Managing risk in a time of deleveraging

22 Nov 2012 08:00
By David Hollis
Vice President & Multi-Asset Portfolio Manager
Allianz Global Investors

When the credit bubble burst in late 2008, it was evident the next economic phase would be a period of deleveraging. It brings with it a completely different economic backdrop, entirely changing the manner in which returns can be generated within financial markets. Many developed markets are facing a debt overhang on four fronts; private, public, household and pension. In the “Golden Age”, developed market credit growth was allowed to persist way beyond sustainable levels as interest rates were set too low on the premise inflation had been eradicated, hence the cost of credit was artificially cheap. In reality, emerging markets were exporting deflation via low goods prices produced with inexpensive labour, and developed countries were funding purchases of these goods via cheap credit.

In a recent working paper, the economists Reinhart & Rogoff identified 26 episodes of public debt overhang, specified as periods when debt to GDP exceeds 90%, since 1800. In 23 out of the 26 episodes countries experienced growth rates that were lower than the average during other periods, proving that deleveraging results in sub-trend growth[1]. Alarmingly, the average period of a debt overhang episode was 23 years, implying that some countries may not achieve a sustainable debt level until 2031, during which they will experience sluggish growth[2]. In just under half of the 26 episodes of debt overhang, real interest rates were lower, or the same, than other periods and at the same time growth was lower.

We can extend this empirical evidence and use simple mathematics to conclude that real (nominal) interest rates must be below real (nominal) GDP during a deleveraging cycle, otherwise the debt to GDP ratio of a country cannot fall. As a result, those securities such as sovereign bonds, inflation-linked bonds, and corporate bonds are likely to outperform. In fact, corporate bonds have empirically out-performed sovereign equivalents during low growth.

Methods of Public Sector Deleveraging – Financial Repression
The preferred method of deleveraging is through a combination of austerity and growth measures, as in Ireland, Denmark, Sweden and Belgium from mid 90’s to mid 2000. However, these episodes occurred when the global economy was expanding, allowing them to depreciate their currency and export themselves out of debt. Today, simultaneous developed market deleveraging results in competitive currency devaluation, and even then export demand from other highly indebted developed countries is depressed. This can only really be overcome by opening up new trading channels with emerging markets.

Financial repression, the means by which governments indirectly or directly compel investors to purchase debt, is the most likely deleveraging route that will be adopted in coming years. It is already evident in extremely low bond yields, which reflect superior demand for sovereign debt, and ultra-stimulative central bank rates. Having exhausted traditional methods of monetary policy central banks have turned to “non-standard measures” such as Quantitative Easing, which involves government bond purchases, to further improve liquidity and lower real interest rates.

There has been widespread pressure on banks to purchase government bonds. For example, peripheral Eurozone banks have been encouraged by their national central banks to exchange non-domestic bonds with the ECB for money that can be invested in domestic bonds. This self-funding of deficits on a national scale is another example of financial repression.

Banking regulation, such as the Basel III and Solvency II Acts, although primarily designed to improve the quality of collateral on bank balance sheets to prevent another Lehman style scenario, invariably involves an increase in low risk assets, such as government bonds, on balance sheets.
Investing During Deleveraging

Under financial repression, yields on low risk investments will remain depressed and capital will flow to the highest yielding risk-adjusted asset. Unfortunately, with free flowing global capital, this will depress asset class return autocorrelation, hence a more dynamic asset allocation process is preferable to a buy-hold strategy.

Moreover, a greater proportion of return will come from income, rather than capital. For example, earnings growth in equity markets is likely to be muted as growth has been empiricially proven to be lower during periods of deleveraging, as a result the capital return on equities will be lower relative to income.

The focus on investing in high yielding and high income assets may result in the mis-allocation of resources, hence investment in traditional growth industries may be deficient and represents a headwind to capital returns.

Low yields in developed countries will prompt investors to seek income opportunities elsewhere; this is best achieved through asset class diversification. However, we would caution that price momentum may drive illiquid markets to excessively high valuations, at which point capital outflow can lead to an abrupt reversal of the positive return trend. Therefore, a dynamic asset allocation process is preferable.

Rising asset class correlation since since 2008 suggest that returns are more easily generated through beta strategies. Alpha generation has become distorted by macro-economic factors such as country risk premia impacting individual stocks.

The key to generating returns and managing risk during deleveraging is to maximise diversification beyond traditional asset classes. This is best executed in the context of a dynamic investment strategy conbined with a proven risk management approach.