In the long term, successful investing is all about choosing the right company at the right price. However, in this post I want to look at the current economic environment to provide clarity on the situation of high government debt and how that effects investment choices. As Joseph Anthony Wittreich wrote, “history may not repeat itself, but it does rhyme.”. After exploring how debt works, I will examine a time with similar government debt to today.
The Mechanics of Debt and the Financial Crisis
In the leadup to 2008, two things happened: government debt exploded, reaching levels last seen after the second world war, and private debt also reached new highs. This is widely known to have caused the financial crisis. In order to survive, governments created money through quantitive easing (QE) and their debt continued to grow. Government and private debt became unsustainable.
Imagine a private loan between a lender and borrower of £10,000 over five years. The borrower gets into difficulty and defaults, paying nothing back. The lender is £10,000 poorer and the borrower £10,000 richer. The lender has the problem, as the borrower can go bankrupt, paying nothing. Consequently, the risk lies with the lender. Why does the lender lend and the borrower borrow? Because the lender is wealthier than the borrower.
Non-payment of debt transfers wealth from the lender to the borrower.
Alternatively, in the same scenario, the borrower offers to pay back at an affordable rate of £200 per year for 50 years. The lender is disappointed, as on repayment, he had planned to spend the £10,000 on a holiday. Now the lender has to wait 50 years for his holiday which then costs £26,916 due to an inflation rate of 2% per year.
Deferred payment of debt in an inflationary period transfers wealth from the lender to the borrower.
Now imagine the borrower is also a government which borrows in its own currency and controls the interest rate. The governmental borrower has more options if they cannot pay the lender back. The government can simply create more money instead of not paying back at all. Default is best avoided, as it forces borrowing rates to rocket as lenders become scared.
Governments also have other ways to bring the debt down. Looking at the postwar period in the US, we can see how this was achieved. Debt levels are measured by the ratio of total government debt to Gross Domestic Product (GDP).
Debt reduction was achieved between 1945 and 1975, despite only two years of budget surplus when tax receipts were greater than government spending. A combination of GDP growing faster than spending, low interest payments and negative real interest rates also cut the ratio of debt to GDP.
Money in the bank at 3% interest whilst inflation is at 4% means you lose 1% of buying power, and the “real interest rate” is negative. Plus, in the governmental context, GDP and tax receipts grow faster than the debt. Over the 30-year postwar period in the US, the combination of these factors brought the debt level to a manageable size without an overall budget surplus.
In 2015, the UK is a similar situation to the postwar period in the US. Unsustainable government debt exists as spending is greater than tax revenues. Plus, many government liabilities like healthcare are understated. To manage current debt, the British government needs a low interest rate. By using negative real interest rates and low rates over decades, the government can bring debt under control. If the government maintains the low inflation target then low interest rates are here to stay.
Over the next few decades, lending investors risk periods of negative real interest rates and prolonged low rates.
With this knowledge, it is important to remember the fundamentals of investing. Buying —at the right price — assets that have a stable, growing and predictable cash flow. Rising markets show that others have come to a similar conclusion.
The Sweet Spot: Companies That Benefit From Low Interest Rates
Companies with sustainable competitive advantages and predictable cash flows can now borrow sensibly at extremely low interest rates to enhance shareholder return.
Companies with such strong cash flow characteristics are rare, so caution is required. Sensible levels of debt are most likely when proven management hold significant personal shareholdings. Two examples, Liberty Global and Charter Communications, fit the bill. Exceptional management teams in these cable businesses use their subscription cash flows to borrow and invest sensibly. Liberty and Charter have great competitive advantages through the replacement cost of their cable networks.
Disclaimer: The above does not constitute investment advice. The author has invested in the companies mentioned at the time of writing.
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