The world is buried under a staggering pile of debt. And the consequences of our collective borrowing binge will be felt for years to come.

The global response to the GFC and COVID was mind-blowingly complex when examined in detail. A myriad of programs spung up around the world to deal with the immense fallout from the twin crises. But zooming out from the detail and it becomes simple to summarise. Governments borrowed a pile of money. Interest rates were lowered to unprecedented levels and the monetary system was flooded with liquidity to encourage everyone else to borrow as well.

This approach worked remarkably well. Economic pain was minimised and everyone did exactly what central bankers and political leaders wanted them to do. The only problem with the instant gratification of debt fuelled spending is that some day you need to pay it back.

How big is our global debt problem?

 

Big. S&P recently put out some commentary on the size of the global debt problem. Total global debt hit $453 trillion in 2022. It equates to 349% of global GDP. That is over $56,000 for every man, woman, and child on earth.

The total government debt to GDP percentage increased 76% between 2007 and 2022. It sits at 102% of GDP. Non-financial corporate debt rose 31% to 98% of GDP. Consumer debt was up only 7% to 64% of GDP. The financial sector held steady at 85% of GDP.

S&P also pointed out that the productivity from debt has declined. Hence the massive increase when compared to GDP levels. The world is like a drug addict that needs to take on more and more debt just to get the same economic high.

What are the implications of the debt binge?

 

There is a great deal of talk about the mortgage cliff. This will undoubtably cause issues for individuals and for the economy in Australia. But confining it to the mortgage market in Australia is minimising the problem.

S&P estimates that 35% of the debt in the world is floating. That means that the interest rate increases that have occurred to date would result in roughly $3 trillion dollars in increased debt servicing costs.

For a company that may be in your portfolio that means less profits. Less money to invest in the business. Less money to pay you in dividends. Governments and consumers will have less money to pump into the economy.

And the effect from higher interest rates takes a while to be felt. Economists estimate it takes 12 to 18 months to work their way through the economy. And as we pass a year into the tightening cycle the first interest rate increases may only be starting to be felt now. Fixed rate debt will expire and have to be replaced with new debt at higher interest rates. This will compound the floating rate issues S&P outlined.

What does this mean for investors?

 

It is a near certainty that we will continue to see implications as the world adjusts to higher levels of interest rates on the pile of debt we’ve run up. We’ve seen implications so far with the banking issues highlighted by Silicon Valley Bank and Credit Suisse and the ongoing issues with First Republic Bank. There are also likely to be issues related to private asset valuations.

These issues are likely to continue to pop up. S&P identified a couple problem areas. The first was Chinese companies. The credit rating agency took a sample of more than 6000 Chinese corporations and found that the average debt to earnings ratio was 6x in 2021. That is twice the global level. In the US S&P found that 36% of companies in September 2022 had a credit rating of junk status. That is double the figure from the same month in 2007.

It seems likely we could see more areas of concern. Perhaps it is more problems in the banking sector. Maybe the opaque world of private debt that so many investors have sought out for extra yield. It could be the office REIT sector where asset valuations have dropped and vacancies have risen. I don’t have a crystal ball and neither does anyone else.

All companies benefited from the era of low interest rates and the flood of capital flowing through the economy. Some of these companies are unlikely to survive an environment with higher priced capital and less access to funding.

How can investors adjust their portfolios?

 

As investors we are constantly being told to adjust our portfolio based on near term market conditions. Encouraged by compelling pitches we churn our portfolio into poor outcomes. In that spirit consider the suggestions below as a long-term reorientation of your investment approach.

As economic conditions change over the years and decades ahead we want to own companies that have the flexibility to respond. This starts with adapting to evolving competitive environments which is why great investors seek out companies with sustainable competitive advantages or moats. But it also means having the financial flexibility to enable the continued investment in the business and the ability to reward shareholders with dividends and buy backs.

A company with financial flexibility has a reasonable level of debt and the ability to meet their day-to-day spending needs with internally generated cash. Our analysts assess the financial condition of a company as part of their Uncertainty Rating and the Capital Allocation Rating.

The Uncertainty Rating is an assessment of the confidence our analyst has in their assessment of the future prospects of a company. This is a proxy for the risk inherent in the business which contributes to the range of outcomes possible for the company. There are several factors that go into this rating but financial risk plays a large part. A company with precarious finances is more likely to go out of business. Look for a company with a low or medium Uncertainty Rating.

The Capital Allocation Rating assesses the balance sheet, investment decisions and shareholder distributions of a company. Balance sheet strength signals resilience to whatever the future holds.

If you don’t have access to our analyst reports there are ways you can assess the financial strength and flexibility of a company on your own. Look at the overall levels of debt and cash on the balance sheet. Review the debt-to-equity ratio which is an assessment of leverage. They tend to vary significantly between industries, but you can compare two companies or a company and the industry average. Lower is better.

A more detailed review of the financial statements can identify the mix between fixed and floating rate debt and the upcoming maturity schedule of existing debt. A company with fixed rate debt maturing far in the future is insulated from the run up in interest rates and the need to roll over debt in a more restrictive credit environment. Looking at a company’s credit rating can also indicate relative costs of funding and continued access to debt.

The future is unknowable. We could of course return to a more speculative environment at any time. But there are certain realities that we can’t wish away. The mountain of debt we’ve collectively accumulated is one such reality. Focusing on quality companies is an investment approach that never goes out of fashion.