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1 How much debt has the world added?

Our research shows that global leverage for all sectors – ie, governments, private households, non-financial companies and the financial sector – has continued to rise since the financial crisis. It currently stands at 298% of world GDP, which is close to the all-time high of 303% set in 2009, but significantly higher than the 279% level set in 2006, on the eve of the financial crisis. In the developed world, this figure is 340% of GDP – lower than the peak levels observed ten years ago, but it has been rising since 2014. In emerging markets, the amount of leverage totals 228% of GDP – about two-thirds higher than it was in 2006.

If we look at leverage by economic sectors globally, it has continued to rise in the private non-financial sector (private households and companies) and in the government sector; in fact, it has recently reached all-time highs. But leverage in the financial sector has been in decline since the financial crisis (see Chart A/).

Not all of this debt has been issued in domestic currencies. Notably, the amount of US dollar-denominated debt held outside the US has doubled during the last ten years, both in advanced and developing economies; it now stands at about USD 11.5 trillion. Moreover, US dollar debt-to-GDP ratios in both developed and emerging markets are now at or close to their multi-decade highs (see Chart B/ and C/) – which will likely be quite a challenge for these borrowers in times of rising US interest rates and a strong dollar. Overall, the rise in US dollar debt has been quite broadbased, and can’t be blamed on select countries like Turkey or Argentina, which saw their respective currencies tank in 2018.

This brings us to another aspect worth highlighting. While banks are still the biggest lenders, some of their market share has been grabbed by many other non-bank financial institutions – such as insurance companies, pension funds, mutual funds, hedge funds, Chinese trusts, private equity funds, broker-dealers, real estate investment trusts, captive financial institutions, special purpose vehicles and others.

The question is, does this leave the financial system less stable or more stable? A decline in financial-sector leverage is in many ways a welcome development. However, some of the “new players” in the credit market are highly leveraged and less regulated – for example, hedge funds – and we know little about their interconnectedness. The reason this is an issue is that in times of financial-system stress we may see changes in market dynamics that are difficult to anticipate – changes that could be damaging.

A/ Global leverage by economic sectors

Source: AllianzGI, BIS, Datastream, data as at Q1 2018

B/ US dollar-denominated debt outside the US in % of GDP

Source: AllianzGI, BIS, IMF, IIF, data as at Q2 2018

US dollar debt-to-GDP ratios in both developed and emerging markets are now at or close to their multi-decade highs – which will likely be quite a challenge for these borrowers in times of rising US interest rates and a strong dollar.

C/ USD debt in emerging markets in % of GDP

Source: AllianzGI, IMF, IIF, data as at Q2 2018

2 Where did all the money go?

Clearly, debt levels have been rising around the world, but this only tells part of the story. A closer examination of which sectors are borrowing and lending may shed more light on the issues associated with rising global leverage.

Let’s start with the US, which is the biggest debt market in the world. Even though leverage has declined overall since the financial crisis, the non-financial corporate sector has levered up significantly, reaching 73% of GDP (see Chart D/). This matches the previous record set in 2009, and it is significantly higher than the 64% level seen at the end of 2006, just before the financial crisis. This rise in non-financial corporate-sector debt can largely be explained by debtfinanced share buybacks, and this kind of leverage does not matter as much in times of strong economic growth, low interest rates and spreads. However, we are now late in the economic cycle, and spreads have widened since early 2018 on the heels of Federal Reserve rate hikes and a subsequent increase in market volatility. It remains to be seen if the recent change in Fed policy following a series of weaker cyclical data will soothe market concerns.

The rise in the amount of US corporate debt is not the only reason for concern: the quality of this debt has deteriorated as well. More than 40% of all outstanding bonds are BBBrated. Moreover, the leveraged loan market – the market for loans to highly leveraged companies – is as buoyant as it was in 2006-2007, and it is bigger than the high-yield bond market. In addition, lenders receive less protection than they did in the past. So-called “covenant-lite loans” now account for about 80% of all bonds – a fact that former Fed Chair Janet Yellen drew attention to a few months ago.

In many economies, there can be an upside to higher leverage: a booming housing market. This has recently been the case in many locations that were not hit (or not severely hit) by the financial crisis – locations such as China, Turkey, Mexico, Malaysia, Canada, Sweden, Norway, Australia, New Zealand and Hong Kong. We think this situation was the unintended consequence of ultra-easy monetary policy in the US and Europe. Their low central-bank rates and massive liquidity injections depressed market yields globally, which lifted demand for credit and real estate in those economies where the private sector did not have to go through a painful balance-sheet adjustment a decade ago.

D/ US non-financial corporate leverage VS interest cover

Source: AllianzGI, Datastream, data as at Q3 2018

3 So what’s the problem with rising leverage?

The crucial question is, does this rise in leverage matter? And if so, under which constraints and to what extent? To answer these questions, it’s important to understand the concept of the “financial cycle”, which was developed by the Bank for International Settlements (BIS) after the financial crisis.

The financial cycle is a way to assess the medium- to longterm health of an economy; it is measured by the joint dynamics of private non-financial sector credit growth and house prices (see Chart E/). Financial cycles are significantly longer than business cycles, which capture the ups and downs in real GDP. The average financial cycle is 16 years long (6 years of contraction and 10 years of expansion), while the average length of a business cycle is 5 years (see Chart F/). Technically, financial cycles can be calculated in multiple ways, but all of them lead to very similar results. The approach we have chosen is similar, albeit not identical, to the approach used by the BIS. We calculate the average z-score of the credit gap – ie, private non-financial sector debt/GDP relative to trend – and the deviation of real house prices from trend (see Chart G/).

Our empirical work on the financial cycles in developed and emerging economies broadly confirms the BIS results for a smaller sample (see Chart H/):

• In times of an expanding financial cycle – that is, when house prices and private-sector leverage increases – economies tend to benefit from structural tailwinds. However, an expanding financial cycle does not preclude a recession – though compared to periods of a declining FC, recessions are less likely, less deep and less long. This makes sense intuitively: houses are typically the biggest single asset of every household and are usually debtfinanced. Hence, an expanding financial cycle points to improving private household balance sheets and a generally expanding economy. The shallow recession in the US in 2001 is a good example of a recession in times of an expanding cycle.
• Conversely, when house prices are falling and banks are constraining credit growth – that is, when the financial cycle contracts – recessions tend to be deep and long. The financial crisis of 2007-2008 is the most severe version of a recession in times of a contracting financial cycle (we analysed the relation between financial cycles and recessions for developed markets only).
  
  

We also made another important finding: near the peak of a financial cycle, there is about a two-thirds probability that a country will face a financial crisis – be it a banking crisis, sovereign-debt crisis or foreign-exchange crisis. In our analysis, all but two of the 36 crises we identified happened around the peak of their respective country’s financial cycle.

E/ Real-Estate price performance VS changes in private-sector leverage

Source: AllianzGI, BIS, Datastream, as at Q1 2018

F/ The financial cycle VS the business cycle – some stylised findings
Financial VS business cycle – stylised facts

Source: AllianzGI, BIS, The Economist, OECD, Datastream, IMF.
Financial cycle calculated as the average z-score of private non-financial debt/ GDP (credit gap) and real house prices relative to trend. Financial-cycle calculations for 14 developed-market economies (US, UK, Germany, France, Italy, Netherlands, Spain, Portugal, Suisse, Sweden, Norway, Japan, Australia, New Zealand) and 12 (former) emerging-market economies (Brazil, Mexico, Turkey, Israel, Russia, China, Korea, Malaysia, Thailand, India, Singapore, Hong Kong) since the 1970s or later, depending on data availability. Business cycle analysis for developed-market economies only. Data on recessions during different stages of the financial cycle indicate the average peak-to-trough move in real GDP and the average number of quarters of GDP below the previous cycle peak.

G/ Expanding financial cycle in major developed economics

Source: AllianzGI, BIS, Datastream, data as at Q1 2018
Legend: financial cycle calculated as the average z-score of private non-financial debt/ GDP (credit gap) and real house prices relative to trend. Financial cycle of country groups are GDP weighted averages of country-specific financial cycles; EUR proxied by DEU, FRA, ITA, SPA, NET, POR, IRE; Small open DM = CAN, SWE, CHE, NOR, AUS, NZL; Asian Tigers proxied by HKG, SGP, KOR, THA; other major EM = BRA, MEX, RUS, TUR, ISR, ZAF, IND

H/ Peaking or contracting financial cycles in some developed and emerging markets

Source: AllianzGI, BIS, Datastream, data as at Q1 2018
Legend: financial cycle calculated as the average z-score of private non-financial debt/ GDP (credit gap) and real house prices relative to trend. Financial cycle of country groups are GDP weighted averages of country-specific financial cycles; EUR proxied by DEU, FRA, ITA, SPA, NET, POR, IRE; Small open DM = CAN, SWE, CHE, NOR, AUS, NZL; Asian Tigers proxied by HKG, SGP, KOR, THA; other major EM = BRA, MEX, RUS, TUR, ISR, ZAF, IND

4  Where in the financial cycle are we today?

In developed economies, the financial cycle is expanding in countries that either caused the financial crisis in the first place (the US, UK and euro zone) or that suffered severely (Japan). The financial cycle is also expanding in New Zealand.

Even though we can’t rule out a recession in the US, Europe or Japan in the coming one to two years – some of our models are indeed pointing at a rising recession risk – we believe that any recession there is likely to be moderate. The one caveat we have to mention, however, is the lack of policy ammunition left with which to counter a recession. In terms of monetary policy, nominal and real central-bank rates are still low in all major developed economies, and further inflating central-bank balance sheets would be technically and legally difficult. In terms of fiscal policy, government-debt levels are generally so high that future fiscal stimulus is likely to be constrained.

To the contrary, the financial cycle is near peak levels – or just beyond them – in several Asian economies (including China) as well as in small, open, developed economies that escaped the financial-crisis fallout a decade ago (notably Canada , Australia, Norway and Switzerland). The financial cycle is also clearly in decline in several major emerging markets (Brazil, Russia, India and Turkey) as well as in Sweden. We therefore expect to see structural headwinds for economic growth in these economies. Moreover, these countries also face heightened risks of stress in their respective financial systems.

For investors, the high debt levels seen in the world today remain an important risk to watch, both for economic growth and for financial markets. This underscores the need for appropriate risk management and tail-risk hedging. Yet compared to the pre-financial-crisis period, the financial cycles of major developed economies are in reasonably good shape this time around – a fact in which we take some comfort.

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