debts and deficits - rwc...if deficits cannot be cut and economic growth refuses to accelerate, then...

www.rwcpartners.com | E [email protected] | Authorised and regulated by the Financial Conduct AuthorityRWC Partners Limited 60 Petty France, London SW1H 9EU | T +44 (0)20 7227 6000 | F +44 (0)20 7227 6003

For Professional Investors and Advisers Only

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Wars

Largest peacetime deficit

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Deficit (% of GDP)

FIGURE 1: US ANNUAL BUDGET DEFICIT SINCE 1791, % GDP

Source: Deutsche Bank, GFD, 1971-2007

Most modern economists tend to agree with Dick Cheney’s advice that ‘deficits don’t matter’ and therefore encourage governments to run permanent budget deficits. Common refrains are ‘we owe the money to ourselves’ and ‘we will always be able to roll the debt over’.

Today’s politicians are only too happy to embrace this advice and implement spending policies on that basis. Many people are shocked, therefore, to discover that until forty years ago when the Bretton Woods Agreement

was ended, governments had managed to live within their means for hundreds of years. Even when a deficit appeared during war time, governments managed to return to surplus shortly after the resumption of peace (see Figure 1). This was because those countries that loosened policy too much would have seen a rush to convert their currency into gold and hence multi decade deficits simply could not occur under the gold-standard1.

Once this system ended, however, countries were no longer forced to defend their currency peg to the gold price or the US dollar, and this ushered in the new world of fiat currencies. With nothing backing paper money, the path to almost unlimited credit creation was opened. In addition, financial regulation was loosened which allowed banks to create money on an enormous scale.

You know, Paul, Reagan proved that deficits don’t matter.

US VICE PRESIDENT DICK CHENEY, 2003

“ ”

1 By 1973, the U.S. was hit with a triple whammy of new social programs (developed by L.B. Johnson) the Vietnam War (which continued to be escalated by Nixon) and rising oil prices and France insisted on gold delivery which ultimately led to the break down of Bretton Woods.

RWC Equity Income Team: Longer Perspective March 2017

Debts and Deficits


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Hence in the last forty years, with the exception of small surpluses between 1998 and 2001 (which were related to the internet bubble), the US has run a deficit every year since 1969. The UK has been in deficit 55 out the last 64 years, Spain 49 out of 54, Japan every year since 1992. Italy, Portugal and France have seen perpetual annual deficits since 1960, 1977, and 1978 respectively2. It seems that politicians have embraced Keynes’ advice about running deficits during a downturn but have then struggled to return to surplus during the good years since nothing is likely to get a politician fired faster than spending cuts or austerity policies. Running permanent budget deficits gives politicians the opportunity to keep large swathes of the electorate happy in the hope that the favour will be returned on polling day.

What is quite staggering is to remind ourselves that most of these countries are still running budget deficits eight years into an economic recovery, and despite benefitting from rock bottom interest rates which lower their debt servicing costs. Despite this, many countries show little sign of being able to reduce their deficits, let alone make any inroads in to their total debt burden, with the UK unfortunately being a good example of this.

In the 2016 spring budget, Chancellor Osbourne said he would borrow a total of £38.8billion in the years 2017 to 2020 inclusive with the UK running a surplus in the last two years. Fast forward to Chancellor Hammond’s recent spring budget and the UK is now forecast to borrow £58.3bn next year alone and £141bn over the next four years, three and a half times more than Osbourne predicted twelve months ago.3

As Figure 2 shows, it is now common practice for all major countries with the exception of Germany to run budget deficits.

FIGURE 2: NATIONAL BUDGET DEFICITS

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Source: The Economist, 04 March 2017

A democracy cannot exist as a permanent form of government. It can only exist until the people discover they can vote themselves largess out of the public treasury. From that moment on, the majority always votes for the candidate promising the most benefits from the public treasury, with the result that democracy always collapses over a loose fiscal policy – to be followed by a dictatorship.

ALEXANDER FRASER TYTLER

“

”

2 Deutsche Bank LT Asset Return Study, 03 September 20123 ‘The scandal of this boring budget is £100 billion in extra borrowing’ by Liam Halligan, Daily Telegraph, 09 March 2017


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To understand why governments have such trouble reducing deficits, it is worth considering where the spending goes in order to appreciate how little flexibility they have to reduce them. Figure 3 shows a breakdown of the $4.4 trillion dollars that the US government spent in 2016.

security, Medicare & interest payments on the debt. Again remember that interest rates were only a shade higher than their historical lows, due to the activities of the Federal Reserve.

Whilst spending such as healthcare, social security and interest payments could be labelled mandatory, the other parts such as defense could be labelled discretionary (even if in reality it is not). What limits the ability of the US to reduce their deficit is that even If the government had decided to ditch all of its other commitments to defense etc., and just funded social security, Medicare and interest … it would still be running a deficit.

So having determined that it is very likely that most developed world governments will continue to run deficits for the foreseeable future, one has to conclude that the debts of these countries will continue to compound upwards. The US has seen debt increase from $10 trillion to $20 trillion in the eight years that Obama was president but with multi-decade compounding of deficits, debt to GDP ratios have skyrocketed everywhere and have continued to climb even post the financial crisis. In a February 2015 report from McKinsey Global Institute entitled ‘Debt and (Not Much) Deleveraging’, the authors showed that global debt had climbed from $142 trillion prior to the financial crisis to $199 trillion in 2014 (see Figure 4). Updating this figure to the end of Q3 2016, global debt now stands at $217 trillion which represents 325% of global GDP.4 Figure 5 shows the main culprits in terms of both their indebtedness as well as how this debt is split between corporate, government and households.

In 2016 the US government spent $1 trillion more than it received in ‘income’ and this was almost double the previous year’s deficit, and comes eight years into a so-called ‘recovery’: a 12 month period in which there was no major war, no recession, no big new infrastructure spend, and no bank bailouts or other crises. The largest portion of the deficit was accounted for by social

FIGURE 3: US NET EXPENDITURE, 2016

Net Cost: FY 2016 ($4.4 trillion)

Department of Health and Human Services – 24%

Social Security Administration – 22%

Department of Defense –14%

Interest on Treasury Securities Held by the Public – 6%

Department of Veterans Affairs – 15%

All Other – 19%

Source: Citizens Guide Financial Report of the United States Government, 11 January 2017

4 Source: Institute of International Finance

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China UK US IndiaJapanGreece

FIGURE 4: NATIONAL DEBT, % GDP

Source: Bank for International Settlements, 1999 - 2015


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FIGURE 5: SPLIT OF DEBT, % GDP

FIGURE 6: 2016 US CHANGE IN CREDIT VS CHANGE IN GDP, $BN

Corporate Household Government

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$633

Source: Bank for International Settlements, 30 September 2015

Source: Federal Reserve Economic Data

Nine years into an economic recovery and with interest rates at nearly zero, almost all developed market governments continue to run large budget deficits whilst economic growth remains muted. Very few politicians have the political willpower to cut expenditure (and as we have seen, in some cases mandatory spending exceeds tax revenues, leading to a deficit even if all discretionary spending were cut to zero). If deficits cannot be cut and economic growth refuses to accelerate, then debt-to-GDP rates will continue to compound upwards.

Figure 6 highlights that in 2016, the US economy added $4 of credit for every $1 of GDP and demonstrates why the debt-to-GDP ratio seems likely to continue to climb.

There is considerable evidence that a high stock of debt increases vulnerability to the risk of a financial crisis5. Figure 7 shows that banking crises were relatively rare prior to 1970 but have been much more frequent as global debt to GDP ratios have increased.

5 See Reinhart and Rogoff 2009, Jorda et al 2011, Gourinchas and Obstfeld 2012

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1945-70 2 banking crises 1980-2010 153 banking crises

1971 BrettonWoods ends

PostGFC

Volcker tames inflation

Financial deregulation andinnovation (securitization)

FIGURE 7: GLOBAL DEBT TO GDP

Source: BEA, Federal Reserve, 1951 - 2014


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Conclusion

As we have highlighted, there is nothing new about this trend towards debts and deficits, it is merely the continuation of a long-term trend that started in 1970. Nonetheless, when making investment decisions investors need to ask themselves some of the following questions that we are constantly wresting with.

• Do you think this trend of increasing debt issustainable or not, and was the 2008 Financial Crisisthe first warning that ultimately it is not sustainable?

• If you don’t think it is sustainable, what are the likelyimplications?

• Could there be another financial crisis and if so, howwill governments react given that interest rates arealready at or near zero and central bank balancesheets are very stretched?

• If the bond vigilantes do eventually awake from theirslumber and force governments to bring their financesunder control, how are they most likely to do this?

• Do you think governments will eventually be forcedinto debt write-offs and restructuring? If so, whatimplications does this have for the banking systemand could this lead to a deflationary bust?

• Or do you think a continuation of financial repressionis more likely (in which interest rates are held belowthe rate of inflation and hence debts are inflated awayover a long period of time)?

• If yes, what confidence do you have that central bankscan generate just the right amount of inflation withoutallowing it to get out of control? Is there a chancecentral bankers are already behind the curve andhave let the inflation genie out of the bottle?

• Have the policies of bailing out bankers, pumping upasset prices whilst simultaneously trying to keep thelid spending has generated the political backlash wehave witnessed in the last eighteen months? Doesthis threaten the political status quo and what might anew wave of populist governments decide to do?


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CONTACT US

Please contact us if you have any questions or would like to discuss any of our strategies.E [email protected] | W www.rwcpartners.com

RWC London60 Petty France London SW1H 9EU T +44 20 7227 6000

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RWC Singapore80 Raffles Place #22-23 UOB Plaza 2 Singapore 048624 T +65 6812 9540

Portfolio Managers

Ian Lance, Nick Purves and John Teahan have managed funds together for over 10 years. Their loyalty and experience is leading within the industry and has awarded them a number of accolades. Ian, Nick and John joined RWC Partners in 2010 to establish the Equity Income team and now manage over £3.5 billion for their clients.

The team’s approach fully integrates conviction led, value-based stock selection with a distinctive and technical approach to stablising assets, with the aim of delivering investment solutions that both grow investors’ assets and protect the purchasing power of capital and income.

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Unless otherwise stated, all opinions within this document are those of the UK Equity Income Investment Team, as at 22 March 2017.

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debts and deficits - rwc...if deficits cannot be cut and economic growth refuses to accelerate, then...

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