LAND OF THE RISING SLUMP
‘With little to underpin growth in debt-laden economies, politicians will do what has always been done and blame foreigners’
A crisis of liquidity and solvency in the private sector, with its origins in excessive deficits and leverage — which in turn inflated bank balance sheets and fuelled asset bubbles — has precipitated serious concerns over government solvency. These are magnified in countries where taxpayers were placed into the capital structure of banks to shield debt holders from losses they should have incurred when asset prices adjusted.
While it would be easy to blame recent poor growth and weak labour markets on an inevitable period of de-leveraging, the truth is that global credit-market debt is at record levels — in excess of $200 trillion, with aggregate debt ratios at record levels in the PIIGS bloc, France, the UK and Japan. Having missed an opportunity to restructure debt in favour of a balance-sheet transfer from the private to the public sector, governments are now struggling to de-leverage alongside similar efforts in the private sector. The net result is a reinforcing cycle of austerity, which has worsened solvency and seen economic growth boosted only marginally by an $8 trillion expansion in central-bank balance sheets.
The Japanese experience, where the private debt:GDP ratio has fallen by almost 50 percentage points to 170 per cent since 1999 and the government has tried to keep a tight rein on spending, amply demonstrates the consequences: private de-leveraging, not government profligacy, is behind the ‘lost decade’ and the looming government default.
In Europe, the situation is exacerbated by the hitherto lack of meaningful bank recapitalisation and reduction in bank balance sheet leverage that will be necessary to stabilise things and revive activity. Eurozone bank assets are almost 350 per cent of GDP, in comparison to 100 per cent in the USA, and they are substantially more leveraged. While monetary expansion has contained the risk of systemic banking failure, it has done so at the cost of elevating asset prices to unsustainable levels, particularly in the USA.
Japan has now engaged in similar policy easing, but it is not clear how 2 per cent inflation would stimulate growth and, moreover, positive inflation and negative real interest rates would lessen the attractiveness to domestic investors of the burgeoning government debt. This could prompt capital flight in search of better alternatives, triggering a domestic funding crisis as the yen is driven lower.
Policymakers have resorted to measures explicitly designed to inflate asset prices and will ultimately create new bubbles. In the US, the S&P500 is valued at 25x trailing ten-year reported earnings. Only 11 per cent of observations in the past 140 years have been higher, with implied real returns — at barely 1 per cent — lower than at any point prior to the late-Nineties bubble. A bubble in housing and a large household-sector deficit in 2006/07 have been supplanted by renewed equity overvaluation and a large government deficit. Deficits have been rolled across the national balance sheet, debt has risen to record levels and the economy continues to meander along at around a 2 per cent growth rate.
Continued monetary expansion is likely to drive asset prices higher and — at profit margins 70 per cent above normal levels — deliver a negative equity risk premium. As margin debt, money borrowed to buy stocks, approaches the previous cyclical peak near 2.5 per cent of GDP, there will be an eventual market decline which the authorities will find very much more difficult to manage and with far more damaging consequences.
The economy in the US and elsewhere cannot be said to be bound by a shortage of liquidity, and widespread debt restructuring will be necessary when the fixation with QE has run its course. Coordinated efforts to restructure debt and manage the adverse consequences are both less palatable politically and more demanding but will, in due course, be the necessary and sufficient resolution of the increase in global leverage.
The political risk
With little to underpin growth in debt-laden economies from China to Spain and back to Japan, unemployment rising and difficult political choices to be made, politicians will almost certainly do what has always been done and blame foreigners. The inevitability of trade disputes and protectionism will turn global markets into local markets again, and price-taking firms back into price-setting firms. Monetary accommodation finally provokes real economy price inflation, debt is deflated if not defaulted and decades of economic integration is reversed.
Real and physical assets, ideally financed in yen, offer the best source of protection, preserving value with inflation and being less susceptible to government appropriation.
Paul Marson is the chief investment officer of Lombard Odier, based at headquarters in Geneva