Rising Global Debt: The Good, the Bad, the Opportunity

The COVID-19 pandemic has been a major catalyst for the increase in global government debt. To fill the massive hole from economic closures, governments around the world have aggressively increased deficit spending. In fact, the amount of spending and subsequent increase in government debt levels has been unprecedented outside of wartime! Investors have a legitimate concern: Will spiraling debt levels cause a bond market revolt as investors demand higher interest rates, making the servicing of deficits even more tenuous and possibly beginning a very un-virtuous circle?

Global Debt Levels

From a historical perspective, current debt levels are clearly very high and look set to continue their climb. Logic would suggest that investors will want higher compensation, via higher yields, for holding that debt as all else equal, higher debt means higher risk. So far, the exact opposite has happened in developed markets. Looking at a country like Japan, where concerns about debt levels have been a narrative for the last 25yrs, we’ve seen falling Japanese government bond yields and a relatively range-bound yen.

So yes, high debt levels are a real concern globally but it’s tough to know exactly when we might see a bond revolt - or even a stern warning. Global central banks (CBs) have been aggressively buying their governments’ debt through various quantitative easing (QE) programs, taking a substantial amount of supply off the table. This, however, will not last indefinitely. As CBs step back from their purchases we will see some pressure higher in yields but in our view, QE is now a tool that will be pulled out in times of need, suggesting CBs will fight back against a disorderly rise in bond yields.

Service Cost Important

It’s important to also consider the cost (and expected cost) of servicing the debt. With such low interest rates, the servicing costs are low for now. We do expect central banks will start to raise rates in 2022 and 2023, but we think the hiking path will be tepid by historical standards, which should keep servicing costs low for at least the medium term.

Debt in Canada

Canada is not indifferent to these global trends. Debt levels are high (and growing), but low debt service costs suggest things are sustainable for now. Canada’s economy may be more interest rate sensitive, given high levels of consumer debt and our reliance on housing. The Bank of Canada has been one of the first to start removal of policy stimulus, but we think Canada will need to be less aggressive about raising interest rates given the interest rate-sensitivity of our market. Over the medium term, we don’t anticipate big increases in rate hikes in Canada leading to materially higher yields in our government bond market.

Portfolio Positioning

Although concerns on debt levels are legitimate, we think that will play out longer term. Globally the growth of debt is alarming and will at some point pull down potential growth and possibly have other negative implications. However, over our investment horizon, emergency spending levels will subside, and we foresee decent growth with slightly higher and more persistent inflation resulting in a reduction in policy stimulus, which we think will push rates up somewhat. We do see higher inflation as being more transitory, though, as longer-term secular forces such as technology, high debt levels and demographics keep inflation more contained and rates behaved.

Tactically, we generally prefer stocks over bonds in this scenario, with less exposure than normal to government paper and reduced interest-rate sensitivity. We like carry trades, favouring corporate and select emerging market debt. Although we don’t want to overstay our welcome, in this environment we think it’s fine to earn that extra carry given the investor appetite for yield and continued support from developed market central banks.

Comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.