The context of ‘financial repression’ requires investors in all asset classes to make appropriate strategic adjustments, according to Nick Armet.
Debt reduction is a key long-term objective for many governments, financial institutions and individuals throughout the developed world.
In the years leading up to the financial crisis, conditions were generally conducive to debt accumulation; however, ever since the financial crisis, we have been living in an ‘age of deleveraging’.
The process of debt rationalisation via ‘financial repression’ and inflation, now underway in much of the developed world, looks set to persist for many years to come and has important implications for investors in all assets classes.
Different ways to reduce debt
There are a number of potential ways in which governments can seek to reduce their debt levels.
Probably the most attractive and least painful way is to promote faster economic growth because this tends to boost tax receipts, whilst raising employment.
A more obvious way to reduce debt is via restructurings or default, but this is highly problematic since it damages the balance sheets of creditors in favour of debtors.
A strategy that has been strongly advocated in the case of indebted peripheral Eurozone economies is expenditure reduction or ’austerity’.
However, a fundamental problem with austerity is that it tends to be counterproductive because of its negative impact on economic growth and tax receipts.
Moreover, as austerity bites, overall demand declines and the potential for self re-enforcing negative debt dynamics and deflationary effects also grows.
The limitations of austerity typically see it supplanted in time by the adoption of less conventional strategies such as quantitative easing (QE), in order to boost economic growth, which normally causes higher inflation.
Aside from the aforementioned avenues there are two somewhat less obvious but widely utilised methods of deleveraging.
Firstly, steps can be taken to boost inflation, which works by reducing the real value of debt.
Secondly, there is a subtle method known as ‘financial repression’ – broadly speaking, this refers to the various policies that are aimed at lowering financing costs for governments, including most notably, by lowering the interest rates payable on government bonds.
The paths to deleveraging are not mutually exclusive and the key requirement for successful deleveraging is to find the right balance between debt adjustment, austerity and debt monetisation.
‘Financial repression’ as a means of deleveraging
Financial repression is another less direct way for governments to deleverage. It widely refers to the redirection of funds from other borrowers to the government; for example, by the lowering of market interest rates on government debt. Most directly, this helps deleveraging by reducing a governments’ interest bill on the bonds they have issued.
However, a more effective and advanced form of financial repression occurs whenever real interest rates are pushed down to the extent that they become negative (ie, nominal bond yields fall below inflation rates).
This is highly relevant in today’s world because this is one important consequence of the various QE programs in effect today.
Financial repression places greater emphasis on the nominal interest rate reduction aspect of the same types of initiatives (hence the term ‘repression’), whereas there are inflationary aspects to debt monetisation programs such as QE.
However, both concepts are consistent because real interest reduction (which is the real key to deleveraging) can be achieved by either lower nominal interest rates on government bonds and higher inflation, or some combination of the two.
In this context then, QE programmes are clearly also very helpful for governments that want to reduce their real debt burdens.
Implications for equity investors
The current environment of deleveraging, weak growth and low interest rates greatly adds to the appeal of quality companies with robust balance sheets and good cashflows that can support healthy and growing dividend payments.
If the global investment universe is screened with these criteria, then many of the companies that fall into this group tend to be well established, high quality large-caps with a broad multinational presence.
The reliability of these companies’ cashflows is often connected to the fact they operate in traditionally non-cyclical areas, such as the consumer staples and healthcare sectors.
Further adding to the appeal is evidence showing that portfolios of these types of stocks tend to provide good long-term returns with acceptable levels of volatility.
Indeed, over long periods, the evidence clearly shows that dividends account for the largest part of total returns.
More generally in situations where inflation is rising or likely to rise, the appeal of real assets such as precious metals, certain industrial and agricultural commodities as well as real estate tends to grow.
These assets tend to be considered as good inflation hedges because their supply is limited while the long-term demand outlook looks favourable owing to factors such as population growth.
In terms of equities, companies that specialise in these areas also tend to have good inflation-hedging qualities, as do the equities of those companies that have the capability to raise their prices in all types of macro-environments.
From a global perspective it is important to note that although deleveraging is widespread in the developed world, it is by no means universal, with many emerging market countries having avoided the kinds of debt accumulation issues seen elsewhere.
The general absence of deleveraging constraints and additional supportive themes, such as rising incomes and growing middle classes, are all factors that strengthen the case for emerging market equities.
Implications for fixed income investors
The long-term path of deleveraging in many developed economies should ensure that growth remains slow and inflation low for several more years.
The response from central banks and governments will be continued ultra-low interest rates, more QE and austerity.
Government bond yields in many developed markets are likely to remain low, yet credit risks in those same governments are elevated when compared to their own history and when compared to large corporates.
In this environment, investors will remain hungry for yield which should support selected investment-grade credit, emerging market and high yield bonds.
However, the uncertain economic background underlines the need for rigorous fundamental credit analysis and careful stock selection.
For example, there are signs of releveraging by some corporates which are taking advantage of very low funding costs to fuel their mergers and acquisitions or capex ambitions. This is likely to have negative implications for their credit profiles.
A prolonged period of low interest rates and QE brings with it the longer-term tail risk of elevated inflation, which strengthens the case for an allocation to inflation-linked bonds.
Finally, among bond investors we are increasingly seeing a move away from market cap weighted benchmarks (which unhelpfully tend to favour the most indebted situations) in favour of more flexible, diversified and strategic investing approaches.
Nick Armet is the investment director at Fidelity Worldwide Investment.
