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On a collision course with the Debt Supercycle

Which is the best investment approach – dividend stocks, index funds, value plays or growth stories? Alas, this debate is looking like an exercise in rearranging the deck chairs. That's because financial markets are on a collision course with the Debt Supercycle.

The Debt Supercycle, a term coined by Montreal-based BCA Research, describes a persistent increase in national debt relative to gross domestic product (GDP). What this means in layperson terms is that many countries are increasingly living beyond their means, raising serious questions about the sustainability of current levels of prosperity.

Since the 1970s, the upward trajectory in financial obligations has continued virtually unabated. For example, public debt in developed countries has climbed from 30 per cent of GDP to more than 100 per cent (upper chart). Total (private and public) debt in the United States has more than doubled to 380 per cent of GDP over the same period (lower chart). A similar trend has unfolded in other developed countries.

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Historically, debt grew in line with GDP, rising faster during booms and falling back during busts. Since the 1970s, however, the quickness of central bankers to unleash stimulus has moderated downturns and kept the corrective phase of the debt cycle from fully playing out. As a result, recoveries have launched from successively higher plateaus of debt. During expansions, central bankers have been slow to withdraw stimulus, accentuating the build-up in borrowing.

With the debt burden becoming ever more onerous, recoveries take longer and longer to get going. More alarming is how relentless the upward spiral has become: Even after the financial crisis of 2008, there are few signs of reversal. Policy-makers continue to kick the can down the road and dodge the hard decisions necessary for stabilizing the trend. Human nature being what it is, the motivation to face up to the issue may only come after a crisis erupts.

We are now in a reflationary period, when the economy is being pumped up by central bankers and other policy-makers. Substantial equity exposure may work during this time, but adhering to target allocations will be more important than ever. Indeed, instead of rebalancing to a fixed asset mix, a progressively more conservative mix might be considered as the reflation matures and moves closer to a possible tipping point.

What will also help is diversification. Equities should include a good weighting in emerging economies given the Debt Supercycle is not as advanced in those countries, advises BCA Research. As for fixed-income securities, say others, a good percentage in short-term quality bonds is advised.

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