When the whole world is a carry trade

By

29/06/2017

Ten years after the global financial crisis, global growth is sluggish, inflation is hovering near record lows, and unprecedented experiments in global monetary stimulus have created the risk of asset bubbles. Put simply, current debt levels are unsustainably high and can’t be propped up forever.

That is the bleak assessment by Satyajit Das. He warns that with debt in many countries having reached three to four times gross domestic product (GDP), levels typically unseen since the Second World War, the continued ability of some sovereign issuers to keep paying back their debts is uncertain.

Das is an Australian-based former banker and corporate treasurer turned academic and author. His most recent book is The Age of Stagnation: Why perpetual growth is unattainable and the global economy is in peril.

Some of his earlier writings, from 2005 and 2006, proved prescient about the risks in derivatives that became more widely apparent in 2007. Given this past form, many investors are now listening carefully to Das’s fears about the global economy being over-leveraged.

To put his concerns about the build-up of debt into context, more than 20 countries now carry debt-to-GDP ratios above 200 per cent, with global debt having grown by $57 trillion, or 17 per cent of world GDP, since the GFC.

Unsurprisingly, Das says, there is uncertainty over these numbers’ short- and longer-term impact on traditional financial markets and lending practices.

What’s arguably contributed to the financial market’s highly distorted view of economic reality, Das adds, is the longstanding fixation with using debt to buy existing assets, rather than to invest in productive businesses.

He explains: “Somewhere along the line, the world became one big carry trade. Here in Australia, people can buy anything they like with borrowed money, and everyone looks rich on paper. But finding a buyer down the track to realise the gain is becoming increasingly problematic.”

Post-war model ‘broken’

What we’ve been left with, Das says, is a world that continues to deny that the post-war economic model is fundamentally broken.

“While most [chief investment officers] continue to target historical returns of 6-8 per cent, or 4 per cent above inflation, it’s less likely that markets will resume delivering these outcomes at some future stage,” Das says. “Similarly, chasing higher yields without understanding the higher risks is like trying to pick up a gold coin in front of a speeding train.”

He says the key problem confronting institutional investors today is that there are many more unknown unknowns than at any time in recent history. As a result, investment chiefs now find themselves trapped in a world where they’re incapable of grappling with fundamental financial problems they’ve collectively created over the last three decades.

“CIOs are playing musical chairs, and when the music stops again, it will do so in a far more radical way than it did during the GFC,” he predicts. “Most growth generated over the last 30 years is due to excessive debt, financial imbalances, and a cycle of entitlement that appears impossible for policymakers to roll back; while companies have been more concerned about financial engineering than real engineering.”

What bothers Das just as much as the mounting debt levels is that the worldwide growth in equity prices since 2009 remains hugely uneven. For example, in the US, the S&P 500 has tripled since the nadir of the GFC; while here in Australia, the ASX All Ordinaries Index still trades about 16 per cent below its peak of 6873 points on November 1, 2007. Japanese equities are lagging even more, with the Nikkei Index trading slightly down on where it was back in 2000.

Das suspects growth and inflation will remain low and volatility variable, with sudden and unpredictable “melt-ups and meltdowns”. Within this environment, he urges CIOs to get better at tapping into the brains trust behind central bank policy.

Mandated traps

Unlike superannuation and pension funds, which are locked into particular ways of investing, courtesy of their mandates, family offices have successfully learnt from their past mistakes, Das says, to emerge amongst today’s best investors. What they’ve understood, he says, is that returns require getting close to real income streams.

As a result, what they’ve successfully done since 2008-09 is switch their previous 80 per cent exposure to public assets into private assets.

“The trouble is, CIOs, et al, can’t do that because their mandates simply don’t allow them to,” he says. “They’re fundamentally flawed because within this bi-polar macroeconomic environment, normal investing rules don’t apply.”

While dealing with the prevailing macroeconomic dynamics isn’t easy, Das recommends CIOs get better at capitalising on whatever conditions the market throws at them. While there’s no such thing as magic pudding, he says the onus is on CIOs moving away from public markets and renegotiating their investment decision rationale.

Within an environment where indices don’t make sense, he recommends moving more towards absolute returns and income than capital gains. “Assuming that CIOs’ hands remain tied and they don’t loosen their mandates, their focus should be on things they can do smarter and learning what they can live with,” Das says. “The alternative is to admit this is an uncertainty that you simply can’t manage and return money to investors.”

While few fund managers are considering such a bold move, a growing number share many of Das’s concerns about global debt levels and the challenges they pose to the outlook for fixed income markets.

Focus on absolute returns

Apollo Advisors head of yield product development Seth Ruthen says that to be successful in the new environment – characterised by fiscal policy exhaustion, low growth, low inflation, low GDP and low interest rates – managers need to think about different types of risks than they are used to and develop strategies diametrically different to those that worked a decade ago.

Ruthen urges institutional investors to seek out managers who can create multi-dimensional opportunities beyond duration, credit quality and volatility.

“That also means moving into unconstrained environments more likely to deliver absolute returns,” he says.

Similarly, Brandywine Global portfolio manager and head of high yield, Brian Kloss, argues that an unconstrained holistic approach should help generate both absolute returns and a stable level of income, while reducing correlations to lower volatility.

In addition to looking beyond the traditional asset allocation approach, Kloss suggests investors look broadly across fixed income markets and sectors to create a multi-asset class fixed income portfolio.

“This return stream should originate from differentiated sources of alpha across multiple fixed income asset classes, including currencies, sovereign bonds, investment grade and below investment grade credit, structured credit and bank loans,” Kloss says.

New approaches needed

Beyond urging a move towards absolute returns and income, Das also recommends CIOs take steps to get on the right side of future M&A activity, and lower their exposures to sectors that will ultimately be killed off by disruption or regulation.

“Instead of overestimating future upside from either emerging markets or geopolitical risk, a much bigger issue confronting CIOs is how to be rewarded for funds under management, especially when ETFs are killing them on the fees [and sometimes on the performance] front.”

To create an environment where CIOs are considerably closer to free cash flow, Das recommends rethinking the investment process and the ability to preserve capital while also generating income and future capital growth. It’s also important, Das adds, that CIOs get better at developing strategies around what a protracted low-growth and low-inflation environment is going to offer.

But given there’s little room for rates to go much lower, Ruthen says expanding the opportunity set to include things beyond what is easily accessible or index-oriented – plus having the discretion to respond quickly across asset classes – has surpassed duration as the most important risk factor.

“That means being able to buy debt off other people’s balance sheets, creating debt within the right parameters, using illiquidity in a prudent manner and getting paid for it in the right way,” Ruthen says. “If CIOs don’t have the skill set to reorient the business around new opportunities, they’re at a real disadvantage.”

Satyajit Das will deliver the opening keynote address at the Investment Magazine Fixed Income, Cash and Currency Forum in Healesville, Victoria, July 25-26, 2017. For registration enquiries, contact Emma Brodie: +61 2 9927 5708, [email protected] or visit the event website