The world's central banks run out of credit with the financial markets
07/10/2012 8:30 am EST
I think that “shrug” marks an important new stage in the torturously slow recovery from the global financial crisis and the Great Recession. It indicates that financial markets now agree that although central bank intervention, especially by the U.S. Federal Reserve, stabilized the global financial system, central banks are now relatively powerless. The next stages of the recovery are about deleveraging to reduce the huge debt load distributed throughout the global economy and then demand creation.
And central banks are simply not very well suited to either of those tasks. It’s normally up to central governments and fiscal policy to make moves that might accelerate progress at this stage of the recovery. But very few governments are in a position to take forceful fiscal action and in even fewer countries is there a political consensus that such action is necessary.
If I’m right, we’re headed for more years of a recovery that at times is going to be so painfully slow that it won’t feel much different from recession.
In this post I’m going to lay out, briefly, my view of where we are, where we’re going, and what kind of investment strategies might work best in what is likely to be a very tough investing environment for years.
As Kenneth Rogoff and Carmen Reinhart so convincing argue in their 2009 book This Time Is Different, this isn’t your standard business cycle recession. Business cycle recessions come in lots of shapes—U and V, for example—and can last for just a few quarters or more than a year—the shortest postwar recession lasted for 6 months and the longest for 16 months. (For more on the length and shape of recessions, see this page from the Minneapolis Federal Reserve http://www.minneapolisfed.org/publications_papers/studies/recession_perspective/ The causes can be a supply or demand shock (such as a huge surge in oil prices), or a drop in confidence that produces a big drop in demand, or over-production at the peak of the business cycle that produces a temporary excess of supply over demand. And the fixes for the run of the mill recession are, according to the consensus among economists, some combination of fiscal and monetary actions to revive demand and restore confidence that can include tax breaks, government spending, and interest rate cuts.
Exactly what the United States has tried in the aftermath of the global financial crisis. (Which isn’t to say, that what we’ve tried was well designed or executed.)
But, Rogoff and Reinhart show, recessions that are the result of financial crises are significantly different from the run-of-the-mill business cycle recession. They last longer. In a run-of-the-mill recession it takes about a year for the economy to make up lost ground and to return to its long-term growth trend. In a financial crisis recession, Rogoff and Reinhart’s data show, it typically takes more than four years for an economy to regain the per capita income level that it had reached before the crisis. And it takes even longer for an economy to get back up to its long-term pre-crisis growth trend.
Where is the U.S. economy on that timeline? U.S. GDP peaked at $14.415 trillion in nominal dollars in the second quarter of 2008 and in inflation-adjusted dollars (constant 2005 dollars) at $13.326 trillion in the fourth quarter of 2007. In nominal dollars, which don’t correct for inflation, the U.S. economy had regained its second quarter 2008 peak as of the second quarter of 2010. In inflation adjusted dollars the economy had recovered the ground lost to the crisis and recession as of the third quarter of 2011.
But since the U.S. population grew during that period, the per capita figures aren’t quite as good. At the end of 2007 constant dollar per capita GDP stood at $44,125. At the end of the third quarter of 2011 it was still only $42,731. Correcting for inflation and for population growth, the United States still hadn’t recovered all the ground it had lost since the peak at the end of 2007.
And with the economy growing at an annual rate of just 1.9% in the first quarter of 2012 and projected to slow from that rate in the second quarter, the U.S. economy still hasn’t rebounded to its pre-crisis rate of growth either.
As discouraging as those numbers are for the United States, the U.S. economy has still managed to rebound more quickly than the economies in much of the developed world. The United Kingdom, for example, is officially back in recession with GDP contracting by 0.4% in the fourth quarter of 2011 and 0.3% in the first quarter of 2012. The optimists among economists are projecting growth for all of 2012 of just 0.4%. The Organization for Economic Cooperation and Development, on the other hand, is looking for the economy in the United Kingdom to shrink by 0.1% for all of 2012.
So why is the Great Recession so much worse than the run-of-the-mill business cycle recession? (So much worse that Rogoff and Reinhart say the term Great Recession is misleading and prefer Great Contraction, a category that for them includes the Great Depression.)
Because, Rogoff, Reinhart, and other economists argue, the financial crisis left the global economy saddled with a huge amount of debt on its balance sheet. For consumers, that debt has meant a desire to save rather than spend. For healthy companies, it has meant a hesitancy to borrow in order to grow. For debt-burdened companies, it has meant cutting back on spending and shrinking operations (and workforces) to pay off debt. For national (and local) governments, it has meant using taxpayer money to bail out banks and manufacturing companies at the same time as falling tax revenue has put pressure on government spending. The U.S. unemployment picture, for example, would look much brighter if state and local governments hadn’t been forced to cut teachers and firefighters and police and park workers in order to make their budgets work.
In other words, before government and business and consumers can get down to the business of increasing demand, the global economy has to do a massive amount of deleveraging.
How much deleveraging and how long might it take? When you start looking at public and private debt together the picture is even darker than all the discussion of the insupportable level of government debt in Spain or the United States indicates. A study by McKinsey Global Institute in 2010 calculated that combined public and private debt was near historic highs in many of the world’s developed economies. Combined public and private debt then stood at 500% of GDP in the United Kingdom, McKinsey concluded. In Spain the combined debt level was 375%. In the United States 290% and in Germany 280%. Reducing these burdens by even 25% McKinsey figured in 2010 would take an average of six to seven years.
McKinsey updated that study this year and the results are depressing. Despite all the pain, only in one developed economy, that of the United States, has the debt burden fallen significantly. In other economies it has stopped climbing but the deleveraging has only just begun. Private debt is the source of much of the drop in the debt burden in the United States with households showing that they’ve reduced their debt to 112% of annual disposable income from a peak of 127% in 2007. Of course, the picture on the public side of the debt balance sheet isn’t nearly as encouraging with the United States badly lagging countries as the United Kingdom that have drastically cut public spending while raising taxes.
How do you deleverage? Well, if you’re a consumer, your choices are rather limited. You can save more and spend less. And you can reduce your debt by defaulting on some of it. That’s pretty much the menu for corporate borrowers too.
Governments have those three options—save more, spend less, and default (although default by a government is a much more drastic step than a consumer or corporate bankruptcy and reorganization)—plus a couple that aren’t open to either consumers or corporations.
Governments, through their control of monetary policy, can choose to inflate their way out of debt. Higher rates of inflation have the effect of reducing the real value of existing debt. And governments can, at the same time as they encourage inflation, work to repress the interest rates they pay on their debt by pursuing, just to take an example, a policy of low interest rates and massive buying of government debt through a program of quantitative easing.
Recognize many of these—and in particular the last two—for exactly what they are: a massive reduction in the burden that debtors carry at the expense of creditors.
In some fantasy world governments and consumer and corporate debtors would oppose the reduction in their debt burden at the expense of the creditors who lent them the money they used to buy houses or develop new sources of natural gas or to fund the rising costs of healthcare.
But in the real world? Not a chance. The crisis has been too big; the hole that debtors find themselves in too deep. Debtors will pursue every method available to them in the years ahead to make the global deleveraging as quick and as painless as possible. And even when all these methods are pressed into use, the deleveraging will be neither particularly quick nor especially painless.
And what about growth? Is it possible for the world to grow itself out of this debt hole? That’s surely an attractive alternative—the debt burden would fall as a proportion of GDP as the size of economies increased. And that growth would add to tax revenue, without raising tax rates, that could be used to reduce the actual size of the debt burden.
Unfortunately, the global economy right now and for years to come doesn’t look especially hospitable to growth—thanks in large part of the after effects of the credit boom that preceded the 2007 credit bust and to stimulus packages unleashed in 2008 to stabilize the global economy.
The worry is that the world didn’t have enough good investment opportunities to absorb all that capital. The money did go into roads and airports and the purchase of more efficient equipment, but it also went into an over-priced high-speed rail network in China, into half-empty commercial and residential projects throughout Asia, and into a global expansion of capacity in the solar, steel, and semiconductor sectors. It isn’t that investments in those areas weren’t (or won’t be) profitable, but that rate of return on recent investments is less than it was when globalization and the emergence of emerging economies were newer trends. For example, Citigroup calculates that between 2002 and 2008 it took four units of investment to produce an extra unit of Chinese GDP. Between 2009 and 2011 that ratio rose to five units of investment to produce an extra unit of GDP.
That doesn’t mean that China or any other emerging economy has stopped or will stop growing, but it does argue that it will be more difficult and expensive to increase growth rates in order to grow out of the global debt burden.
And that anyone thinking that China or any other emerging economy will “bail out” the world with a repeat of the huge post-Lehman stimulus package is likely to be disappointed.
In this situation investors should watch the debt loads that are accumulating in the developing economies. If growth in this part of the global economy is to be more modest than in the past, investors can’t simply say debt—pubic and private—in these economies doesn’t matter because these economies will be able to grow their way out of any debt problems. The debt service costs for households and companies in Brazil, China, Turkey, and India have marched upwards recently. In China, for example, private sector credit has risen from 107% of GDP in 2007 to 127% in 2011, according to Capital Economics. In Brazil, consumer credit is a lower 50% of GDP, but because the average interest rate on consumer loans was a staggering 35.3% in April (down from 37.3% in March), economists have started to worry that the Brazilian consumer is over-stretched.
So where does all this leave investors?
- Back on May 15, I advised that in the short-term you shouldn’t bet against the world’s central banks http://jubakpicks.com/2012/05/15/in-the-short-term-dont-bet-against-the-worlds-central-banks-but-in-the-long-term-the-risks-are-that-one-central-bank-or-the-other-will-make-a-mistake/. I think that advice needs an update. We are already nearing a point where decisions at the Federal Reserve, the European Central Bank, and others are having less and less of an impact on economic growth in the short and medium term.
- But in the longer term a version of that advice still holds: because their conventional tools are providing less and less bang for the buck (or euro or yen), I think central banks will gradually move toward unconventional methods such as allowing inflation to rise while continuing to suppress bond yields to the degree they can. (Suppressing bond yields also has the effect of supporting stock prices.) If this scenario is correct, it is one more reason to prefer dividend stocks with their (one hopes) rising dividends to the fixed payouts of bonds.
- I do not see a way out of the current Great Recession (or Great Contraction if you will) without substantial inflation. I think investors can expect rising inflation (and rising inflation targets at most of the world’s central banks) over the next decade. Hard assets—to the degree that their prices aren’t depressed by slower economic growth—will do well in that environment as a defensive haven. That’s especially likely to be the case as the U.S. dollar loses some of its allure as a safe haven not to other currencies but to rising U.S. inflation. My favorite hard asset stocks would be in the gold and oil sectors.
- There will continue to be economic growth in the world but it will not be so strong across the board as to constitute a rising tide that will life all stocks. I’d expect that for returns stock selection inside individual markets will become relatively more important than the selection of individual markets.
- In a world of slower growth and increasing pressure on rates of return on invested capital, I can think of two classes of investment opportunities to watch out for. First, look for the companies facing the most opportunities for high returns on future investments of capital. I gave you advice on using rate of return on invested capital to do that and the names of some stocks to watch in my June 15 post http://jubakpicks.com/2012/06/15/theres-still-a-place-for-fundamental-long-term-investing-in-your-portfolio-even-in-this-market/ Second, look for companies that are successfully pursuing their own deleveraging strategies. Shares of highly indebted companies that are relatively quickly digging themselves out of their own debt holes should move up even if global economic growth is sluggish.
If all this sounds to you like a recipe for a very difficult investing environment, then you’re hearing my message loud and clear. Add in the volatility that I expect and that I’ve described in my posts on the Paranormal Economy (see my post http://jubakpicks.com/ to get started on that topic) and the challenge gets a bit more daunting.
But we like challenges, don’t we?
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/