Is there a global debt bubble?

 Many savvy global investors one speaks to are convinced that we are in the midst of a global debt bubble, and one that is looking quite over extended at this point in time. They point to the unique nature of the current debt cycle and its atypical behaviour post the stock market collapse of 2000.

 The concern stems from the fact that private sector(household plus corporate) leverage has never been higher in most of the developed economies of the world. In the UK it is currently189 per cent of GDP(private sector debt/GDP), in both the US and Germany it is approximately 145 per cent of GDP.

 What is of greater concern is that private sector leverage has actually continued to increase post the bursting of the stock market and investment bubbles of 2000. This is quite unprecedented and not the outcome one would expect if you were to look back in history.

 During the previous debt cycles, private sector leverage has normally peaked at around the same time as the stock market. Normally as the bubble gets unwound in the stock market , leverage levels across the economy fall, as both corporates and consumers give up their lofty growth ambitions and adopt a more conservative financial stance, building free cash flow and savings.

 This cycle however is different, as the level of private sector leverage has continued its relentless march upwards, irrespective of the stock market bust. This continued rise in the level of leverage in the economy has been primarily driven by the household sector, as leverage in the non-financial corporate sector peaked in 2002(and has declined slightly since then).

 However, household sector leverage reached record levels in both the US and UK in 2002 and has continued rising since then. While there is no magical number defining what is the right or sustainable level of leverage in an economy, the situation spiralled out of control in Japan when this ratio (private sector debt/GDP) hit a peak of 193 per cent in 1990.

 It is currently down to 170 per cent today. Even though private sector leverage has been rising at varying speeds for forty years now, it is very unusual for it to continue doing so even after a bubble has burst and we have gone through a recession.

 Timing the top of a potential bubble is next to impossible and it is certainly feasible that the household sector will keep piling on more and more leverage in the US and UK for the foreseeable future. But at some stage this will have to moderate and reverse even if only temporarily.

 I am not sure global investors have fully thought through this potential reversal and its implications. What will happen if private sector leverage (private sector debt/GDP) were to actually reduce in the system? It has happened before and there is no reason why it cannot happen again.

 Given the unique nature of the current debt cycle, investors globally, both in the fixed income and equity markets have to understand its implications.

 Firstly the US economy and stock market have never been more dependent on earnings from the financial sector. Earnings from financial services account for 40 per cent of after tax profits for the entire US corporate sector(MS estimates using National income accounts).

 Also, more than half of the incremental growth in earnings for the entire US corporate sector in 2003 is likely to be generated from financial services.

 Just to give a sense of perspective, at the beginning of the equity bull market in 1982, the financial sector accounted for no more than 10 per cent of total corporate sector profits and the absolute levels of profitability were $ 10 billion in 1982 compared to $ 140 billion today.

 Undoubtedly there will be many cyclical explanations for this surge in relative profit share of the financial sector, the easiest one being the relative weakness of non-financial earnings.

 But to my mind, the major reason for this increase in relative and absolute share of financial earnings is due to the sharp rise in private sector leverage over the last thirty years and most recently, the massive turnover of the debt stock at the household level(mortgage refinancing).

 The key point here is that the US stock market and therefore economy are hugely dependent upon and sensitive to the earnings performance of the financial services sector. This implies that the stock market is very dependent on both low and falling interest rates as well as the growth in absolute debt levels(as pointed out by MS in a recent note) to deliver its earnings projections.

 If we look at both of these variables, interest rates are already at near record lows, and if they were to rise significantly, it would undoubtedly damage financial sector earnings. As for further growth in the absolute level of debt, at some stage the household sector will have to curtail its growth in leverage, which will undoubtedly impact financial sector earnings.

 On a prima facie basis, to have the US market trading at 19 times current year earnings, with 50 per cent of these earnings coming from the financial services sector (the sector having yet to face a reversal of the debt cycle) seems a dangerous proposition.

 The financial services sector has been one of the biggest beneficiaries of the build up in private sector debt over the past two decades. Most investors are either ignoring or underestimating the impact a reversal of this debt build up will have on the earnings of this sector and consequently the earnings of the market as a whole.

 Another area of concern is the whole mortgage refinancing boom, rise in house prices and the impact of these two variables on consumer demand. If you look at the surge in household sector leverage it is predominantly driven by the rise in mortgages, as households have taken advantage of low interest rates and strong property prices to extract equity from their houses.

 This equity extraction has undoubtedly helped consumers maintain spending levels and moderate their balance sheet adjustments. There is considerable debate on Wall Street as to what impact a moderation of the mortgage refinance cycle will actually have.

 As interest rates stabilise and house price increases moderate, this continuous mortgage debt build up is unlikely to sustain. Wall Street differs considerably in its assessment of the significance of the coming slowdown in the mortgage refinance cycle. The more bearish camp feels this reversal of the refinance cycle could reduce consumer spending by upto 1.5 per cent in 2004.

 While the more sanguine bunch of economists expect its impact to be very modest at best, citing the predominantly fixed interest nature of the newly refinanced obligations.

 There you have it, the rapid build up in private sector debt in the system in the developed world is unlikely to sustain at its current pace.

 As this slows or even temporarily reverses, it will have serious consequences for the level of earnings delivered by the broad stock market as well as consumer spending. Most people have yet to fully appreciate these linkages.