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Three can get you two

“Debt will get you in trouble” is a strange admonition when it comes a guy who helps to lend $1 trillion of it. This was the opening line used by Bill Gross, Managing Director of PIMCO the world’s largest bond fund in his Investment Outlook for June 2010.

In this issue, he talks about the dangers of chasing yield. High yielding investments can also carry high risk and he warns how quickly a high debt burden can turn into a crisis.  Some quotes from his article include:

Another lesson I’ve learned over these last 40 years is that while “two gets you three,” it’s also true that “three gets you two.” Sometimes it gets you zero, as in “default” – a big goose egg.

The burden of debt can take decades to accumulate, but only a few short months to change course into crisis. Many investors, economists and politicians alike have little understanding of why attitudes and lending standards can reverse so quickly – how a seemingly innocuous “two will get you three” build-up of debt will suddenly produce a crisis like it did aboard my ship in 1968. They operate with the mindset that markets, jobs and economies will “come back.” “I’ll just wait ‘till it comes back” is the common saw amongst underwater investors, just as “something will turn up” is a sad refrain of many unemployed or underemployed workers. Sometimes it doesn’t come back. Sometimes nothing turns up. Sometimes “three gets you two” in the real, as well as the financial, economy.

Borrower countries are hoping they can grow their way out of their debt burden. However, economic historians such as Kenneth Rogoff point out that at debt levels of 80-90% of GDP, a country’s real growth becomes stunted, and many countries are well past that standard as shown in the graph below.

Any lender with a little bit of common sense would be pretty worried when they see such an unsustainable growth in debt. The natural reaction is to demand that borrowers reduce spending but that will also retard growth so a recession becomes the fait accompli. The deficit/GDP ratio moves ever higher because of skyrocketing risk premiums and a plunging GDP denominator. In many cases therefore, it may not be possible for a country to escape a debt crisis by reducing deficits so the only way out might be via default or the more politely used phrase of “restructuring”. This was essentially what happened in the 1930s Great Depression after the debt burden went up to unsustainable levels. We have reached an even higher level of debt as a percentage of GDP so a long period of debt deflation seems inevitable in the years ahead.

We all know what happened in the stock markets in the 1930s. If you don’t, check out my earlier post One year later. As Bill Gross said, investors should be very happy to get 4-6% annualised returns in the next few years. Be careful about chasing high yields as sometimes “three gets you two”.

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