Perennial Asset Management

The Tinderbox of Debt and Deficits

December 2013 | PDF Version

Executive Summary

As parents we try to assist our children in every way we can.  This assistance is not always in their best interest, despite our well-intentioned plans. Government leaders of many developed economies find themselves in a similar situation, as they seek to protect society by putting out small fires today. However, by extinguishing today’s small fires, governments are creating a more fragile environment. This is likened to feeding the tinderbox that may ignite devastating fires tomorrow. This paper looks at the economies and government finances of Ontario, Japan and the U.S. to understand where we are today, where we’ve come from, and how the future may evolve.

The Japanese people are known for their prudence and responsibility, yet their government has run a deficit every year since 1973. Forty years of fiscal mismanagement has saddled them with debt of a quadrillion Yen and a stagnant economy. The debt service alone is consuming a high and ever-increasing amount of government tax revenue, and the trajectory is not positive. In a desperate attempt to overcome their economic and financial woes, Japan is implementing extreme strategies of money printing and government spending. Desperate and untested strategies rarely lead to positive outcomes.

The U.S. economy has long been admired for its flexibility, and companies have historically found a way to rebound from each economic recession with renewed vigour. However, since the 2008 financial crisis, both the U.S. government and the central bank have positioned themselves as the “economic saviours,” since they don’t trust that companies can reinvigorate the economy on their own. The U.S. government is running huge annual deficits to keep the economy going, and the central bank is also printing unprecedented amounts of money. This strategy has burdened the U.S. government with $17 trillion of debt and a printing press that cannot be stopped. America appears to be following the unsuccessful and deteriorating Japanese model.

Over the past five decades, we have witnessed increasing government debt and slower economic growth in both Japan and the U.S. While each country’s situation is unique, servicing a growing debt load constrains a government’s choices, and ultimately has a negative effect on the economy. Various studies have concluded that significant debt is an impediment to economic growth and it’s our belief that this time is no different.

The U.S. and Japan are not alone. Significant government debt is a global phenomenon and it’s creating an incessant drag on the global economy. As Canadians we are proud that our banks are prudent, and that our government is less profligate. However, our provincial governments have been less responsible, and Ontario is starting to experience similar problems to Japan and the U.S.  With annual deficits of around $10 billion and outstanding debt of $252 billion, Ontario’s annual interest charges are affecting government spending and future solvency.

The mountain of debt globally continues to hamper economic growth, and we don’t see how this environment can ultimately be positive for equity markets going forward. Despite the dramatic efforts in Japan to kick-start its economy, the stock market (the Nikkei) remains down over 60% from its 1989 peak. On the other hand, equity markets in the U.S. have performed well, despite lacklustre economic growth. Low interest rates have left investors with nowhere to invest their funds other than stocks, and this has driven equity markets much higher. Current steep valuations already assume strong economic growth going forward.

The tinderbox is primed and the spark could ignite at any time.

To read the full paper on “The Tinderbox of Debt and Deficits,” please continue on Page 2.


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