In an IMF Working Paper, “Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten,” authors Carmen M. Reinhart and Kenneth S. Rogoff provide some interesting insights into the potential impact of the current high U.S. federal debt.
In their paper, reference is made to their earlier research (Reinhart-Rogoff’s, 2012) in which 26 episodes of developed country debt that exceeded 90% of GDP for at least five years were analyzed. The upshot of their research is that, when central government debt exceeds 90% of GDP, the economy contracts at a 0.1% annual rate. These “debt overhangs” last, on average, for 23 years. Also, in comparing countries with and without debt overhang, the countries with the debt overhang experienced, on average, 1.2% lower economic growth.
The Reinhart-Rogoff IMF Working Paper emphasizes that historically, the way forward out of these debt overhangs has been through “capital controls, financial repression, inflation, and default.” They do refer to the possibility of a “soft exit” brought about by economic expansion. However, they point out that “an aging society, an expanding social welfare state, and stagnant population growth would be difficult in the best of circumstances.”
While the U.S. may not (yet) be experiencing hyperinflation and default seems unimaginable, financial repression has arrived. Due to the policy of central banks to keep interest rates below inflation, the level of interest savers receive on their deposits cannot keep up with the rising cost of living. In effect, this erosion of buying power is a socialization of the debt, the cost of which is mainly borne by savers.
The authors note that a common scenario in which the debt overhang is dealt with is through a “steady dose of financial repression accompanied by a steady dose of inflation.” It seems that this will, at minimal, be the end result of the U.S. topping the 100% ratio of government debt to GDP. How should this climate impact investment, saving and spending strategies?
The high correlation between countries with low debt overhang and increased GDP growth would seem to build the case for investing in countries that have low sovereign debt relative to GDP. Thus, the search for growth ought to be a global search. In spite of the fact that there has been a recent pull back from emerging markets, this asset class is generally dominated by countries that are growing at a healthy clip and have low government debt relative to their GDP. The down side is that these emerging markets (unlike the huge development markets) have limited capacity and, thus, can become overheated quite quickly. Therefore, it is important to not overpay for this asset class by staying focused on the fundamentals of each individual security as well the economy in which it operates.
Knowing that inflation is a chief means for countries to overcome debt overhang, plan advisors ought to specifically focus on what their money managers are doing to positioned investors if inflation should begin to intensify. One possible means of accomplishing this is by focusing on investing in companies with strong fundamentals that have pricing power (to keep pace with inflation) due to strong brands and large “moats” around their businesses. Commodities have also been a traditional hedge against inflation. However, one has to consider whether this asset class has been oversold relative to expected demand in a world dominated by over-supply and low growth in the advanced economies.
There are, of course, many different strategies to prepare a portfolio for inflation. It is up to the plan advisor to consider, based on research such as the Reinhart-Rogoff studies, how important it is to insulate their plan investment lineups from inflation.
