Mark Lister: Debt-reduction plans only delay inevitable

Opinion

Greece's high debt levels and the public protests that followed some much-needed austerity measures have dominated global business headlines. With some short-term solutions now in place, the focus has quickly shifted to other countries, including Italy, which has similar debt levels, but is six times bigger and therefore much more important.

Italy is nowhere near the basketcase that is Greece, with lower fiscal deficits, higher private-sector savings and a more solid banking system. Unemployment is also much lower, at 8 per cent, compared with 16 per cent in Greece.

However, its debt levels do remain high and this makes it vulnerable. If investors lose confidence and demand higher interest rates in return for lending Italy money, it will become difficult and very costly for Italy to raise new funds.

Being part of the euro has not been all good for countries such as Greece and Italy. Upon joining, their borrowing costs fell sharply as they became part of a bigger, stronger union. But sharing a currency with stronger countries in Europe has also created some problems.

Their own currencies would have plunged when their economies began to look shaky, which would have increased their export competitiveness, boosted tourism, and provided a much-needed shock absorber to their economic woes. Within the euro, none of these natural rebalancing factors have been able to occur.

But it's not just Europe that will be the focus over coming weeks. Some of the financial headlines might belong to the United States, as the world's wealthiest and largest economy has its own debt deadline to meet in early August.

The US debt ceiling is the statutory upper debt limit that Congress allows the Treasury to borrow up to, which basically means it is the Government's self-imposed maximum debt level. The current limit of US$14.3 trillion ($16.9 trillion) was set a year-and-a-half ago, and it was reached about six weeks ago. Just to be clear, US$14 trillion written numerically looks like this - US$14,000,000,000,000.

That's a huge number, but the US is a huge economy, the biggest in the world. At these levels, US total public debt is about equal to the country's annual GDP, which is very high, but not unmanageable. The problem is that it's growing even bigger, by about US$125 billion a month.

Without an agreement by Congress to increase this limit, the US Government would have to limit spending to no more than it is taking in revenue. The worst-case scenario would be that some contracts would not be met and the US Government would technically be defaulting on its debts. Having enjoyed a rock-solid reputation for fiscal responsibility for more than 200 years, this would garner a severe reaction in almost all areas of financial markets.

The debt ceiling first breached the US$1 trillion level in 1981, during Ronald Reagan's first term, and it has been increased numerous times since. So it is very likely it will simply be raised again. The main stumbling block to an agreement being reached is the political posturing that is going on, with all parties keen to come out looking like winners.

Last year Obama's fiscal commission put forward quite a sensible proposal to tackle rising debt levels, which included spending cuts and tax increases. But in February, the Democratic Obama Administration released a Budget that only modestly took these recommendations on board. In April, the opposing Republicans responded, with more aggressive measures to cut spending but fewer tax increases. Obama has since countered these suggestions, with a plan that looks more like the original one from his fiscal commission.

The Greek situation, Italy's problems and the level of the US debt ceiling have two key things in common - they are no more than a reflection of what happens when you live beyond your means for too long, and they have but one simple (yet painful) solution.

When a household spends more than it earns and becomes indebted with credit cards, a mortgage and hire-purchase agreements, its options are limited. It can look for ways to bring more income into the household to ease the pain of the interest payments, or it can review spending habits and make some difficult choices about where the cuts will be made and who will have to forgo something they would really rather not.

A country with too much debt and a growing interest bill is facing the same dilemma and set of solutions, although on a much bigger scale. It can either raise taxes, or cut spending on services, or both. Raising taxes and cutting spending don't help economic growth prospects, especially when economies are already weak. They also don't particularly help politicians at the polling booth, and there is an election in the US next year.

These long-term issues have not escaped the rating agencies, which have fired a few warning shots at America. A downgrade of US debt from its AAA rating has been threatened if the fiscal problem is not dealt with in a sensible and timely way. It is the only country with a triple-A rating without a credible debt reduction plan and the rating agencies want to see US debt on a downward trajectory over the next few years.

Whether it's Greece, the US or Italy, the main point is that the resolutions we are seeing at present are short-term fixes, rather than real solutions. The strategies of raising debt ceilings or giving Greece aid buy authorities more time, but they only delay the inevitable. To put an economy on a sustainable footing for long-term recovery and growth, outgoings simply have to be less than incomings.

The whole debate over raising the US debt ceiling is a bit of a red herring, despite the posturing reflecting poorly on US political leadership. It might be an 11th-hour solution with some nail-biting in the lead-up, but I suspect that an agreement will be reached and it will be raised. The more relevant debate is when and how we will start to see these longer-term measures occur.

It's easy to ignore many of these issues on the other side of the world, from the relative safety of New Zealand. But as investors, we need to be mindful of the risks that these situations pose, and position our portfolios accordingly. Unlike the events of 2008, political leaders as well as bodies such as the IMF are acutely aware of these risks, which should ensure a more proactive approach to managing them.

The most probable outcome is that Europe and the US will face a long process of debt repayment, which leads to lower consumer spending and consequently implies a period of below-average economic growth. This suggests that interest rates and investment returns will be subdued for a while.

A worse outcome, which is unlikely but still possible, is that the situation worsens and we have a relapse of some of the issues from a few years ago. If the latter occurs we would see equity markets fall, the New Zealand dollar would probably weaken (it fell nearly 40 per cent in less than a year during 2008 and 2009) and we could face higher interest rates as smaller, highly indebted countries are seen to be higher risk by global investors.

Ensuring portfolios are well diversified remains by far the best protection against such risks. Investors should ensure a good balance between low-risk assets (cash and fixed income) and growth assets (shares and property). Within these growth assets, diversification across geographies and sectors is essential, as is a decent allocation to defensive stocks with solid dividend yields. At least a portion of assets should be diversified away from the New Zealand dollar,
as our currency tends to fall when global risks increase.

* Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column is general in nature and should not be regarded as personalised investment advice.