What does deleveraging mean to investors?

Ryan Bushell - September 30, 2011

Downside volatility, not seen since the global financial crisis, sent shockwaves through markets, reported the Leon Frazer Quarterly Review for the third quarter of 2011. Plus, the Review weighed in on debt, savings and what they means for investors

The debt crisis currently gripping much of the developed world began long before the financial meltdown exposed itself in 2007.

While it is easy to blame US mortgage lending and financial sector leveraging, at the root of the problem lies consumer debt. Enabled by the globalization of banking and a period of ever lower interest rates, consumer debt has grown steadily over the past 70 years, becoming a main contributor to the financial crisis and leading us to the first worldwide recession since the 1930s.

Consumer debt has grown steadily over the past 70 years, becoming a main contributor to the financial crisis

Consumer debt started increasing after World War II, escalating every year from 1940 until it reached a peak in July 2008. As interest rates fell from a high of over 18% in 1983 to a low of 1% in 2009, debt continued to increase as households increased their borrowing, particularly though home mortgages.

deleveraging, debt, consumer debt as cause of financial crisis

Rising house prices meant that the ratio of household debt to assets appeared stable in the years before the crisis. But household debt compared with disposable income increased significantly. This should have raised a red flag long before the crisis hit.

Total US consumer credit rose at a pace of 7.5% per year from 1983 to 2009, as consumers racked up new purchases at ever-declining interest rates.

In the meantime, saving rates suffered as money was poured into luxury cars and housing with little or no money down. So, when the financial crisis hit in 2007, it hit hard. Over-extended consumers could no longer afford the lifestyles they had become accustomed to, and housing foreclosures reached record levels. Consumers were forced to change their spending and savings habits.

Since the financial reckoning of 2009, consumers have started saving and are now paying down debt to repair their personal balance sheets.

Since 2009, total US consumer debt has fallen by 3% per year. Savings rates are climbing steadily.

Deleveraging, a fancy word for paying down debt, has occurred through a combination of increased savings, debt repayment and debt forgiveness. Some consumers have been fortunate enough to roll over their debt at significantly lower interest rates.

debt, deleveraging, savings,

At the same time, there has generally been less access to credit as a result of stricter underwriting standards. The inability to qualify for home equity loans and other forms of credit has slowed the pace of household debt increases.

Corporations, too, have followed suit. Corporate balance sheets are strong and flush with cash due to deleveraging and cost cutting. In contrast to individuals and corporations, however, government debt continues to grow at alarming levels, and government deficits are at all time highs.

 

What it means for the investor

So what does this mean for investors? Do investment opportunities even exist? Nervous investors are seeking shelter in government bonds, despite ridiculously low yields, rather than jumping back into undervalued, higher-yielding stocks. At 2%, a government of Canada 10-year bond currently has a negative yield after tax and inflation. Instead, investors would do better to look at the compelling value of dividend-paying companies.

Dividend-paying companies have a proven long-term track record for preserving buying power and protecting capital value. And, for the first time since 1955, dividend yields are higher than bond yields.

In a persistent low interest rate environment, dividend-paying companies provide a competitive, tax-advantaged income stream with the potential to increase over time.

READ MORE. LEON FRAZER QUARTERLY REVIEW, Q3 2011

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