How do we pay for all this?

After the global financial crisis of 2008/9, a new consensus emerged that debt was bad. Consumers started to cut back on debt – a process known as “deleveraging” – and companies were supposed to clean up their balance sheets. Yet within just a few years, it was obvious that deleveraging wasn’t quite going according to plan. In 2015, for instance, consulting firm McKinsey brought out a paper titled Debt and (not much) deleveraging. The firm’s researchers found that global debt had “grown by $57 trillion… no major economy has decreased its debt-to-GDP ratio since 2007. High government debt in advanced economies, mounting household debt, and the rapid rise of China’s debt are areas of potential concern”.

Flash forward to 2019, and even cautious central banks were hitting the alarm bells. In its annual report, the BIS – the main organisation representing central banks – warned that one of the clearest signs of overheating in the global economy was the level of outstanding loans made to risky companies. “The overall landscape is one of a global economy that has been unable to jettison its debt-dependent growth model,” the report states. “Indeed, aggregate debt (public plus private) in relation to GDP, while it plateaued in the past year, is much higher than precrisis… should the global economy slow down at some point, it is hard not to imagine that the debt burden would increase further.” The McKinsey consultants returned to the fray, observing in another paper – Is a leverage reckoning coming? – that overall corporate debt in the US had grown from $2.3 trillion in 2008 to $5.2 trillion in 2018, while companies were more highly-indebted relative to their profitability than at any point since 2008. Then, in the early months of 2020, coronavirus emerged. As a result, we’ve taken on even more debt, with central banks around the world – the US in particular – unleashing extraordinary lending packages, with even more radical intervention than we saw in 2009. London-based research group Cross Border Capital tracks global liquidity, with a focus on central bank monetary policies. By early April, it was already reporting a huge expansion in central bank balance sheets – pledges of emergency central bank funding added up to “injections of $6.5tn, increasing global central bank balance sheets by 32% and representing 8.2% of world GDP”.

The Federal Reserve in the US, the Bank of England, and even the European Central Bank are now engaging in huge government bond-buying programmes to help finance soaring state spending. In mid-May, for instance, the BBC reported that coronavirus-related measures could cost as much as £298bn for this financial year alone. Last year in total, the government borrowed £55bn, but in April 2020 alone it borrowed £62.1bn. The good news is that with the promise of central bank backing, there’s no shortage of demand for this debt. In mid- May, the UK government’s Debt Management Office reported record-breaking order volumes for UK government bonds (gilts). Around £53bn-worth of orders were received for just £7bn-worth of 2061 UK gilts (which are due to be repaid in 41 years). Negative-yielding gilts (i.e. where demand is so high that investors effectively pay the government to lend to it, rather than the other way around) have also been issued. What does this global flood of debt mean for investors? It’s still early days, but we can hazard some guesses. On the positive side, with yields on bonds and central banks’ key interest rates close to zero, the cost of servicing this debt is low. That might encourage even more borrowing and spending by governments keen to kick start a post-outbreak recovery. But that mountain of debt won’t be going away any time soon – and this might, in turn, encourage central bankers to keep interest rates close to zero for longer. More importantly, central banks and governments might also be willing to put up with higher levels of inflation in any recovery, so as to eat away at the “real” value of this debt over the long term.

A willingness to accept more inflation – say above a 2% to 4% band – might result in more volatility in the foreign currency markets with higher inflation currencies becoming weaker over time, which will increase the value of foreign equities held by local investors. “Real” assets – ranging from gold to property and infrastructure – might also benefit from this more permissive inflationary environment, particularly if investors start to worry about inflation rates spiralling out of control in a Zimbabwe or Weimar Republic-style hyperinflationary scenario. Whatever the outcome, be under no illusion – we are still living in an age of “peak leverage”, and investors should hedge themselves appropriately.