Recent data suggests that global economic growth is gradually improving from its trough in April. After a significant decline between February and June, consensus forecasts for global growth have stabilised. Global equity markets have, therefore, continued their recovery path, fueled by central bank easing and the gradual reopening of some economies following lockdowns. Although the pace of central bank easing has stabilised, unprecedented fiscal support and collapsing revenues have led to sharply wider fiscal deficits in several economies. The world is now awash with debt issued, especially by governments, and it is tempting to believe that these high debt levels are sustainable indefinitely due to record low-interest rates. Like most other economies, South Africa is expected to accumulate debt at a significant pace over the next 18 months. The debt to GDP ratio is expected to reach 85% by 2022, a level last seen in 1935. The rise in government debt has been a necessary consequence of COVID-19.
Nonetheless, investors still need to answer the question - do high government debt levels have an impact on the performance of financial markets? Unfortunately, yes, and history shows us that previous waves of rapid debt accumulation have only ever ended in financial crises! Therefore, investors may have to start thinking of ways to insulate their portfolios against such a dreaded outcome.
Because we believe that this time is different and that excessive government debt levels can be managed through innovative policies. In 1947 the world-renowned economist Abba Lerner argued that very high government debt does not have to end in default. The interest burden that government incurs can be met by... printing money. If inflation becomes a problem, then the government can raise taxes! Today, a slightly adapted version of this framework is being applied – the modern monetary theory or MMT. The higher interest burden that governments must pay can be met by the central bank, significantly reducing interest rates. If investors, or banks, start fearing a government default and prompt a sell-off of government bonds, then the central bank can buy those bonds, thereby maintaining the debt service cost at very low levels. Investors and banks will be left holding money instead of government bonds. But the newly acquired money will not lead to a rise in inflation because investors will not invest, and banks will not lend into a weak economy. Without a sharp increase in inflation, interest rates can remain lower for longer, and very high levels of public debt can be sustained. But history tells a different story…
Due to selective memory, today’s information is more likely to receive higher weight when making investment decisions, than the facts that transpired five decades ago. This is one reason why it is essential to study long periods of history – to understand what can happen. According to the recent World Bank publication titled ‘Global Waves of Debt Accumulation’ - there have been three major debt waves in emerging markets since 1970, and all three waves ended in financial crises! Like today, the three waves of debt began during periods of low real interest rates. They were often facilitated by financial innovations that promoted borrowing - the Latin American debt crisis of the 1980s, the Asia financial crisis of the late 1990s, and the global financial crisis of 2007-2009. Of particular concern for South African investors, is that the countries that fared worst during these crises were those that had – inefficient sectors with poor corporate governance, poor revenue collection, widespread tax evasion, public wage indexing and monetary financing of fiscal deficits. Despite current exceptionally low real interest rates, the latest rapid pace of debt accumulation by South Africa, and most other economies, could follow the historical pattern and eventually culminate in financial crises. While we cannot offer a crystal ball for assistance, we do believe that there are ways investors can navigate this highly uncertain period.
Investing, when faced with unchartered waters, is a challenging exercise. However, we will continue to focus on the basics. Firstly, we believe that success in investing is driven by the ability to detect patterns in a noisy world and using these patterns in investment decisions to deliver better returns. In the SA Equity Fund, we continue to focus on the selection of growth companies. The ‘growth’ beta performs better during the latter part of economic expansions or during early to mid-slowdowns (‘risk-off’). During these ‘risk-off’ periods, investors are more cautious and safer assets such as US treasuries and the US dollar benefit from a flight to safety. The ‘value’ beta tends to perform well during an economic recovery or early expansion period (‘risk-on’) when investors are likely to pay up for riskier assets. Secondly, a comprehensive risk management framework is critical to an investment process. While we all want perfect forecasting models, the reality is that most investment decisions are based on models that have low forecast power. This means that we should not only consider the probability of being wrong but the consequences as well. We use scenario analysis daily to estimate the value of the investment portfolios we manage, given changes to certain critical factors. Our portfolios have been positioned to ensure that significant changes in the oil price, gold price, or currency do not lead to a substantial difference in the portfolio’s return, compared to the returns of the benchmark. We believe that managing portfolios in a risk-controlled manner while pursuing a growth strategy, is critical if we are to deliver the best outcomes for our clients in a season of darkness.
Lima Mbeu Investment Managers (Pty) Ltd is an authorised financial services provider in terms of section 8 of the Financial Advisory and Intermediary Act, 2002, FSP number 49018, Registration No 2017/399814/07. This document is for information purposes only. Past performance is not indicative of future performance. The information contained herein is derived from sources which are believed to be reliable. Any opinion expressed herein is based on the presenter’s current analysis and is subject to change. This presentation does not constitute an offer to sell or a solicitation to buy any security. Lima Mbeu has a conflict of interest policy which outlines how conflicts of interest are managed. This policy, as well as additional information about Lima Mbeu’s products, is readily available upon request or on our website: www.limambeu.co.za
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