Many developed markets are facing a debt overhang on four fronts – private, public, household and pension. In the run-up to 2008, the growth in credit within developed countries was allowed to continue beyond sustainable levels because of a combination of uniquely advantageous economic factors.
When the credit bubble finally burst in late 2008 and bank lending dried up, it was evident that the next economic phase would be a period of deleveraging. Deleveraging brings a completely different economic backdrop and challenges, entirely changing how returns can be generated within financial markets and how risks can be managed.
The preferred method of deleveraging is through a combination of austerity and growth measures, as applied in Ireland, Denmark, Sweden and Belgium from the mid-90s to mid-2000, but these may not always be possible.
Previous examples of deleveraging were delivered when the rest of the world was growing; so countries could depreciate their currency and export their way out of the debt overhang through growth.
The implementation of austerity and growth measures to deleverage is not the only method that has been employed historically to reduce debt levels in an economy. Following World War II right through to the 1980s, the US successfully deleveraged its economy through financial repression, encouraging and, in some cases, compelling investors to hold government debt.
Financial repression is already increasingly evident throughout the developed world. Bond yields have fallen to extremely low levels as a result of central banks lowering nominal base rates at the infancy of the credit crisis to stimulate growth.
Having exhausted traditional methods of monetary policy, central banks turned to “non-standard measures” such as quantitative easing, which involved purchases of government bonds, to further improve liquidity and lower real interest rates. By forcing interest rates to low levels and allowing inflation to run at a higher rate, governments are able to erode their debt burden.
We expect the majority of deleveraging to occur through financial repression over the coming years. This method of deleveraging brings with it a range of problems for investors and a different landscape. One significant feature is the over-valuation of sovereign bonds that can persist for an extended period.
As a result, yields on low-risk investments will remain depressed and capital will flow to the highest yielding risk-adjusted assets. Unfortunately, risk is sometimes ignored by investors attempting to generate higher returns. To enhance the yield on investments, a more dynamic asset allocation process is preferable.
During deleveraging, volatility can also be expected. Therefore, investors look to move dynamically between asset classes to capture returns and lock in profits in volatile markets.
The key to generating returns and managing risk during deleveraging is to diversify exposure beyond the traditional asset classes. This is best executed in a dynamic investment strategy combined with a proven risk management approach. Therefore, a well-managed multi-asset fund that is risk managed should provide one viable investment solution for a financially repressed world.
Nick Smith is head of retail sales (ex-Germany) at Allianz Global Investors