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Beware: the impending ‘debt trap’ is upon us

Beware: the impending ‘debt trap’ is upon us

Investors are taking heed of the Bank for International Settlements’ (BIS) warning of an impending ‘debt trap’.

The global clearing bank says the trap has been caused by a persistent easing bias among policymakers, which has embedded instability into the system.

The scenario presents investors with two key questions. First, what do policy makers do now? Second, if there is a debt trap, what does this mean from an asset allocation perspective?

The BIS argues that persistently loose monetary policies have lulled governments into a false sense of security, delaying necessary consolidation – which has created a risk that instability could entrench itself in the system. A downward bias in interest rates and an upward bias in debt levels makes it very difficult to raise rates without damaging the economy, equating to a debt trap.

Aberdeen Asset Management’s Bruce Stout, who manages the Murray International trust and Aberdeen World Equity fund, says the trap has been created due to ‘the misguided experiment that is quantitative easing (QE)’.

‘They have failed to deliver what they wanted, which was inflation to inflate debt away. All they have done is layer debt on existing debt,’ Stout said, highlighting a debt-to-GDP ratio of 350% in the US.

While the prospect of rate rises could strangle any recovery, in his view a more worrying prospect is talk of further government intervention to reduce debt levels in the form of wealth taxes, higher corporation taxes and even debt write-offs.

He is concerned this could simply compound mistakes that have already been made.

‘The most difficult aspect of the whole picture is that the 10-year bond, probably the most important instrument in the world is the wrong price,’ he said. ‘Not having an accurate price means everything else is mispriced. It is being priced according to some mechanism, but we don’t know what it is.’

His concerns are echoed by Ian Brady, CIO of OakTree Wealth Management, who agrees with the BIS’s warning. The UK’s failure to rebalance its economy poses a key risk in the face of rising rates, he said. ‘I actually think this is why productivity in the UK has not been great. So many zombie companies have been kept alive.’

While QE has continued to power a bull market in equities, he expects this momentum to continue in the near term but warns of a 33% probability of an ‘upside melt-up’, where markets are driven upwards on momentum rather than improvements to the economy. He anticipates this could be to the tune of 15-20% over the next three to six months.

Against this potential backdrop, he has scaled back bond exposure and let cash in portfolios drift up to 10-15%, dependent on the client’s risk profile.

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