On the verge of the Federal Reserve's decision on interest rates there is lots of discussion around what the implications will be of a relatively (seemingly) benign 1/4% increase.
The debate, on the global consequences, surrounds the amounts of debt outstanding mostly in (but by no means limited to) emerging market countries.
Simply put, as long as the interest cost on borrowing is less than the growth of the assets that you have purchased with the borrowed money, borrowing is good.
If the growth of those assets slows or even worse, begins to decline, then you have to ask yourself if you had better sell assets and pay down the debt (or the lenders may decide for you, if they become concerned about the situation).
If interest rates begin to rise (and so does the cost of servicing the debt) and there is no growth in those assets, it becomes even more of a problem.
In essence, this is what we are looking at on a global scale.
There has been significant borrowing because interest rates have been at such low levels for so long.
This is has been happening at the household level, the corporate level and the government level.
In Canada, at the household level, low interest rates have continued to hold the Debt Service Ratio (share of income needed to pay interest and amortization) to record lows, however this has enabled borrowers to borrow record amounts relative to their income levels.
As long as the value of the assets is growing and the debt to total assets (pale blue line) is declining, this is not a concern because the debt is productive.
If assets stop growing or interest rates start rising (or a combination of the 2) then assets must be sold and the debt load reduced.
The big problem is liquidity.
If a great deal of debtors need to sell assets to reduce debt, prices of the assets that are being sold may decline in a hurry (significantly more sellers than buyers).
We have seen a glimpse of this effect in the recent global bond, stock and commodity market volatility.
Unfortunately, this is just the "tip of the iceberg".
This is the big issue that central banks are grappling with:
Is global growth at current (and future) levels enough to sustain the enormous amounts of borrowing that exist if interest rates move higher?
Further, the continuing strength of the US$ has increased the debt burden for those (especially emerging/developing nations) that borrowed in US$.
If global growth is slowing and we are in a period of low returns for assets, the time for reducing debt may be at hand.
It may be wise to do so, before you are forced to do so.
Tuesday is weekly webinar day at High Rock, feel free to tune in to our recorded version which will be posted at or about 5pm EDT:
Scott Tomenson,CIM Managing Partner, Chief Investment Strategist