As debt falls from fashion, stocks to suffer: James Saft

-- James Saft is a Reuters columnist. The opinions expressed are his own --

By James Saft

LONDON (Reuters) - Debt, which seemed like such a good idea only last year, could stay out of fashion for a long time, a trend that would be toxic for stocks.

Easily available credit and low inflation have encouraged a huge increase in borrowing, or leverage, across the economy in recent years.

Individuals borrowed to finance investment in real estate as it went up, or borrowed against their houses to fund consumption. Corporations borrowed in huge numbers to buy back their shares, increasing returns for their smaller, more aggressive capital base.

Many companies too were taken private in debt-heavy deals which had the side effect of raising prices for shares across the markets.

All of this debt was great for stocks; supply was limited and the consumer was spending.

It's not so much that all of this has come to an end, but there are, for the first time in a very long time, reasons to believe that the amount of leverage in Western economies is on the way down and may remain relatively depressed.

Leverage really is a great game, so long as it lasts. If what you are investing in goes up, be it a house or a stream of corporate earnings in the future, leverage improves returns.

But there are two snags; it hurts like heck if what you invest in goes down, and it leaves you more vulnerable to rainy days.

With the price of a lot of investments sliding and with hard rain falling in the form of a credit crunch and likely recession, there is reason to think that borrowers and lenders of all stripes will rethink what represents prudent borrowing.

You can also argue that the way central banks, particularly the Federal Reserve, have cut interest rates in the wake of the dotcom and housing bubbles has insulated borrowers from the risks of their debt, encouraging them to borrow more and stimulate the economy while planting the seeds of the next bubble.

But that has only been possible, argues Tim Bond, head of global asset allocation at Barclays Capital in London, because inflation was contained, making the costs of very low interest rates manageable, at least as measured in inflation.

Bond thinks rising living standards in emerging markets will now fuel sustained inflation in resources, like oil and food, thus limiting central banks' ability to cut and save the market's bacon.

It may not happen quickly, but just as investors figured out in the 1980s and 90s that they could safely borrow more as inflation fell, so they will now come to relearn the potential costs.

"Those who do not understand that the central bank economic safety net is diminished in scope and resilience will not survive," Bond wrote in Barclay's Equity Gilt Study.

"If inflation pressures are now less quiescent, it is reasonable to suppose that leverage ratios will begin to stagnate or decline."

A NORMAL DOWNTURN OR A STEP CHANGE?

It does seem certain that borrowing will be on the decrease, as you would expect. Consumers, who floated the economy out of the recession earlier this decade, will be less able to borrow, especially those whose house is now worth less than their mortgage.

Against a backdrop of weak consumer spending, corporations won't really be too keen to take on debt to finance expansion, according to Steve Cleal, who sets asset allocation for $157 billion of funds at Morley Fund Management.

"People may be surprised at how quickly corporate profits are heading south if we go into a recession," he said. "Corporate profits would perform pretty poorly and companies are not going to want to increase spending ... if they see a fall in demand."

If Bond at Barcap is right about the Fed safety net being removed from markets, you can expect more economic volatility, with downturns lasting longer. This would tend to reinforce the new prudence being shown by corporations and consumers.

It's also true that markets attach a price to volatility. If economic performance is more volatile, you can expect profits to be too, and by extension stock prices. That should tend to act as a drag on values.

And if emerging markets keep growing and eating up assets, they will need a huge allocation of resources, including a big chunk of the available debt.

That would be all well and good if you are long of stocks exposed to that demand, according to Bond. But it would also tend to raise the cost of capital for shares that aren't part of the broad resources complex, especially areas like banks and others that have done well out of household debt and consumption.

While all of this may seem daunting, in a way it's a good thing. Successive speculative bubbles cause misery when they burst, even if it is of our own making.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund -

(Editing by Ruth Pitchford)