Is This All the Recovery We Get?
07/10/2012 9:00 am EST
Because this recession really was different, the recovery will be too. Here’s a plan for investing in what looks to be a slow, tortuous road back for years to come, writes MoneyShow’s Jim Jubak, also of Jubak’s Picks.
Last week, on July 5, three of the world’s central banks moved virtually simultaneously to stimulate the global economy. And financial markets shrugged.
I think that shrug marks an important new stage in the agonizingly slow recovery from the global financial crisis and the Great Recession. It indicates that financial markets agree that central banks are now relatively powerless.
Yes, central bank intervention, especially by the US Federal Reserve, stabilized the global financial system. But the next stages of the recovery are about deleveraging to reduce the huge debt load distributed throughout the global economy, and then about demand creation. (See my related blog post on the markets’ collective shrug here.)
Central banks are not 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 few governments are in a position to take forceful fiscal action. And in even fewer countries is there 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 a recession.
In this column, 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.
More Than a Standard Recession
As Kenneth Rogoff and Carmen Reinhart so convincingly argued 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 six months, the longest for 16 months. (For more on the length and shape of recessions, see this page from the Minneapolis Federal Reserve.)
A recession is typically the result of a supply or demand shock (such as a huge surge in oil prices), a drop in confidence that produces a big drop in demand, or overproduction at the peak of the business cycle that produces a temporary excess of supply.
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. Those actions can include tax breaks, government spending, and interest-rate cuts.
Those are 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, as Rogoff and Reinhart argue, recessions that are the result of financial crises are significantly different from run-of-the-mill business-cycle recessions. For one thing, they last longer.
In a typical 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 its pre-crisis per capita income level. And it takes even longer for an economy to resume its long-term pre-crisis growth trend.
Our Lagging Recovery
Where is the US economy on that timeline? The US gross domestic product peaked at $14.42 trillion in nominal dollars in the second quarter of 2008 and in inflation-adjusted dollars (constant 2005 dollars) at $13.33 trillion in the fourth quarter of 2007.
In nominal dollars, which don’t correct for inflation, the US 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 because the US population grew during that period, the per capita figures aren’t 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 only $42,731. Adjusting for inflation and for population growth, the United States hadn’t recovered the ground it had lost since 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—results aren’t in yet—the US economy still hasn’t rebounded to its pre-crisis rate of growth, either.
As discouraging as those numbers are, the US economy has still managed to rebound more quickly than many other economies in 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 UK growth for all of 2012 of just 0.4%. The Organisation for Economic Co-operation and Development, on the other hand, expects the economy in the United Kingdom to shrink by 0.1% for 2012.
The Debt Keeping Us Down
So why is the Great Recession so much worse than a run-of-the-mill business-cycle recession? (It is so much worse that Rogoff and Reinhart say the term Great Recession is misleading; they 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 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 just as falling tax revenue puts pressure on government spending. The US unemployment picture, for example, would look much brighter if state and local governments hadn’t had to cut teachers, firefighters, police officers, 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 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, it was 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, in only 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 begun.
Private debt is the source of much of the drop in the debt burden in the United States, with households reducing their debt to 112% of annual disposable income, down 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 (such as the United Kingdom) that have drastically cut public spending while raising taxes.
The Devil in the Deleveraging
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 consumers or corporations.
Governments, through their control of monetary policy, can 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—as well as 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 health care.
But in the real world? Not a chance. The crisis has been too big; the hole that debtors find themselves in is too deep. Debtors will pursue every method available to them 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.
Growth Can’t Beat This Debt
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. That growth would add to tax revenue, without raising tax rates, and the added revenue could be used to reduce the actual size of the debt burden.
Unfortunately, the global economy, now and for years to come, doesn’t look especially hospitable to growth—thanks in large part to the aftereffects 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 overpriced high-speed rail network in China, half-empty commercial and residential projects throughout Asia, and 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 rise of emerging economies were younger trends.
For example, Citigroup calculates that between 2002 and 2008, it took four units of investment to produce an additional unit of Chinese GDP. Between 2009 and 2011, that ratio rose to five units of investment to produce an additional 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 become more difficult and expensive to increase growth rates in order to grow out of the global debt burden.
And it means 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—public 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 upward 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 overstretched.
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, in "Can the Central Banks Keep Us Safe?" 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 US dollar loses some of its allure as a safe haven, not because of problems with other currencies, but because of rising US 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 lift 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 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 column, "Investors, Eat More Big Macs."
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 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 columns on the paranormal economy (see "5 Rules for an ’X Files’ Market" to get started on that topic), and the challenge gets a bit more daunting.
But we like challenges, don’t we?
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