ECONOMIC COMMENTARY. Global government debt BY CHRISTOPHER BREMER, DIRECT0R - PRIVATE CLIENT SERVICES PORTFOLIO MANAGEMENT MARCH 2014

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1 NORTHWESTERN MUTUAL WEALTH MANAGEMENT COMPANY ECONOMIC COMMENTARY BY CHRISTOPHER BREMER, DIRECT0R - PRIVATE CLIENT SERVICES PORTFOLIO MANAGEMENT MARCH 2014 Debt: A Double-Edged Sword In 2006, at the top of the real estate bubble, consumers, corporations, banks and governments had built up an unsustainably high level of debt. As long as the economy held up, the debt was manageable. But when the global financial crisis took hold in earnest in 2007, leverage became a major problem It s a hole that governments, corporations, banks and consumers have been digging out of for the past seven years. Leverage by itself isn t a negative; but too much leverage for the weakest governments, consumers and corporations can often create havoc if the economy suddenly weakens or experiences a crisis, as we saw in While it may not be over yet, much progress has been made. Government austerity, pullbacks in consumer spending and corporate and bank deleveraging have contributed to an improvement in their respective balance sheets but at the cost of a slower recovery in the global economy. As the economy has recovered at an uneven but ultimately steady pace and consumers, corporations and governments have worked on repairing their balance sheets, these more stable entities are all in a position to contribute to global economic growth. And with these different economic contributors on a more stable footing, the stage is set for the global economy to continue to recover and to potentially move into a higher growth phase as the level of incremental austerity subsides and the purse strings are loosened. In this month s commentary, we ll explore the issue of leverage for governments both globally on a national level and in the U.S. on a federal, state and municipal level from the perspective of corporations, financial institutions and consumers. We ll look at where these entities have been and where they are today. And finally, we ll place these observations and facts in context for the economy and markets. Global government debt Globally speaking, government debt relative to GDP levels has been falling since Debt levels are variable, with struggling members of the European Union on the high side and emerging market countries, which didn t suffer from a debt overload, on the low side (fig. 1). Overall debt in advanced economies was projected to fall by 1.5% of GDP last year, which would mark the fastest pace of debt consolidation since Because the financial crisis was so deep, many advanced governments adopted fiscal stimulus policies earlier in the cycle in an attempt to stimulate

2 employment and economic growth. Many governments subsequently adopted austerity policies in an effort to trim budget deficits. Austerity was especially prevalent in Europe, where the countries struggling with the largest debt burdens Greece, Ireland, Portugal, Italy and Spain were forced to borrow from the European Union and the International Monetary Fund (IMF) to stay afloat. Those economies are slowly recovering, but unemployment remains very high and GDP is barely edging into positive territory. Deficits are projected to fall further in 2013, especially in the U.S. Figure 1; Source: International Monetary Fund; *Projected; ** Includes financial sector support The U.S. federal deficit With the economic picture brightening, the U.S. is projected to continue to whittle down its budget deficit. In fact, the Congressional Budget Office reported in its February report that the budget deficit has fallen sharply during the past several years and is projected to decline further this year and in However, beginning in 2016, budget deficits are projected to rise because spending is likely to rise more rapidly than revenues and GDP due to increased spending on entitlements (fig. 2). State and municipal debt While consumers and the federal government were hit hard by the financial crisis, states and municipalities were some of most deeply affected. State and municipal revenues are closely tied to real estate, and the bust in the real estate market resonated through state and city budgets and forced deep budget cuts, including layoffs and some bankruptcies. State revenue collections show considerable improvement in 2013 and are projected to continue to improve in 2014, though not at their 2013 pace. States that were hardest hit during the Great Recession have, for the most part, recovered more slowly Figure 2; Source: Congressional Budget Office than those that weren t as deeply affected. Yet, in its November report, The Fiscal Survey of States, the National Association of State Budget Officers notes that modest fiscal improvements are widespread across the country. While some states have surpluses and are demonstrating improved financial conditions, many states are still struggling to a degree in that they haven t yet surpassed pre-recession nominal revenue and spending levels (fig. 3). America s cities are slowly recovering from the Great Recession in a similar fashion. A survey of municipal city financial officers published by the National League of Cities states that nearly three-quarters report that their cities are better positioned to meet their financial obligations in 2013 versus Despite the improvement in the real estate market, property tax revenues in many cities continue to decline, although sales tax revenues and local income tax revenues are increasing. Detroit is the biggest example of a municipal bankruptcy. The city s municipal services have been slashed, massive layoffs 2

3 occurred and even its art collection was on the chopping block at one point. In its plan to exit bankruptcy, Detroit is proposing to pay bondholders, pensioners and other stakeholders less than they are owed. Since 2010, 38 municipalities have filed for bankruptcy. Corporate and financial sector debt Thanks to rock-bottom interest rates, corporations have been able to refinance existing debt and issue new debt at low rates. And due to improvement in the U.S. and global economies, U.S. corporations are generally financially stable and their outlook should remain so through this year, according to Standard & Poor s. Non-financial corporations are sitting on $1.4 trillion in cash. S&P does not expect a significant increase in corporate leverage in That being said, leverage for high-yield debt (BB+ and lower) is creeping close to 2007 levels. While such companies haven t experienced financial problems in the most recent past, many companies ran into trouble during the recession, experiencing credit-rating downgrades and even defaults. Such trouble could reoccur if the economy encounters another recession. That said, S&P expects corporate America to grow at a steady pace, predicting overall private sector expansion of 3.5% versus a U.S. GDP growth rate of 2.8%. The financial sector has experienced considerable deleveraging during the past seven years, both in the U.S. and overseas, though U.S. bank deleveraging is ahead of European deleveraging. In the U.S., the vast majority of the financial institutions that received funds from the U.S. government through the Troubled Asset Relief Program (TARP) have repaid those funds, according to ProPublica. In general, banks are in a much more stable financial position, as their balance sheets have strengthened by means of higher capital reserves and lower loan defaults. Figure 3; Source: National Association of State Budget Officers deleveraging process is still far from complete, one factor that s holding the European economy back. Consumer deleveraging Although consumer debt is on the rise again, according to the Federal Reserve Bank of New York, it is still below its recessionary level, which peaked in the third quarter of 2008 (fig. 4). The reasons for the spike in borrowing are at least somewhat healthier than those that justified the home buying splurge that consumers embarked on during the real estate boom. That s because banks are easing up on lending standards, consumers are a bit more confident about their own financial futures and the prospects for the economy, and more loans are being offered to borrowers with high credit scores. In addition, new regulations as a result of Dodd- Frank legislation have served to reign in risky behavior that could endanger individual banks and ultimately global financial stability. In Europe, many banks are still experiencing the repercussions of loose underwriting in bad debt expenses, so the Figure 4; Source: FRBNY Consumer Credit Panel/Equifax

4 While total outstanding debt for the four quarters ending in December has increased for the first time since 2008, overall consumer debt still remains 9.1% below its peak of $12.68 trillion in the third quarter of Foreclosures continue to decline, a trend that began in the second quarter of 2009, and now stand at their lowest level since Mortgage delinquency rates are also falling. On a less positive note, student loan debt continues to rise, as do student loan default rates and credit card delinquency rates. Car loan delinquencies have remained steady at 3.4%. However, overall loan delinquency rates declined from 7.4% in 2012 to 7.1% in the fourth quarter of Student loan borrowing has slowed somewhat from its recent torrid pace it s up 70% in the past five years and has grown to a total of $1.08 trillion, up $114 billion in An increase in mortgage debt is a major reason for the overall increase in borrowing. Mortgage debt makes up 70% of consumer debt, according to the New York Fed, and mortgage borrowing increased 1.9% in That ended a string of declines that lasted for the past four years. Although mortgage rates and home prices are up from prerecession lows, mortgages remain highly affordable by historic standards. In late February, mortgage rates were hovering near 4% for a 30-year fixed mortgage and 3% for a 15-year fixed mortgage, according to Bankrate.com. Housing prices are still affordable in many areas, and now that prices have been rising for a sustainable period, more potential buyers are stepping off the sidelines. Fortunately, at the same time, more homeowners are willing to sell because fewer mortgages are underwater. Amid the overall decline in consumer leverage, real consumer net worth reached a new high in the third quarter of That s a positive support for overall consumer spending, which makes up two-thirds of U.S. GDP. However, the increase in net worth has contributed less to consumer spending than in past recoveries due to several factors including declining availability of home equity loans, the increased payroll tax credit and uncertainty over government policies. What to watch for Debt isn t entirely good or bad for the economy; it depends on the type of debt and what it s being used for. Keep an eye on federal budget deficit numbers; reductions in the budget deficit are positive for the economy, and it s very positive that those numbers are declining. If Congress and the Presidential Administration can work together to continue to reduce the deficit, it would be a significant win for the economy as both businesses and consumers would be more willing to spend on large, long-term capital outlays. Consumer debt can be a double-edged sword. Over-leveraged consumers tend not to spend, which is bad for the economy. However, if consumers don t have access to credit to borrow for capital goods like homes that tend to spur economic growth due to lack of bank lending, that s a negative for the economy. So increases in traditional mortgage lending where underwriting standards are appropriate but not overbearing are positive, while an increase in any kind of delinquencies is negative. Also keep a close eye on student loan delinquencies. A combination of soft labor markets for graduates plus high levels of student debt is a cocktail for increased defaults. Where we go from here The economy in the U.S. has experienced a cyclical recovery after a severe recession, and both governments and consumers have undertaken a large amount of belt-tightening as a result. This tightening has reduced leverage amounts for consumers at the expense of adding to both local and federal governments. As the economic recovery continues, some of the added leverage on government balance sheets is subsiding as government spending remains restrained and tax receipts recover. All things considered, our view remains consistent with years prior in that the global economy will continue to muddle through in a slower growth scenario, albeit it at a slightly higher rate. In this state, we expect to see leverage amounts at the government level to continue to improve but not as rapidly as we ve seen in the last couple of years. We may see consumers increase leverage amounts as the housing recovery continues, but we see this as a sign of confidence in the economy as long as debt levels remain reasonable and significantly less than the peak in 2007.

5 Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) (life and disability insurance, annuities) and its subsidiaries. Northwestern Mutual Wealth Management Company, Milwaukee, WI, (investment management, trust services, and fee-based financial planning) subsidiary of NM, limited purpose federal savings bank. Northwestern Mutual Investment Services, LLC, (securities) subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC. Christopher Bremer is the Director, Private Client Services Portfolio Management with Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources. Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss. Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market. The securities of small capitalization companies are subject to higher volatility than larger, more established companies and may be less liquid. With fixed income securities, such as bonds, interest rates and bond prices tend to move in opposite directions. When interest rates fall, bond prices typically rise and conversely when interest rates rise, bond prices typically fall. This also holds true for bond mutual funds. When interest rates are at low levels there is risk that a sustained rise in interest rates may cause losses to the price of bonds or market value of bond funds that you own. At maturity, however, the issuer of the bond is obligated to return the principal to the investor. The longer the maturity of a bond or of bonds held in a bond fund, the greater the degree of a price or market value change resulting from a change in interest rates (also known as duration risk). Bond funds continuously replace the bonds they hold as they mature and thus do not usually have maturity dates, and are not obligated to return the investor s principal. Additionally, high yield bonds and bond funds that invest in high yield bonds present greater credit risk than investment grade bonds. Bond and bond fund investors should carefully consider risks such as: interest rate risk, credit risk, liquidity risk and inflation risk before investing in a particular bond or bond fund. All index references and performance calculations are based on information provided through FactSet, a provider of real-time and archived financial and market data, pricing, trading, analytics and news. The International Monetary Fund (IMF) is the intergovernmental organization that oversees the global financial system by following the macroeconomic policies of its member countries, in particular those with an impact on exchange rate and the balance of payments. The Congressional Budget Office (CBO) is a federal agency within the legislative branch of the United States government that provides economic data to Congress. The National Association of State Budget Officers (NASBO) is a professional membership organization for state fi n a n c eo ffi cers. It advances state budget practices through research, policy analysis, education and knowledge sharing. Standard & Poor s (S&P) is a U.S.-based financial services company. It issues credit ratings for the debt of public and private corporations and is recognized as a statistical rating organization by the U.S. Securities and Exchange Commission. ProPublica is an independent, non-profit newsroom that produces investigative journalism in the public interest. The Dodd Frank Wall Street Reform and Consumer Protection Act, signed into law on July 21, 2010, is a component of U.S. financial regulatory reform designed to lower risk in various parts of the U.S. financial system. The Federal Reserve Bank of New York one of the 12 Federal Reserve banks of the U.S. It plays a leadership role in monetary policy, financial supervision and the payments system. Bankrate.com is a provided by Bankrate, Inc., a financial services company based in North Palm Beach, Florida. The website offers financial articles and decision-making resources to consumers.