Is the Eurozone headed for two decades of japanstyle slow growth?

Despite it being more than 10 years since the global financial crisis (GFC), the world remains heavily indebted and there is no realistic prospect of that debt reducing in the short or medium term. Barring glaring historical exceptions (such as in the wake of the Great Depression when US debt to gross domestic product (GDP) peaked at almost 120%), sovereign debt levels in many economies are close to all-time highs. They are certainly much higher than they were just two or three decades ago.

In the US, the net debt to GDP ratio is 106% and rising, compared to less than 40% in the early 1980s. UK net debt to GDP is at almost 86% but between 1975 and 2018 it averaged below 45%. The story is similar across the eurozone. In Spain, for example, debt to GDP is 96%, against an average of just over 55% since 1980. Today, Italy’s debt stands at 130% of GDP, while in China it is over 300%.

Can central banks afford for debt to continue spiralling upwards, exacerbated by a crisis or recession? Or will a perennial low growth and low inflation world mean interest rates stay lower for longer and we can continue to ignore global debt levels?

RISING POST-CRISIS DEBT LEVELS

It is worth reminding ourselves how we got here. These current levels of elevated government and total debt are almost exclusively hangovers of the GFC.

When the GFC hit, banks reined back their lending as they grappled with ballooning bad loans and deteriorating balance sheets and needed capital. A credit crunch ensued, hurting economic growth. At the same time, borrowers (both households and corporates) faced a debt overhang as housing and real estate prices fell but debts remained constant. They responded by deleveraging, despite interest rates being at or near zero.

Normally, central banks can redress this imbalance by lowering interest rates, encouraging borrowing. But after the GFC, the private sector had too much debt and preferred to pay it down rather than borrow, despite plummeting interest rates.

A decade ago, from having an abundance of borrowers pre-crisis, there was suddenly a dearth and the private sector became a net saver – evidenced by huge increases in deposits in the banking sector. This mounting cash sitting on deposit only exacerbated the downturn as, with fewer individuals and companies stepping in to borrow and spend the money on deposit, it failed to contribute to growth. Moreover, tax receipts relative to spending fell and debt to GDP was already climbing as nominal GDP went into reverse.

This is where governments stepped in, emerging as the sole remaining borrowers and spending the private sector savings. Government intervention certainly staved off a deeper financial crisis, but there was a huge cost to bailing out the banks and stimulating the economy in this way.

Today, this cost can be measured by sharp rises in government debt to GDP. These elevated debt burdens have negative consequences for future growth as they have effectively brought tomorrow’s consumption forward to today. Clearly, it is a given that future consumption will therefore be lower.

Then there are the swelled central bank balance sheets. Post the financial crisis, central banks such as the US Federal Reserve, the European Central Bank (ECB) and the Bank of England, printed money to purchase government debt.

The ECB now owns 26% of Germany’s bond market as well as 21% of the bond market in France and 20% of the bond market of Italy. The Bank of England owns 25% of the UK bond market, the Federal Reserve 18% of the US bond market and the Bank of Japan 40% of Japanese bond market.

The central banks could, in theory, write off these debts, significantly improving their sovereigns’ debt burdens overnight. But such a move by a central bank in isolation would undermine currency stability and the integrity of central bank functionality, while coordinated central bank action in our current age of European disharmony, US/China trade wars and a gradual move towards deglobalisation seems highly unlikely. Therefore, countries’ elevated debt to GDP levels look set to remain elevated for some time.

TURNING JAPANESE

How is this going to play out? Are developed economies, in particular the eurozone, heading towards a credit crunch, or are they entering a sustained period of low growth and low inflation similar to the last two decades in Japan?

Neither is a particularly appealing scenario, but a credit crunch, inflicting perhaps a prolonged period of negative growth, would be by far the worst. Debt to GDP would conceivably rise even further and this would likely result in the déjà vu effect of governments once again having to step in, but this time from a weakened position, having not had time to repair their balance sheets. This is clearly an unpleasant prospect, but it would result in interest rates remaining necessarily low, which would be one positive.

Japan-style stagnation is also possible. Since the mid-1990s, Japan has been stuck in a negative/low growth environment with the country struggling to escape entrenched deflation – but at least, even with its net debt to GDP currently at over 235%, its interest costs are still affordable.

Indeed, interest rates at or close to zero are a huge comfort for major developed global economies, maybe too much of a comfort. Today in the UK, for example, despite much higher government debt levels than in the 1970s and 1980s, debt servicing costs are much lower. In 1978, interest costs on UK government debt were about 4.8% of GDP. Today the comparative figure in the UK is below 2%. A similar picture emerges in the US, France, Germany, Italy, Canada and Japan.

Central banks will seek to keep interest rates low, partly to keep these manageable debt servicing costs in place. If debt servicing did become a worry, it is likely that given the structure and duration of debt, central banks would have the time to address the issue and tighten their belts. There is also the positive scenario that if rates were to climb steadily upwards, it would be accompanied by economic growth, which would negate to some extent the adverse effects of pricey debt.

But a sharp hike in rates could make some already elevated debt to GDP ratios a cause for concern. In particular, a sharp rise in rates in Italy (where debt servicing costs are only just about manageable) would have severe negative knock-on effects for its financial sector and the wider eurozone economy.

Yet the main reason we are sanguine on rising rates in the eurozone is because we foresee neither major inflationary pressures nor accelerating economic growth – necessary precursors for a rising interest rate environment.

Indeed, we think the eurozone economy bears some striking similarities to Japan’s, making a prolonged period of low growth and low inflation in the eurozone a high likelihood. Firstly, both economies have sizeable banking systems, which account for roughly 70% of the funding of the corporate sector – dominated by small- and medium-sized enterprises (SMEs). Lower interest rates are still not creating sustained loan growth to this sector across the entire eurozone. In the periphery, growth is only just returning now, 10 years on from the crisis. And in Italy, it has not yet returned. Similarly, in Japan it took well over a decade from their crisis for sustained credit growth to return despite ultra-low rates. In the absence of borrowers from the corporate sector, both banking systems have also loaded up on government bonds, facilitating the growth in government debt to GDP.

THE CONSUMER DEBT BOOM

We should also remember that debt is not only a national or government issue – decades of low interest rates have fuelled a consumer debt boom that is once again swelling to alarming levels. UK household debt (including mortgages, personal loans, student loans and credit card balances) as a proportion of household income ballooned from 85% in 1997 to a peak of 148% in 2008. [1]

Post-GFC, consumers deleveraged as credit became more difficult to obtain and people focused on paying off existing debt. But borrowing has accelerated once again, evidenced by the debt to household income ratio creeping up from 127% in July 2015 to 132% in Q1 2019.

It’s a similar story in the US, with non-housing debt peaking at $2.71 trillion in Q4 2008 followed by a period of deleveraging. Fast-forward to this year and non-housing debt had reached a record $4.02 trillion in Q1 2019. Around the world, household debt to income ratios are sky-high, with the highest percentages to be found in Denmark (270%), the Netherlands (222%), Australia (202%), Sweden (181%), and Canada (168%) [2]

Clearly, the cost of servicing debt is much lower now than it was prior to the recession, with interest rates near historic lows, but how many households would be able to cope in a rising rate environment? In the UK, according to the Money Advice Service, 17.2% of the population or 8.9 million people were over-indebted in 2018, meaning they found keeping up with bills and credit commitments a heavy burden, and/ or they missed domestic bill or debt repayments in any three of the past six months. Low income households can be particularly vulnerable to overindebtedness, and it remains to be seen how they and others would cope if higher interest rates ever became the “new normal” once again, as they were in previous decades.

The fact remains that a generation of borrowers in developed economies has not lived in such an era – in the UK the Bank base rate peaked at 17% in November 1979 and hovered in a range between 8.375% and 15% for the following 13 years. But since the GFC, the range has been 0.25%-0.75%. In the US, Federal Reserve data shows the average 30-year mortgage interest rate topped out at 18.45% in October 1981 – it is now 3.77% and has not been higher than 5% since 2010.

LOWER RATES FOR (A LOT) LONGER

No matter how low the European Central Bank takes interest rates, the monetary policy mechanism will not work properly if SMEs – the key drivers of economic growth – are not borrowing and their governments are prevented from stepping in because of the Maastricht Treaty deficit caps of 3%. The result will be continued deflationary pressures, increasing the need for sustained low interest rates.

This is further supported by the fact that wage growth – a key driver of rising prices – is showing little sign of materialising within the eurozone. A myriad of factors, ranging from globalisation, technology and automation, to a rise in part-time and flexible contracts and falling unionisation numbers, are so far keeping salary rises to a minimum. Where there have been rises in wages, they haven’t sneaked their way into inflation figures. We see there being little change to this in the medium term.

What’s more, the experience in Japan indicates that it will be very hard to escape a low growth and low inflation environment even if productivity is rising and governments are running fiscal deficits. Increased corporate and personal borrowing would counter this but potential solutions to fix problems in the banking sector (such as bank consolidation, relaxing fiscal rules or changing ECB inflation targets) look unlikely.

We therefore believe the eurozone is entering a prolonged period of low inflation, combined with low growth, which will keep interest rates low for the next 10 to 20 years. In this lower for longer environment, elevated debt levels are here to stay.

It’s going to be a multi-year, perhaps even multi-decade workout, with a dearth of growth and income opportunities persisting for savers and investors. High levels of leverage would also suggest a heightened level of volatility. Time to buckle up for what is likely to be a bumpy ride.