For those of us from a Judeo-Christian heritage, it is
sometimes possible to believe that suffering is worthwhile; a way of paying for
past sins. In this light, the age of austerity in which we supposedly live has a
sort of redemptive quality. Grit our teeth, and we will come out the other side,
purified and ready for robust economic recovery.
However, the prayer that policy makers have been uttering is
that of St Augustine: make me virtuous, but not yet. After five years, we are in
a worse place than when we started.
One would have thought that the recent deleveraging should
have caused debt ratios to collapse. Yet, after the financial maelstrom of the
last five years, debt ballooned to a weighted average of 417 percent of GDP from
381 percent in June 2007 in the eleven economies most under the market
microscope. Strikingly, in each of Canada, Germany, Greece, France, Ireland,
Italy, Japan, Spain, Portugal, the UK and the US, the ratio of total debt to GDP
is now higher than it was in 2007.
There are variations, and it is notable that debt in the US
has increased the least, from 332 percent of GDP five years ago to 340 percent
today (Goldman Sachs, Federal Reserve Z1 Report) - although we should not draw
too much consolation from that, as the statistics do not include social
entitlements such as Medicare or Social Security. Add in these ‘off-balance
sheet’ items, and the ratios would look a great deal worse.
As can be seen from the chart on this page, deleveraging is
proving impossible to execute. The world is still staggering under a mountain of
debt, the costs of which extinguish the ‘animal spirits’ which ought, by now, to
be coming to the rescue.
Based on this analysis, we can make five predictions. First,
as deleveraging has not even started yet, the real crisis of the world economy
has not begun either. All the perceived unpleasantness of the past few years is
merely a warm-up act for the greater crisis still to come. The requirement to
get debt levels down is as pronounced as ever in the euro-zone, particularly in
southern Europe, but also in the US and Japan.
Second, it will take a minimum of 15 years or so for the
economy to reach escape velocity and attain a level consistent with healthy
growth scenarios. This is because debt levels need to come down by at least 150
percent of GDP in most countries. History suggests you cannot reduce debt by
more than ten percentage points a year, without unleashing major social and
political dislocation.
Third, when we do finally start cutting our debt, the
economic impact will be massive. Countries like Japan and the US need to
increase their primary balance by more than 10 points of GDP, in order to
stabilise the ratio of public debt to GDP to 2007 levels. Considering negative
feedback loops between deficit cuts and growth, each stands to lose more than 20
percent of GDP against trend. And this does not account for the required private
deleveraging.
The precise level of economic devastation is a function of
the so-called multiplier, which measures the impact of spending reduction on
economic growth. In a recent World Economic Outlook, the International Monetary
Fund (IMF) calculated recently that under current circumstances the multiplier
can be as high as two: every dollar cut from the deficit will lead to a two
dollar reduction in GDP. The multiplier is as much as four times higher than in
pre-2008 conditions.
Fourth, risky assets are set to perform badly for a long
period of time. Levels of corporate profits are highly correlated with changes
in leverage: reduce debt to meaningful levels and profitability will fall.
Current levels of valuation in equity markets are therefore unsustainable over
the medium term. Besides, the equity risk premium on major indices, such as the
S&P 500, is at historically low levels. This needs to rise dramatically in order
to compensate investors for multiple market risks, ranging from sovereign
default to inflation, deflation and geopolitics.
The fifth and final point is that there is no magic bullet.
In the past, policy makers had various instruments to cushion the impact of
measures taken to stabilise debt levels. For example, they could cut interest
rates or allow their exchange rates to fall, leading to export-driven recovery.
But in an era of low or zero interest rates, with most countries competing to
devalue their currencies, such policy tools have lost effectiveness, hence the
high multiplier. Even inflation, long touted as a back door solution to debt
reduction, will not help. The onset of inflation would send bond yields sky
high, compounding the costs of servicing debt and killing off any recovery. And
‘off-balance sheet’ entitlements, the biggest item that needs trimming, are
inflation adjusted.
How do asset classes rank on the totem pole if this scenario
plays out? Bonds of solvent governments and corporates should do well in a
deflationary environment where rates are kept lower for longer; stocks should
revert to new lows; and currencies of highly leveraged, growth-sensitive markets
should be sold. The possibility of making money on property is now much more
reliant on where in the world it is. As for alternative investments, such as
commodities, it depends on what you have gone for and where it is in its own
economic cycle.
In the words of an old Austrian adage, the situation is
hopeless, but not serious. It is not serious, as politicians simply fail to
acknowledge the elephant in the room, namely leverage, introducing instead a
succession of policy gimmicks. It is hopeless, in that virtue is not likely to
be rewarded for a generation. But money can still be made - just remain liquid!
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The above data and research was
compiled from sources believed to be reliable. However, neither MBMG
International Ltd nor its officers can accept any liability for any
errors or omissions in the above article nor bear any responsibility for
any losses achieved as a result of any actions taken or not taken as a
consequence of reading the above article. For more information please
contact Graham Macdonald on [email protected] |
