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ISCOVER
The massive build-up in government debt post-GFC is arguably the single biggest cause of uncertainty over the future of the global economic environment
Brad Matthews
Chief economist
Hillross
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Forecasts by the International Monetary Fund (IMF) suggest that government debt in the seven largest industrialised nations will average 110 per cent of GDP by the end of 2010.
While this synchronised lift in government indebtedness is unusual, it should be noted that various governments have dealt successfully with debts at current levels in the past.
The period following the Second World War is the most recent example of when debt levels reached comparable levels to today across many developed nations. In 1946, the United Kingdom recorded a government debt to GDP ratio of 250 per cent. At the same time, the comparable ratio in the United States was 121 per cent.
Even Australia, where large government debt levels have been absent for some time, built government debt up to 120 per cent of GDP immediately following the War.
THE WORLD THAT WAS
Perhaps paradoxically, the two decades that followed the huge WWII debt build up have become known as the "golden economic age".
Strong economic growth, low unemployment and a general improvement in economic prosperity characterised this era across most of the developed world.
The 1950s and 1960s clearly demonstrated how the relative size of government debt can be reduced through economic expansion with some inflation. The chart below shows hypothetically how quickly relative debt can be reduced, even in the absence of any debt repayment by governments, simply through natural growth in the nominal size of the economy.
IT COULD BE DIFFERENT THIS TIME
There is a certain amount of comfort that can be drawn from the economic success of the post war era and the ability of debt to be ‘naturally' eroded through moderate economic growth and inflation. However, the same degree of success in debt management may be more difficult in the current era. Importantly, many developed economies were already recording structural government budget deficits and debt build up prior to the onset of the GFC.
Australia was an exception in this respect, having made some significant progress on building a pool of savings for future liabilities.
In addition, the nature of the GFC has been such that the scale-back of lending activity by financial institutions is thought by many to have deflationary consequences, making even a moderate inflation rate problematic to achieve.
Genuine reforms to government spending and taxation will be required in many developed nations and this will ultimately put a ceiling on the rates of economic growth that can be achieved. It will be critical however, that these fiscal reforms do not stop economic growth altogether as the expansion in the nominal size of the taxation base will be the most important tool in achieving debt reduction.b
Market snapshot
AUSTRALIAN EQUITIES: OVERWEIGHT
The combination of a booming mining sector, a relatively subdued household sector, rising interest rates and a strong currency suggests that earnings growth across Australian companies will not be uniform. On the whole, current valuations remain cheap and there is considerable room for share price growth. Given the likely disparity of earnings growth in the current environment, active portfolio management will be more important than normal.
INTERNATIONAL EQUITIES: NEUTRAL
Despite the strong rally over September, global share markets remain on the cheap side of valuations. However, there remain a number of risks in the global economic outlook, making Australian equities a more attractive relative proposition on a risk adjusted basis.
PROPERTY: UNDERWEIGHT
Prospective returns from global property securities appear less attractive on a valuation basis than global equities, with much of the risk premium being eroded by price rallies over the past year. Australian listed property looks more solid on a valuation basis.
FIXED INTEREST: UNDERWEIGHT
Bond yields are well below historical "fair value" levels and do not provide compensation for the inflationary risks of a strong domestic economy. Opportunities remain in credit, which appears superior to sovereign debt on a risk adjusted basis.
ALTERNATIVES: NEUTRAL
Given the fine balance between inflationary and deflationary forces, a neutral exposure to inflation sensitive assets such as infrastructure and commodities is warranted. With ongoing disparity in valuations, higher than normal returns may be available to absolute return managers.
AUSTRALIAN CASH: OVERWEIGHT
With the yield curve relatively flat, the prospect of higher cash interest rates suggests that short term cash styled investments should be preferred to longer term fixed interest investments.
