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Financial Planning > College Planning > Student Loan Debt

Sovereign Debt and Asset Allocation

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It’s always educational to travel. During my recent trip to Europe and Australia, I was able to observe different points of view on a number of economic and political topics. The one subject that seems to be on the forefront of everyone’s mind is the level of sovereign debt, both here and abroad.

The phrase “time heals all wounds” may be the type of sage advice you’d get from your mother after a bad breakup, but it also goes a long way in explaining how countries grow their debt but manage to keep on truckin’.

It all started after World War II, a period characterized by a number of dramatic boom-and-bust business cycles. Global policy makers learned from observation that during lean times, economies have a tendency to go through a periods of debt reduction. This makes intuitive sense from a banking standpoint, as loans are harder to get during economic contraction and easier to get during periods of expansion. However, the ability to borrow money during these former periods became so difficult that recessions were severe and long-lasting.

The government was not happy with the social instability resulting from these recessions, so they introduced a number of so-called “stabilizers,” or social programs designed to ease the pain during difficult economic swings. Unemployment insurance and Social Security are two great examples.

It’s pretty easy to see how such programs could minimize the pain of recessions. Before, if someone lost their job, the bank would come along and repossess their house and car. After the programs, unemployment benefits would allow for some purchasing power until new employment was acquired.

This benevolent legislation had its downside, as debt level reduction during recessions was virtually eliminated. And when the economy started growing again, debt levels increased even more. This is commonly known as the debt “supercycle,” which is characterized by gradually increasing public debt loads.

The government has historically dealt with this by expanding the economy through accommodative fiscal and monetary policy. As long as the country’s debt-service-to-GDP ratio stays reasonably low, this cycle of ever-increasing debt can be effectively managed.

Of course, things don’t go like they should. The U.S housing crisis, which morphed into the global banking crisis, which then progressed to a worldwide credit crunch, virtually gridlocked economic growth. Countries around the world responded by dramatically increasing government spending (to replace the lack of private spending) in order to keep their economies from collapsing (and faced with the very real possibility of a global depression, they didn’t have much choice).

This brings us to today. We’re facing extraordinarily high levels of government debt, but GDP growth rates are only showing moderate levels of recovery. Are we facing disaster? The answer to this question depends on which region of the world is being considered.

The biggest areas of concern lie in places that suffer from above-average debt loads (as a percentage of GDP) and reduced growth prospects. One can see how market participants judge the relative safety of each country by looking at how expensive it is to insure bonds against default. The most expensive insurance includes that of Iceland, Greece, Portugal, Ireland, Spain, Italy, England, and France. Using this metric, the safer countries include Norway, Finland, Canada, the U.S., and Sweden.

In addition to their lofty levels of debt as a percentage of GDP, many of these more risky countries also have extremely generous social programs. Riots broke out in Greece when that country decided to implement an austerity program to limit the growth of its national debt. I would expect the same to occur in France if it, too, attempts to reign in spending (France guarantees employees six weeks of annual vacation and subsidizes the cost of living for every French citizen living in Paris).

Some observations regarding these observation’s effect on asset allocation decisions are as follows:

1) Emerging-market economies have much less debt than their developed market counterparts, and much higher growth prospects.

2) Developed Europe is decelerating economically, and is mired in significant debt.

3) The U.S. dollar remains the world’s reserve currency. Although growth prospects domestically are about average compared to other nations, our level of wealth and the breadth of our economy will put us in the “winner” category.

4) As economies grapple with debt reduction, I expect the U.S. dollar to rise in value against other currencies.

5) Although there seems to be minimal political will to do so, debt reduction will have to be enacted by the developed world. I expect austerity programs will become in vogue and a will be a hallmark of responsible fiscal policy. Let’s hope it is accomplished through reductions in big government rather than by much higher taxes, although it will most likely include both of these strategies. At any rate, it will be those countries that can reduce their spending that will be able to keep on truckin’.

In closing, the above scenarios should create some a plethora of opportunities for savvy investors. We look forward to such interesting dynamics.

See More of Ben Warwick’s Portfolio Gourmet Blog Post

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