Global Deleveraging During the Great Rotation

By: Pavan Rangachar

April 2013

What is a deleveraging?  The term refers to countries reducing their debt-to-income ratios when they are too high.  A deleveraging is generally accomplished through debt restructurings (writing off some of the country’s debt by saying “Sorry, I can only pay 50% of this”), austerity (raising taxes/cutting public spending), and/or debt monetization (printing money essentially).  All of these methods have different effects on the economy. The United States has been deleveraging for the past few years, and the issue they face is this: how do they pay down the excessive debt without hindering the growth of the economy? So far, the solution has mostly been inflationary measures via quantitative easing (the 2% payroll tax increase post-Fiscal Cliff hardly makes a difference from a deflationary standpoint).  Until the end of 2012, most of these inflationary efforts did not see strong results, as unemployment remained high and business investment/capital spending remained low throughout the year (despite super low interest rates).  Starting in October however, things have started to change.  Firstly, unemployment dipped and stayed below 8%.  Also, as January came to an end, capital spending showed an increase through increase durable goods.  While these occurrences may not be caused entirely by QE, they show that lower interest rates are slowly starting to help drive our economy.  The main question people are now asking is this: since interest rates have been reduced so low to get businesses to invest, have rates finally bottomed out?  That is-when will this “Great Rotation” from bonds into stocks finally begin?   In my opinion, that’s not entirely the right question.  I believe rates will rise regardless because the yield curve is providing a negative real return under a 15 year maturity.  The real question, in my opinion, depends on how long and how high rates are going to rise.  If it took this long for business investment to increase-with super low interest rates-what will happen when rates rise?  Debt is viewed on a completely different level when compared to how it was viewed with Paul Volcker in 1980; 15% 10-year rates can cause Wall Street Analysts to consider a few firms on the brink of bankruptcy just because of an EBITDA Coverage ratio.  The real question, in my opinion, is this: to what point, and how quickly, can interest rates be pushed upwards, before there is a backlash on the economy because businesses do not want to invest at such high rates?  While the US has strong catalysts for growth in the upcoming years (3D printing, natural gas, etc.), there is uncertainty in when and how that growth may occur.  Currently in the US, the economy still has high unemployment of 7.7% (well above the Federal Reserve’s Target of 6.5%) and other tough economic factors, but stock markets are hitting all-time highs.  This is leading many people to think that stocks are currently overvalued-meaning there should ideally be a correction in markets.  In Europe, there has already been heavy austerity, and it is expected that there will be more.  Stock markets have been depressed, and are forecasted to continue to do poorly there as well.  Thus the question becomes, where can we invest if 2 of the world’s most developed economies are deleveraging with uncertainty?  Now may be the time to turn to firms with a strong exposure to emerging markets. This will be topic of my next article, but for now as the saying goes-“Sell in May and Go Away”-for both yourself and your stock portfolio.