Debt – investment implications of higher borrowing levels

Covid, high energy prices and elevated interest rates have slowed economic activity, forcing governments to borrow huge sums to support their economies. High debt levels will keep interest rates higher and limit the scope of fiscal policy to boost growth, impacting global equity investors.

“You cannot spend your way out of recession or borrow your way out of debt”
- Daniel Hannan, UK Member of the European Parliament (1999 – 2020)

Our four-part series investigates the key structural trends identified by Axiom Investors as the key drivers of long-term equity returns. Axiom refers to them as the 4D’s:

• Deglobalisation
• Disruptive innovation
• Demographics
• Debt

We previously published analysis of the economic effects and investment implications of deglobalisation, disruptive innovation, and demographic change. In this article, we investigate how increasing debt levels are impacting economic growth and what this means for investment returns.

Sovereign and corporate debt levels reached an all-time high of US$100 trillion at the end of 2023, a similar size to global GDP according to the OECD¹.

Why have debt levels soared?

The GFC gave rise to an extended period of ultra-low interest rates from the end of 2008 until early 2022 and governments took full advantage. Borrowing surged to maintain spending as the global economy struggled with recession and later the 2020 pandemic and 2022 energy crisis.

Meanwhile, low interest rates and high savings levels also led to a surge in borrowing by companies accessing debt below their cost of equity. According to the OECD¹, the value of outstanding corporate bonds jumped from US$15 billion in 2008 to US$34 billion in 2023.

What are the implications for governments and economies?

Government debt levels in developed economies are highly unlikely to fall sustainably relative to GDP in a low inflation world. This would require sustained economic growth, low interest rates, and the political willingness to run primary budget surpluses (i.e. before interest costs).

Debt will keep rising as the costs of an ageing population, climate transition and increased geo-political threats fail to be met by a willingness to pay higher taxes.

Unfortunately, most sovereign debt has financed current spending to keep voters happy rather than investing in education, training, or infrastructure that increases economic growth. Re-allocating resources to make higher interest payments weakens demand, which further slows economic growth.

Low growth leaves economies particularly vulnerable when bond yields spike. This was starkly demonstrated when the bond market effectively forced a change of UK Prime Minister in 2022 and fleeing depositors brought down several medium-sized regional US banks in 2023.

What does this mean for investors?

Investors need to rethink their management of financial risk in light of two challenges:

• 40% of government bonds and 37% of corporate bonds will mature between 2024 and 2026 according to the OECD¹ and will be refinanced at considerably higher yields
• Governments which inflate debt away will deliver higher long-term borrowing costs as the neutral rate of interest (r*) rises

Investors might consider how:

• Higher inflation over the economic cycle leaves government bonds less able to preserve wealth
• High inflation expectations increase stock and bond correlation, this increases the volatility of traditional “balanced” portfolios
• Companies with limited borrowings and strong balance sheets may well outperform
• Innovative companies with differentiated product offerings and pricing power should be able to grow earnings, outperforming those dependent on real income growth during periods of economic weakness

Axiom Investors, who manage the Pengana Axiom International Funds focus on debt as one of four distinct structural themes. Axiom’s data driven process provides unique insights which deliver a deep understanding of how these macro shifts impact individual companies. It identifies stocks that demonstrate higher earnings growth and lower debt levels.

The Fund maintains positions in exciting companies such as Nvidia and Meta Platforms which have no net debt. Over the last year they delivered earnings growth of 461% and 114% respectively, having been able to invest in R&D thanks to their strong balance sheets.

Eli Lilly and Novo Nordisk also have low debt levels and unique products, which brings these companies pricing power that sustains margins during periods of elevated inflation.

While the growth of debt can present a gloomy outlook, opportunities remain for investors with the right processes to identify and carefully analyse them. Rising debt levels represents a risk factor that global investors should think carefully about and discuss with their financial advisor.

¹ OECD, Global Debt Report 2024, Global Debt Report - OECD