Leverage: the long-term perspective

The recent McKinsey report “Debt and (not much) deleveraging” is well worth a read.

It shows that we are still in a global credit boom with global debt/GDP rising at a very fast pace: from 220% in 2008 to 260% in 2014.

Given that world GDP itself must have been boosted by the debt growth (borrowing money and spending makes it someone else’s income…) then clearly we are set up for a crisis at least somewhere in the world.

I will go through the numbers for credit growth in different parts of the world to understand which countries or asset classes might be vulnerable to deflationary credit busts. I will also try to understand which asset classes have seen the largest amount of inflows since the global financial crisis, under the heading “fund leverage”.

If the 2008 global financial crisis was caused by easy credit due to financial innovation and deregulation in the US mortgage sector, then this time the risks are primarily in developed market sovereign debt and emerging market corporate debt.

Sovereign debt

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The bigger offenders in terms of government debt are Euro periphery countries such as Ireland, Portugal, Greece and Spain as they dealt with the fallouts of a Euro-driven credit bubbles. But Japan also increased its debt/GDP ratio by 64 percentage points to 400% as budget deficits reached 8-9% between 2010 and 2014. United States and United Kingdom have also seen rapidly growing debt/GDP. Government debt in emerging markets look relatively low at the moment.

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Corporate debt

The value of corporate bonds outstanding has grown by $4.3 trillion 2007-2014, compared to $1.2 trillion 2000-2007. Bank lending to corporate borrowers has also increased substantially.

It is clear that emerging markets are the big offenders as this chart from BIS clearly tells. The leverage ratios of corporations in emerging market economies have grown from 1.5x to 3.0x since 2008.

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Real credit growth in the private sector has been by far the largest in countries such as China, Brazil, Turkey and Mexico. India and Australia have also seen significant increases in private sector debt.

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Starting with China, it is clear that a lot of the increase in corporate debt has gone to the property sector. McKinsey estimates that half of the debt of Chinese households, corporations and governments is directly or indirectly related to real estate. Housing construction accounts for 15% of GDP. These numbers are not far those of Spain’s economy pre-2007 when 50% of loans went to construction companies and real estate developers. Total debt levels in China has nearly quadrupled since 2007: from $7.4 trillion to $28.2 trillion in the second quarter of 2014. China is clearly the big elephant in the room.

Given recent exchange rate volatility, whether the corporate debt is denominated in local or foreign currency is another important question. Total USD-denominated debt to non-bank borrowers (both corporate and households) has in any case grown about $4 trillion since the crisis, split almost half-half between debt securities and bank loans.

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Out of these $4 trillion, almost $800 million comes from Chinese issuers, roughly $150 million from Brazilian issuers and roughly $50 million from Indian issuers. Adjusting for the fact that China’s GDP is 4x larger than Brazil, the relative size of USD-denominated debt issuance has been almost as big in Brazil as in China. The big difference between China and Brazil is that the property sector accounts for the biggest share of non-bank issuance whereas in Brazil the commodity sector accounts for a larger share.

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Household debt              

Below charts illustrate the link between rising household debt and property market booms. Countries with rising household debt (Australia, Canada, Hong Kong, Korea, New Zealand, Norway, Singapore and Sweden) has seen much higher property price increases than countries with deleveraging households (Greece, Ireland, Italy, Portugal, Spain, the UK and the US).

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Household debt-to-income ratios are high and have been rising in countries such as Denmark, Norway, Netherlands, Australia, Sweden and Canada. These countries have all experienced property booms. Given low and falling interest rates, housing prices could easily continue their upwards trends. Regions with exposure to commodity-related industries in Canada, Norway and Australia may be exceptions.

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Fund leverage

There is another type of leverage: inflows into bond and equity funds. Once these inflows turn into outflows, funds will be required to sell underlying assets without regard to their economic fundamentals. Liquidity can dry up very quickly. The leverage inherent in funds is therefore similar to that of pure borrowing.

Cumulative flows into bond funds (both ETFs and mutual funds) have been massive since the global financial crisis, to the tune of $3 trillion.

tempFund flows into mutual funds and equity ETFs have been less extreme but still around $500 billion since the global financial crisis.

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The following chart is from mid-2013, but it indicates that cumulative flows since the financial crisis has been bigger into emerging markets than into developed markets. Whether that is still the case, I am not sure.

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Conclusion

What to make of all this?

I use macro data to find good hunting grounds for stock ideas. Given the above analysis, I conclude that such hunting grounds may include:

  • Shorting sovereign debt in countries such as the PIIGS and Japan. Shorting USD government debt or the currency may not be such a good idea given a $9 trillion short position of the US Dollar driven by QE-driven carry trades.
  • Shorting property developers and other cyclical companies in China. Financials are tricky to short as most of them are state-owned. Both solvency and liquidity issues can easily be resolved by the strong hand of the government.
  • Shorting highly leveraged commodity producers in Brazil with USD-denominated debt
  • Shorting property developers and financial institutions in countries such as Norway, Canada, Australia, Sweden and the Netherlands if and when rates are forced up by capital outflows
  • Hedging equity portfolios by shorting bonds
  • Not being overweight emerging market equities
  • Cash deposits in countries such as the United States and Germany

Of course, debt problems may already be priced in when it comes to individual names.

To be continued.

Fritz

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