March Newsletter: Strange Times

Posted by Alex Frey (@alexhfrey )

“We are living in strange times.”

At one level this statement is probably always true, since no one times could possibly resemble the past along every dimension, thereby every time is “strange” in somewhere or another when compared to the past. And yet, the time we are living today seems peculiarly strange – and not just because Donald Trump is now the presumptive Republican nominee for President. 

The strangeness I am speaking of today is related to two of the most important economic variables in the world. We are speaking of interest rates and debt levels. We wrote a newsletter about interest rates a year ago in March. At that time we noted that interest rates had been unusually low for a long time. In the past year, nothing has really changed. Long term interest rates are still very low despite the fact that the Federal Reserve Open Market Committee (the “Fed”) raised the U.S. “federal funds rate” by a quarter of a percent. 

Figure 1 shows the interest rate on a 10 year treasury bond from 1871 to 2015. In 2015, the rate was 1.88 %, almost exactly where it is as we write this letter. This is the lowest that it has been since 1871, although the low during World War II was similar. Many people would ascribe these low rates to actions by the Fed, but as we pointed out in our letter last March, the Fed’s ability to fix interest rates is limited. Economic theory says that there is a natural rate of interest. If the Fed tries to push rates lower than this they get inflation, and if they try to push rates higher, they cause a recession. The fact that we have had very low rates for a relatively long time without inflation indicates that something else is going on.

Figure 1: Interest rate on 10 year treasury bonds (data from Robert Shiller).

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Low interest rates are not just a U.S. phenomenon. The 10 year bond rates in the Euro area and Japan are also at historic lows, as shown in Figures 2 and 3. The most recent rate on the Japanese 10 year bond has gone negative. Creditors pay the debtor (the Japanese government) for holding their money! Ten year interest rates in China have also dropped significantly in the last two years, as shown in Figure 4. In Europe and Japan, the benchmark overnight rate (similar to the U.S. “fed rate”) that the central banks pay member banks for overnight deposits has also gone negative in some cases. The European Central Bank and the central banks of Sweden, Denmark, Switzerland, and Japan all have negative benchmark rates. 

In economics 101, we learned that when interest rates that are too low (relative to the “natural rate of interest”), the economy will be over stimulated, and this is likely to cause inflation. That doesn’t seem to be happening. Per the Economist magazine, the growth rate in the EU for the last half of 2015 was 0.3% per quarter (1.2 % per year). In Japan, the growth rate went negative in the last quarter of 2015. Inflation is close to zero in both areas. In the U.S. the GDP growth rate in the second half of 2015 was about 2% per year, and the inflation rate in the fourth quarter was about 1.4% (data from

Figure 2: Euro area 10 year bond rates. Data from European Central Bank.

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Figure 3: Interest rate on 10 year Japanese government bonds.

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Figure 4: Interest rate on 10 year Chinese government bonds. Data from

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While interest rates are at historical lows, debt is rising to historical highs. In some ways, this might make sense. After all, if borrowing is cheap, why not borrow a lot? However, from another point of view, it is strange. If debt levels are high, one might expect that the fear of default would drive interest rates up. Debt levels are not as straightforward as interest rates. There are various kinds of debt: government debt, household debt, corporate debt, and financial system debt (banks). These generally don’t move in unison, so getting a full understanding can be difficult. There is also internal debt, which is debt that is denominated in local currency and owed to people in the country, and there is external debt that is denominated in other currencies and owed to outsiders. Economists generally agree that it is much easier to deal with internal debt than with external. Internal debt can reduced by inflation and can be mitigated by other policy options, such as interest rate controls and taxes on interest. So external debt is probably of more concern than internal debt. Further, although much attention has been focused on government debt, many people believe that the total debt (government plus private) is a better indicator of when trouble might occur. 

So let’s look at what has been happening with debt around the world . In the U.S., government debt, as a percent of the gross domestic product (GDP) sharply increased during the Great Recession, but it has now leveled off and maybe decreased a little. Figure 5 shows the data from 1970 to 2014. This figure is quite threatening, but a longer perspective may make it slightly less so. Figure 6 shows the U.S. public debt from 1940 to 2014. The current debt level is approaching the level achieved during World War II, but it is still less than the WWII level. Figure 7, taken from the Economist magazine, looks at total public and private debt for the U.S. The total debt rose rather steeply just before the financial crisis in 2008, but it has been declining somewhat since. Close inspection of Figure 7 shows that household and financial debt has been decreasing while government debt has increased, but the total has been coming down slowly. Nevertheless, it remains at very high levels compared to historical values.

Figure 5: Total public debt as a percent of gross domestic product for the U.S.

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Figure 6: Ratio of debt to GDP, in percent, from 1940 to 2014 (data from

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Figure 7: Total U.S. debt (public plus private) from 1975 to 2012 (Data from the Economist magazine)

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Much of the rest of the world is also having a problem with debt. Reinhart and Rogoff (1) have published an analysis of recent trends in world debt. Figure 8 is taken from their paper and shows the trends in government debt, as a percent of GDP, for 22 advanced and 25 emerging market countries. For the advanced economies, debt levels are approaching the WWII peak. On the other hand, the emerging market economies have seen decreasing debt levels over the past 20 years and now have much lower debt levels than do the advanced economies. Figure 9, also taken from Reinhardt and Rogroff, shows the levels of total (government plus private) external debt for the same countries. In the advanced economies, external debt has grown from about 25% of GDP in 1970 to more than 250% in 2011, although it has begun to decline slightly recently. The emerging market economies followed the trend of the advanced economies until about 1985, but since then external debt in the emerging market economies has declined. 

Figure 8: Gross government debt/GNP for emerging market and advanced economies from Reinhart and Rogoff (1).

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Figure 9: Total external debt/GDP for emerging market and advanced economies from Reinhart and Rogoff (1). 

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We should note that the charts just given include gross government debt. This means that debt that the government owes to itself is included. For instance, in the U.S. the debt that is held by the Social Security Administration is included, and one might be tempted to subtract this since it is debt that the government owes to itself. However, the liabilities of the Social Security system far exceed its assets, so a proper accounting of Social Security would increase the total debt, probably significantly. In fact, most of the developed countries have aging populations, and the assets of their pension systems (Social Security in the U.S.) are significantly less than their liabilities (what they owe future retirees). So in most cases, a proper accounting of the pension systems would increase the total debt level. On the other hand, the central banks of some countries have bought government bonds as part of their “quantitative easing” programs. These bonds are included in the gross figures, but probably should be removed.

McKinsey & Company looked at recent trends in total world debt, including government debt, household debt, and non-financial corporate debt. Their report (2) says that total world debt has risen to $57 trillion and that no major national economy has reduced its debt to GNP ratio since the financial crisis in 2007-2008. Figure 10, taken from McKinsey’s report, shows how the debt to GNP ratio as changed since the financial crisis for 47 national economies. The debt to GNP ratio has increased significantly in most countries.

Figure 10: Change in debt to GNP ratio from 2007 to 2014. McKinsey data.

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Figure 11: Breakdown of Chinese Debt 2000 to 2014. McKinsey data.

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Figure 10 shows that China has increased its debt substantially since the financial crisis. Since China is the world’s second biggest economy, it’s worth looking in more detail at the data for China. Figure 11, taken from the Economist magazine, shows that the total debt of China has increased dramatically in the last 14 years and is approaching 300% of GNP. However, for China, most of this debt is private. The debt of the government is a rather small part of the total.

So what does one make of this situation? In the advanced economies, debt levels are close to historical highs while interest rates are at historical lows. The emerging market counties are doing much better with respect to debt. Based on historical data, Reinhart and Rogoff have said that high debt levels are likely to suppress future growth rates. Demographics will also tend to suppress growth in developed countries. For these reasons, the advanced economies will have trouble growing out of the current debt problem. Further, if interest rates were to return to “normal” values, the burden of servicing the debt may be very high. All of this makes us very cautious about the economic prospects of the advanced economies. Slow growth and a rival of inflation (a time honored method of reducing debt) would not surprise us. However, as regular readers of these letters know, we don’t believe in timing markets or making predictions about particular segments. We continue to think that a broadly diversified portfolio that includes developing market stocks and inflation resistant assets such as REITS and commodities (including gold) is the best way to proceed. The IvyVest portfolios provide this type of diversification.

1) Carmen M. Reinhart and Kenneth S. Rogoff, “Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten”, International Monetary Fund Working Paper WP/13/266, December, 2013.
2) Richard Dobbs, Susan Lund, Jonathan Woetzel, and Mina Mutafchieva; McKinsey Global Institute, “Debt and (not much) deleveraging”, February, 2015.

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By Alex Frey