Sovereign Debt and Asset Allocation

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.