Weekly Asset Allocation (July 23, 2021)

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Confluence Investment Management offers a variety of asset allocation products that are managed using top down or macro analysis. We publish asset allocation thoughts on a weekly basis in this report, updating the report every Friday, along with a podcast and chart book.

The availability of abundant investment capital is vital for economic growth in rich, well-developed countries as well as in poorer developing countries. However, if the available capital is misused and/or the level of debt becomes too high, the results can be quite negative. In such a situation, economic growth may slow as businesses and individuals struggle to repay their debts. Economic shocks can cause businesses, individuals or governments to miss payments and go bankrupt, potentially triggering a financial crisis and damaging the country’s financial system. China’s high debt levels have been a particular concern for years, so it may be worth looking at the latest data on that country from the Bank for International Settlements.

As the following chart shows, stronger, wealthier advanced countries can generally tolerate a higher level of indebtedness (consistent with BIS practice, we focus on total credit to the non-financial sector). For the average advanced country in the BIS database, total credit to the non-financial sector stood at 321.3% of gross domestic product (GDP) at the end of 2020. For the average emerging market, credit to the sector non-financial amounted to only 240.1% of GDP. Note, however, that China stands out with its debt burden of 289.5%, which is significantly higher than the emerging market average and well above the burdens of other large developing countries such as Brazil, India and Mexico.

The BIS figures are broken down by the amount of credit extended to the non-financial corporate sector, the household sector and the public sector. At this level of detail, we can see that China’s heavy overall debt burden stems primarily from its non-financial corporate sector. In China, non-financial corporate debt alone represents 160.7% of GDP compared to 119.4% of GDP in the average emerging market. Moreover, the high indebtedness of Chinese companies relative to the rest of emerging markets has persisted for years. Often, the debt burden for Chinese companies by this measure is almost half that of the average emerging market. China’s non-financial corporate debt burden is even higher compared to 104.4% of GDP for an average advanced country. Indeed, non-financial corporate debt to GDP in China is even higher than in heavily indebted Japan, and it is almost as high as in Belgium.

This heavy reliance on corporate debt marks a new strategy for China. During the 2008-2009 global financial crisis, Beijing relied primarily on fiscal spending and government borrowing to support the economy, but that left many government entities saddled with debt for years. In contrast, Beijing’s approach to supporting the economy during the 2020 coronavirus pandemic was to channel funds through the business sector to keep workers in their jobs and maintain production where possible. The resulting increase in debt in the corporate sector was even greater than the increase in debt in the public sector, as shown in the chart below.

Due to the increase in credit to the corporate sector last year, Chinese companies could now be hampered by their high debt levels, especially if interest rates rise or geopolitical rivalry escalates. between the United States and China further hinders Chinese trade flows. This is one of the reasons why we have taken steps to limit our exposure to China in our asset allocation strategies. In our view, the combination of high levels of corporate debt in China and heightened regulatory risks from potential restrictions on capital flows should argue in favor of below-benchmark weightings for the country.

Past performance is not indicative of future results. The information provided in this report is for educational and illustrative purposes only and should not be construed as individualized investment advice or a recommendation. The investment or strategy discussed may not be suitable for all investors. Investors should make their own decisions based on their specific investment objectives and financial situation. The opinions expressed are current as of the date indicated and are subject to change.

This report was prepared by Confluence Investment Management LLC and reflects the current opinion of the authors. It is based on sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change. This is not a solicitation or an offer to buy or sell securities.

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