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Time for some good debt

Record low interest rates around the world have resulted from unprecedented monetary stimulus, yet the global economy remains sluggish. These low interest rates have driven increasing debt; but has it been ‘good debt’? Has the grand experiment of huge monetary stimulus by central banks around the world succeeded in encouraging confidence and economic growth?

What’s good debt?

At a personal level, good debt is a loan that enables you to buy a growing asset and/or growing income; and lazy debt is borrowing as needed to buy lifestyle… like your home. In business, companies that don’t borrow to invest are said to have a ‘lazy’ balance sheet (summary of their assets and liabilities/debts). Judicious debt can accelerate business development, while excessive, poorly managed debt can bankrupt it.

For governments, good debt refers to loans used to invest in projects like infrastructure or investing to stimulate future industries – activity that delivers more return over time than the cost of the loan – using money to make money.

Australia’s debt

Driven by populism and the media cycle, politicians globally have failed to lead. In that vacuum, central bankers around the world reduced interest rates to restore public confidence and spending. As we’ve said before, Australia has modest Government debt. For Australia the debt problem is individual debt that feeds our house buying frenzy. In fact, over the last 30 years, Australian household debt to GDP has risen from around 40% to almost 130%. Meanwhile, Government debt moved from about 40% to 45% – though Government debt was low at about 10% of GDP in 2006/07, driven by the huge mining boom on China’s emergence.

This record household debt helped to drive the average price of a home in Sydney up 44% since 2013. Is this good debt? Will this debt produce a growing income for investors? Or will it help produce increased government income/receipts? Since 2013 real wages have only risen 2%, so it’s unlikely rental returns could keep pace with this dramatic asset appreciation.

Australia’s cash rate is now 1.5%, while unconventional monetary policies around the world have seen rates cut to near zero (negative in parts of Europe and Japan). While these policies have boosted asset prices (as shown in property prices here), helped to stimulate some economic growth and prevented deflation, perhaps they’re reaching their limits. In fact, negative policy rates may hurt bank profitability and thus banks’ willingness to extend credit. Yet most economies are far from where they need to be.

Fiscal Stimulus

Australian governments on both sides have undertaken little good debt activity in recent decades. With rates now enticingly low and deflation looming, the need for public confidence and improved productivity is strong, so some good debt borrowing seems well overdue.

Post Brexit, the UK is spending to spur growth, Japan is also spending more, while Germany is spending more on refugees, security and infrastructure and China is guiding itself to more diverse, lower growth. Whichever US President is elected, both are expected to spend more on infrastructure, military and in civil areas. These steps in the right direction should boost growth by about ½% p.a. – though markets would fall on a Trump result, due to the trepidation and unpredictability it may bring.

So, the next step in Australia may be to invest more on improving productivity, by spending ourselves into national prosperity.

Recession?

Australia is nearing 25 years of continuous economic expansion, compared with US history of never more than 10 years. So, is a recession due? Hopefully not. And if the government begins to activate some fiscal spending, relieving some of the pressure on the RBA to carry the burden, it could further stimulate the economy in the event our 2.25% growth became more sluggish. In recent years we’ve seen low interest rates punish savers, repress the cost of capital; and encourage reckless risk-taking in an income-constrained climate. Potentially dangerous terrain for economies desperately in need of productivity-enhancing investment.

Next global experiment?

In summary, the grand experiment of huge monetary stimulus by central banks around the world to encourage confidence, has not worked. Instead it has distorted efficient capital allocation and encouraged speculation without really enhancing financial confidence. So, the next step is likely to be the stimulus of Government spending via borrowing on productivity improvements like technology and infrastructure.

Experts in the global economy anticipate increased spending on infrastructure and technology investment opportunities, with slowly increasing inflation (from 1.75%) and cash interest rates from 1.5% now, up to 3% p.a. over time.

Meanwhile, investors can either accept lower income or retain their income and higher expected return by accepting more risk and volatility with increased equity exposure. If the latter, that equity risk must be carefully managed. Whatever your appetite for risk may be, good financial advice can help you navigate through the uncertain times ahead.

If you would like to discuss the information in this article or your investment options with one of our wealth management professionals, get in touch today!

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Disclaimer: All information in this article is intended to be general in nature for discussion purposes only. So you should not rely on it and seek personalised professional advice before making any decision.