 79th Annual Report, June 2009. BIS Working Paper 300, March 2010. IMF Global Financial Stability Report Market Update, July 2010.
 
The opinions expressed are those of the Fund managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through July 22, 2010, and are subject to change due to market conditions or other factors. 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. • Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. • Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. • Holdings information is not intended to represent any past or future investment recommendations. Holdings and allocations can and do change frequently.