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Growing debt wave shifts sovereign risk assessment: Franklin Templeton
The global “debt wave” is at a historic high and likely to keep growing, a situation that will become less sustainable as the low-inflation, high-liquidity backdrop reverses. That points to an “increasingly structural polarisation” between countries that can easily manage debt and those that cannot, an investment strategist says.
The dramatically changing investment and economic landscape is creating a heightened global urgency to raise capital and will necessitate a “massive reallocation of resources”, says Kim Catechis of the Franklin Templeton Institute (pictured) in a recent analysis. This, in turn, implies that positive real interest rates will be necessary, with so much government and private-sector debt sparking greater competition for investors’ money.
“The traditional sources of long-term savings might be squeezed or even reduced over time, as the working populations in mostly high-income countries shrink and their costs increase,” Catechis writes. “In our opinion, this scenario makes every investment decision loaded with implicit factor weights that are not currently mainstream.”
Rise of ‘friend-shoring’
The total global debt load currently stands at US$299 trillion, according to the International Institute of Finance, with about one-third of that amount in developing economies. According to Catechis, historically, government debt would typically have made up the bulk of that issuance.
“But some of the more interesting developments in the last 20 years include a drive for efficient balance sheets in the publicly quoted companies and greater access to credit as capital markets broadened and deepened,” he says. “As emerging countries benefitted from the long boom in globalisation, addressed their sovereign balance sheet structures and oversaw a deepening of the capital markets, debt shifted from the public to the private sector.”
The ratio of countries’ debt to their gross domestic product (GDP) was already growing globally before the COVID-19 pandemic, Catechis explains, noting that “‘fiscal responsibility’ has moved from the mainstream of political and economic policy debate to the fringes”.
But the deepening intersection of geopolitics and economics means countries can no longer take for granted the traditional mechanisms for escaping debt, such as economic growth via global trade, he says. This represents a major challenge for China and emerging markets.
“In aggregate, countries have been able to literally grow their way out of debt piles by dint of exports into a burgeoning global free trade market,” Catechis says. “As boards of directors debate the pros and cons of recalibrating their supply chains, they will increasingly be focussed on minimising physical, geopolitical or geoeconomic risk, leading to a preference for onshoring or ‘friend-shoring’.”
“But this is also an opportunity for less-established supply chain players – those countries that have significant access to specific raw materials that are critical for semiconductors or electric vehicle (EV) batteries, as well as the ability to offer a stable base for manufacturing or processing.”
While this trend presents an opportunity for “less-established supply chain players” with access to key raw materials, friend-shoring and supply chain diversification also eliminate “some of the most powerful catalysts helping countries climb the knowledge ladder”, Catechis says. “This trajectory points to a widening polarisation between developed countries and developing ones.”
‘A global zeitenwende‘
Currently, global sovereign debt is estimated at about $84 trillion, with one-third of that amount ($24 trillion) in developing countries. Catechis says sovereign issuance is likely to accelerate, “limited only by affordability and ratings”.
“As emerging-market issuers will be competing with developed sovereigns, investors will demand higher premiums, translating to higher costs for the issuer,” he adds. “That clearly puts pressure on the lower-quality, more needy issuers, and constrains the room for manoeuvre for the relatively stronger ones.”
A key aspect of the sovereign debt picture is demographics, with a growing “wall of liabilities” looming around the world as ageing populations drive higher healthcare and pension costs. According to Catechis, the challenge will be less for those governments willing to set policies that encourage pension savings and healthcare investment.
“We believe we are at a global zeitenwende, with implications that range from structurally higher debt, inflation, and interest rates to a requirement for higher investment returns at a time of economic fracturing of the world,” he says. “Ultimately, perhaps the biggest investment takeaway is that investors need to adjust the traditional mechanisms for calculating individual country risk premiums, because the traditional measures do not adequately account for the multifaceted investment challenges of today.”
