Debt: A cause for caution. Bruce Cooper, CFA Chief Investment Officer, TD Asset Management Chair, TD Wealth Asset Allocation Committee

Transcription

1 Debt: A cause for caution Bruce Cooper, CFA Chief Investment Officer, TD Asset Management Chair, TD Wealth Asset Allocation Committee March 2016

2 Debt: A cause for caution Debt may be a four-letter word, but it s not inherently bad. So long as it is used productively and borrowing capacity is not exceeded, it can be a very useful tool. However, since the financial crisis, debt has continued to climb; the global debt-to-gdp ratio now stands at 236% versus 209% a decade ago.¹ Recently, debt has climbed particularly quickly in the emerging world, especially in Asia. Overall, the size, scale and pervasiveness of current debt levels globally are concerning and have been a central part of the TD Wealth Asset Allocation Committee s ( WAAC ) thought process for the past several years. Debt is widespread, residing in a number of places, including various levels of government, within state-owned enterprises in China and at the household level globally. For example, federal government debt in the U.S. is more than $18 trillion dollars (100% debt-to-gdp ratio),² and state and local governments are no strangers to debt either, as witnessed by California s struggles and the City of Detroit s bankruptcy. In Canada, Ontario now has the dubious distinction of being the most indebted sub-sovereign government in the world,³ and at the household level, the Parliamentary Budget Officer reports that Canadians debt has reached 171% of disposable income. In the developing world, China s overall debt (including government, state-owned enterprises and households) is more than 240% of GDP % 200% Figure 1: Global debt to GDP ratio March March 2015 Total debt/gdp 150% 100% 50% 0% Source: Bank for International Settlements, TD Asset Management 1 DEBT: A CAUSE FOR CAUTION

3 In addition to debt being high from a long-term secular perspective, research at TD Asset Management (TDAM)* suggests that debt is also stretched from a cyclical perspective. These elevated levels of debt are concerning because debt can slow economic growth and increase financial market volatility. In an environment of slow economic growth, WAAC ( we ) expects interest rates will remain low for an extended period and companies will find it challenging to grow their revenues and earnings. In addition, increased volatility can make investing nerve wracking. As a result, we remain cautious and continue to believe that investors will be well served by a diversified portfolio of high quality assets. Debt: Dragging down growth For many years, our most important investment theme has been that we live in a persistent low growth world. One of the underpinnings of this view has been that high sovereign debt depresses growth. Historically, when government debt reaches or exceeds 90% of a country s GDP, the period that follows is one of sub-par expansion.** We are now at a point where many of the key governments in the world, including the U.S., Japan and much of Europe, are through this 90% threshold. 5 Complicating this situation is the reality that household and corporate debt are both significantly above trend from a cyclical perspective. Increasing levels of household debt are positive for growth in the short term as consumer spending helps to fuel the economy. But over the long term, consumption must be driven by income. If debt increases too quickly, it will begin to weigh on household finances and consumer spending will wane. Increasing corporate debt levels can also help to boost growth; in fact, corporate credit has been a key driver of growth since the financial crisis as companies took advantage of record low interest rates. However, credit growth has been outpacing GDP growth, which is unlikely to persist. TDAM s research shows that private debt (which includes household debt, non-profit debt and non-financial corporate debt) is above trend and at the high end of the range, which means we are unlikely to be able to rely on credit growth to fuel future economic growth. Further complicating matters is that, as shown in Figure 2, elevated levels of corporate and household debt have historically preceded recessions. 2

4 Figure 2: U.S. private non-financial sector debt/gdp cycles % 4% 2% % from trend 0% -2% -4% -6% U.S. private non-financial sector cycle Recession United States Source: Thomson Reuters Datastream, Bank for International Settlements, National Bureau of Economic Research, TD Asset Management Private non-financial sector includes households, non-profits, and non-financial corporations While we are not predicting an imminent economic downturn, we are noting that government debt has now reached a level that may well restrain growth while corporate and household debt levels indicate that they are unlikely to make meaningful contributions to growth in the near term. This leaves us cautious as it is unclear what the drivers of future growth will be. Debt: Igniting volatility In addition to restraining growth, debt can also increase financial market volatility. When levels are elevated, debt can cause uncertainty and can be a conductor of contagion, spreading problems from one region to another, both of which drive volatility. Remember that when heavily indebted Greece faced a possible default, investors here in North America felt the effects of associated volatility even though Greece is a small, far off country. While the problems may have seemed remote, the world is increasingly interconnected, which means we are more susceptible to shocks from abroad. Here s a simplistic example of how debt can transmit problems from one region to another and influence global financial markets. Imagine Greece issues bonds. Distribution is not limited to Greece; the bonds are widely available, so Greek people buy the bonds, and so do a number of European banks. If Greece defaults, ramifications will go beyond its borders as both the Greek citizens and the European banks would be affected. For example, impairment of 3 DEBT: A CAUSE FOR CAUTION

5 the Greek bonds might lead to a reduction in the banks capital. That in turn could impact any North American companies that have invested in the European banks. Thus, Greece s troubles have quickly become global troubles. Debt doesn t just transmit problems from one region to another, it can also transmit them from one asset class to another a debt default can have implications for equities and currencies as well. For example, if Russia defaults on some of its bonds, bond holders might be forced to sell other assets, such as equities, to cover their losses. In addition, the default will cause the ruble to move lower, which could have implications for global currency traders. Debt can also increase the volatility of individual securities. In recent years, corporations globally have increased the amount of debt on their balances sheets, partly to take advantage of historically low interest rates. However, as shown in Figure 3 below, this corporate borrowing has not been particularly productive, and increased corporate borrowing has not resulted in increased investment (for example, in things that will help businesses to grow and increase shareholder value, such as new plants or machinery). Figure 3: Corporate borrowing vs. investment New investment as a % of PP&E; S&P 500 Index 4% 3% 2% 1% 0% -1% New investment as % of property, plant and equipment (PP&E); S&P 500 Index rolling 4Q Recession United States Source: Thomson Reuters Datastream, National Bureau of Economic Research, TD Asset Management Instead, many companies have been using the proceeds of their loans to buy back shares or increase dividends. While these are shareholder-friendly activities and are commendable to a point, they should be funded from free cash flow rather than from debt. Borrowing to buy back stock allows companies to make more efficient use of capital, but the cost is less financial flexibility and a more vulnerable and volatile balance sheet. Essentially, debt limits a company s ability to take advantage of opportunities or deal with adversity, and it supercharges the volatility of the balance sheet not an ideal combination. 4

6 What does this mean for investors? The low growth world we re living in has important implications for investors. Today, nominal growth of global GDP is running at about half the pace it was prior to the financial crisis (approximately 4% versus 8%) 6. We believe this lackluster trend will keep interest rates low, both at the central bank policy level (we expect the loosest tightening in U.S. Federal Reserve history) and out the yield curve. For equity investors, we anticipate that slow economic growth will translate into tepid revenue and earnings growth. We are already seeing signs of this, with Q4 revenue growth for S&P 500 Index companies coming in at around 1% and earnings growth at around 4%, 7 even excluding the weak Energy sector. This is likely to create an environment of modest returns, which, when combined with the volatility referred to earlier, could create a roller-coaster ride for investors. Our view We turned more cautious on markets in early 2015, and TDAM s analysis of the role of debt in the global economic picture leaves us cautious today. In this context, it is more important than ever for investors to have a plan and to stick with it, even during difficult periods. In particular, we believe investors can benefit from embedding three key elements into their portfolios: an emphasis on risk management that ensures risk taking is being properly compensated; a high level of diversification to help mitigate the impact of market movements; and a focus on quality companies with strong balance sheets, high returns on capital and consistent cash flows that are positioned to prosper in a difficult environment. This disciplined approach should help investors navigate the challenging environment they face today. 5 DEBT: A CAUSE FOR CAUTION

7 About the author Bruce Cooper, CFA Chief Investment Officer, TD Asset Management Chair, TD Wealth Asset Allocation Committee About TD Asset Management (TDAM) TD Asset Management (TDAM), a member of TD Bank Group, is a North American investment management firm. Operating through TD Asset Management Inc. in Canada and TDAM USA Inc. in the U.S., TDAM brings new thinking to investors most important challenges. TDAM offers investment solutions to corporations, pension funds, endowments, foundations and individual investors. Additionally, TDAM manages assets on behalf of almost 2 million retail investors and offers a broadly diversified suite of investment solutions including mutual funds, professionally managed portfolios and corporate class funds. Collectively, TDAM manages over C$300 billion in assets as at December 31, 2015.

8 *TDAM s research was inspired by and builds on work done by the Bank for International Settlements. ** See Reinhart and Rogoff s This Time is Different for more detail. Sources: 1Credit Suisse, Bank for International Settlements, 2Federal Reserve Bank of St. Louis, 3Bloomberg Finance L.P., 4 Peoples Bank of China, 5 Bloomberg Finance L.P. 6 Credit Suisse, Bank for International Settlements, 7 Bloomberg Finance L.P. The statements contained herein are based on material believed to be reliable. Where such statements are based in whole or in part on information provided by third parties, they are not guaranteed to be accurate or complete. The information does not provide individual financial, legal, tax or investment advice and is for information purposes only. Graphs and charts are used for illustrative purposes only and do not reflect future values or changes. Past performance is not indicative of future returns. TD Asset Management Inc., The Toronto-Dominion Bank and its affiliates and related entities are not liable for any errors or omissions in the information or for any loss or damage suffered. Certain statements in this document may contain forward-looking statements ( FLS ) that are predictive in nature and may include words such as expects, anticipates, intends, believes, estimates and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS. The TD Wealth Asset Allocation Committee ( WAAC ) is comprised of a diverse group of TD investment professionals. The WAAC s mandate is to issue quarterly market outlooks which provide its concise view of the upcoming market situation for the next six to eighteen months. The WAAC s guidance is not a guarantee of future results and actual market events may differ materially from those set out expressly or by implication in the WAAC s quarterly market outlook. The WAAC market outlook is not a substitute for investment advice.td Asset Management (TDAM) operates through TD Asset Management Inc. in Canada and TDAM USA Inc. in the United States. Both are wholly owned subsidiaries of The Toronto-Dominion Bank. Bloomberg and Bloomberg.com are trademarks and service marks of Bloomberg Finance L.P., a Delaware limited partnership, or its subsidiaries. All rights reserved. All trademarks are the property of their respective owners. The TD logo and other trademarks are the property of The Toronto-Dominion Bank. (0316)