The mathematics of a growing debt load

September 10, 2018

Trade tensions combined with divergent economic growth trends and a looming currency crisis in Turkey have kept a lid on the rise in government bond yields over the past few months, but the ultimate obstacle in the way of significantly higher rates over the longer term remains the growing global debt load.

As discussed in a recent insight, A secular bear in bonds? Not so fast, the maturing cycle in yields may still have another leg up despite the economic headwinds facing investors today. However, as rates climb higher, the cost of borrowing does too, meaning it will eventually become too onerous for people to service their liabilities.

Let’s take the United States as an example. At last count, the country’s total debt was approximately US$65-trillion across the four major borrower categories of government, non-financial corporate, financial corporate and consumer, according to Ned Davis Research data. That equates to a near record leverage ratio of about 3.5-to-1 (down only modestly from a historical peak of 3.75 just after the Great Recession nine years ago) given the country’s current annual GDP of US$20-trillion.

The interest expense on this debt is about US$2-trillion a year based on an average interest rate of 3% that takes into consideration short and long-term government debt, as well as corporate debt and all types of consumer debt from mortgages and auto loans to credit cards that carry much higher borrowing rates.

This US$2-trillion in annual interest expenses represents a sizeable 10% of annual U.S. GDP. While it has not been sufficient to derail the recovery from the Great Recession, it has exerted an obvious drag on growth, resulting in the most anemic rebound in U.S. history, which has averaged just 2.2% annualized growth since 2009.

Debt Snowball

Global debt is up almost $150 trillion over 15 years

Source: Institute of International Finance as of July 11, 2018

So what happens if interest rates continue to rise from here? An increase in the average interest rate to 5% from 3%, for instance, would add another US$1.3-trillion in interest expenses, which then would total over US$3.3-trillion and account for more than 15% of annual GDP (up from 10% now).

Said differently, a rise in rates of this magnitude would cause a drag on GDP growth that would be difficult for the U.S. economy to absorb if it only continues to grow at its current nominal pace of 4-5%. In this scenario, the US$800-billion to US$1-trillion added to the country’s total annual GDP of US$20-trillion would be completely subsumed by the annual growth in the country’s debt.

Exacerbating matters, borrowers will eventually be unable to service the increase in their interest expenses, and at some point creditors will stop earning income from loans that borrowers can’t pay back.

Not all of this happens right away, of course. A good deal of the debt outstanding is based on fixed rates, and so higher rates today won’t have an impact on some borrowers until they are required to refinance sometime in the future.

Even so, debt levels are probably too high for the U.S. economy to withstand if rates move too much, too quickly, resulting in a growing wave of defaults. Instead, economic growth would almost certainly slow, leading to a potential recession that inevitably forces the U.S. Federal Reserve (and bond market) to push rates back down again.

And this may only be half the battle. On top of the US$65 trillion in debt, the U.S. economy must also account for another US$60 to US$70 trillion in unfunded liabilities from entitlement programs like social security and Medicare that are starting to come due as the baby boom generation begins to retire.

Nor is the U.S. alone in this situation. Global debt levels are rapidly approaching US$250-trillion as compared to global GDP near US$80-trillion, resulting in a similar mathematical outlook for the rest of the world. As a consequence, we believe there’s limited scope for interest rates to rising significantly higher from here.

David Stonehouse is a senior vice president and portfolio manager at AGF Investments Inc. He is a regular contributor to AGF Perspectives.

Commentaries contained herein are provided as a general source of information based on information available as of August 28, 2018 and should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. Investors are expected to obtain professional investment advice.

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