Governments will have to rely on ‘financial repression’ to deleverage economies as the world heads into the third major debt cycle of the post-industrial era, according to Samy Muaddi, T Rowe Price fixed income portfolio manager.
In a webinar for NZ and Australian investors last week, Muaddi said in-hock governments have only two choices (barring default) to manage long-term debt: running surpluses; or, keeping nominal growth above interest rate levels.
He said prior to World War I developed economies paid down massive fiscal debt (mostly incurred to fund wars) over a century or so by grinding out government surpluses.
Post WWI, however, governments increasingly relied on economic growth outpacing interest rates to manage debt – a trend that accelerated further after WWII.
But as global sovereign debt has risen to historically high levels in the wake of 21st century crises and an almost zero prospect of renewed “fiscal discipline”, Muaddi said governments have no choice but to keep growth higher than interest rates – an effect achieved by either real productivity growth or inflation.
“We need inflation,” he said. “The alternative is worse. Our financial architecture is not built for deflation.”
Supported by repressed interest rates, governments have been able to embark on massive fiscal stimulus programs (including the latest US$1.9 trillion cash-splash by the Joe Biden administration) funded by sovereign bonds.
Repressed government bond yields, though, create a dilemma for investors.
“Solving this puzzle is key for everything else in financial markets,” he said.
However, Muaddi said “developed market sovereign debt cannot grow infinitely”.
And claims by modern monetary theory (MMT) advocates that governments can print money forever without risk were seriously misguided, Muaddi said.
“MMT is not modern – the Romans did it 2,000 years ago when they debased their currency – and it’s not monetary, it’s fiscal,” he said. “And it’s not a theory – I’ve seen it in practice in emerging markets, it always ends poorly.”
With financial repression – engineered low interest rates and rising inflation – a defining feature of the looming third great debt cycle, income-focused investors have little choice but to take on more risk through equities or high-yield debt, Muaddi told the T Rowe Price audience.
In the fixed income market, high-yield securities provide the “last avenue for investors to compound out of financial repression”, he said.
There were still opportunities to achieve 5 per cent annualised income in the high-yield credit market, Muaddi said, along with the possibility of some capital gains through active management.
High-yield debt investors need to diversify across developed (US and Europe) and emerging markets, he said, with a focus on managing downside risk.
Emerging market credit has evolved considerably since the 1990s, Muaddi said, offering strong returns and diversification benefits along with exposure to fast-growing economies.
Currently, though, he said there are “not enough high yield bonds to go around”.
Pointing to “one of the most shocking charts” of the year, Muaddi highlighted the fact that the entire US high yield market cap of US1.6 trillion remains smaller or about equal to that of each of the three largest US listed companies, comprising: Apple (US$2 trillion); Microsoft (US$1.75 trillion); and, Amazon (US$1.54 trillion).
The Baltimore-headquartered T Rowe Price has about US$1.9 trillion under management across multiple asset classes but is broadly known for its growth-oriented ‘strategic investing’ style, especially in equities.