What have we learned in 2,000 years?
"The budget should be balanced, the Treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest Rome become bankrupt. People must again learn to work, instead of living on public assistance." -Cicero - 55 BC
Absolutely nothing it would seem!!!
Ben Bernanke and others including President Obama have suggested that recent economic data could be signaling the early stages of an economic recovery, hence the “green shoots” analogy. Equally however I am reminded of the old saying: “One swallow doesn’t make a summer”.
So which shall it be: green shoots leading to explosive blooms, with Fed members frolicking aimlessly and care-free in the lush green fields of summer?(Ugh) Or will we find that an anxious Fed Chairman was peering through extra strength sun glasses only to find a wayward swallow perching on some dead wood? Or will we find that the green shoots really are there, brought on by an Indian Summer, they grow a little (maybe even for a year) but meet a brutal end as the harsh and unrelenting winter resumes.
If the green shoots theory is correct then the recent surge in world stock markets could mark the beginning of a new bull market in stocks. But if the Swallow and Indian Summer theory proves more accurate then the relenting bear market will claim more victims as it shows that dead cats dropped from multi-story buildings really do bounce. And after that: splat !!!!!
There is no doubt that some recent data including a small uptick in the Conference Board’s Consumer Confidence Index, an increase in monthly new home sales and the partial unfreezing of some areas of the credit markets could be nascent signs of a turnaround, or at least a stabilisation from recent quarters of near free-fall in economic data. If so that would be a positive development. However these figures are from an exceptionally low base, and one should be cautious about extrapolating one month’s figures into the next boom.
For some time now Gary Schilling (www.agaryshilling.com), whom I regard as one of the best economists in the world today, has argued that the bursting of the world economic bubble would occur in four distinct phases. Phases 1 and 2 were largely financial in nature whilst Phases 3 and 4 saw the problems in the financial sector flowing through to the real economy. As Mr. Schilling sees it the phases are:
Phase 1: The collapse of the housing sector, touched off by the subprime slime;
Phase 2: Spreading of the woes to Wall Street;
Phase 3: Consumer retrenchment; and finally
Phase 4: Globalisation of the downturn.
I think that the financial crisis has evolved pretty much on cue.
The purpose of this article is to look at the current state of play i.e. where we are now in terms of the deleveraging cycle and the status of the real economies. In future articles I will seek to lay out my view as to the root causes of these economic and financial problems before looking at some key strategies that I believe governments will need to adopt before sustainable growth and prosperity can resume.
How Much Further to Go in the Deleveraging Cycle?
1. Overall Debt - Clearly excessive debt is one of the core issues at the heart of the current malaise so it is here that we must start. When looking at the question of deleveraging, one needs to consider a number of different dimensions, including the state of the banking and financial systems themselves, the state of the asset markets, the overall level of debt in the economy as well as the level of indebtedness of the various actors in the economy.
I think it worthwhile if we start at the macro level and work down from there. A key indicator of the status of deleveraging refers to the overall level of debt in the economy as measured by total credit market debt. A graph prepared by Ned Davis Research shows that Total Credit Market Debt for the US stood at $49 trillion as at February 2009, which was a record 350% of US GDP. And these figures don’t include the forthcoming budget deficits or the massive level of unfunded liabilities in the US, which some put as high as another $49 trillion. Adding unfunded liabilities to total credit market debt puts the debt to GDP ratio at a staggering 700% of GDP.
Not only is the current ratio of 350% the highest on record but it far surpasses the peak of 300% that was reached in 1929. In the aftermath of the Great Depression total credit market debt declined over the following two decades to reach a low of 130% in the mid-1950s.
Some quick calculations show that based on a modest savings rate of 4% and real GDP growth of 3% pa, zero interest payments and the assumption that no more debt is created (which is unlikely given the Federal Government’s proclivity to spend), it would take until about the year 2026 to get back to a more sustainable debt to GDP ratio of say 150%. At a savings rate of 8% pa then you could get to the same level by about 2022.
When one includes unfunded liabilities, based on the above criteria it would take until 2030 just to get back to the current historically high rate of 350%.
Therefore based on the current trajectory of debt creation and without some rather radical changes in policy it appears that the US is not only looming as a basket case but will be unable to fund its way moving forward. As the saying goes: “Where GM goes so does the US”. Can anybody say Chapter 11? I think it is fair to say that any financially ill-prepared baby-boomers are going to have a somewhat difficult time of it and should practice their Wal-Mart and McDonald’s greetings.
Analysis by Morgan Stanley highlights that the composition of this debt has also changed since the 1930s, with the household’s proportion of total debt increasing from 18% to 27% whilst corporate debt has declined from 51% to 22%. Government and financial debt has also increased significantly over that time. This suggests that consumer deleveraging will be of paramount importance in any sustainable recovery in the US and elsewhere.
And the US is not the only nation up to its eye-balls in debt. Recent figures highlight that Ireland has $1.8 Tn in debt vis-à-vis GDP of $200 Bn (900% ratio), the UK has $10.5 Tn debt against GDP of $2.3 Tn (456%) whilst conservative Switzerland has a debt of $1.3 Tn versus GDP of $300 Bn (433%). Iceland is broke and on IMF life support. And in a recent newsletter John Mauldin stated that Eastern Europe has borrowed an estimated $1.7 trillion, primarily from Western European banks. And with Eastern European home buyers entering their own form of carry trade by borrowing in Swiss francs, they are suffering as their own currencies decline by as much as 50% against the franc.
These are indeed scary figures and it raises the question: Can all of these debts ever be repaid? Based on current policy settings by governments and central banks alike, I think the answer is a definitive “No”, at least not without destroying the world’s fiat currencies, massive write-downs and / or repudiation of debt. What it will require is a shift back towards governments and central banks encouraging savings rather than debt, and more fiscal responsibility on the part of governments. Green shoots or Indian Summer? Which ever it is it will take more than a couple of years downturn to resolve.
2. State of the Financial System - As many commentators have stated another key element in supporting a return to sustainable growth is turning the troubled banking and financial system around. I think it is pretty clear that we are not talking about just a liquidity issue here but rather the solvency (or lack thereof) of the entire banking and financial system. Recent estimates by the IMF suggest that total write-downs might reach $4.1 Tn, well up on its previous estimates of $1.4 Tn and $2.2 Tn. The IMF suggests that banks will bear about two thirds of the losses with insurance companies, hedge funds and others taking up the remainder. The IMF estimates that in the United States, banks have reported $510 billion in write-downs to date and face additional write downs of $550 billion. Euro zone banks have reported $154 billion in write-downs and face a further $750 billion in losses. British banks have written down $110 billion and face an additional $200 billion in write offs. A key issue of course is how the banks have provisioned these losses and what happens if the situation deteriorates further, particularly if there is a black swan-type event.
In a recent article Satyajit Das, a well-regarded Australian economist, stated that even after $900 billion in new capital, the global banking system remains short of capital by around $1-2 trillion. This translates into an effective reduction in available credit of around 20-30% from previous levels. Bank earnings and balance sheets remain under pressure.
These figures support recent estimates by Nouriel Roubini (www.rgemonitor.com) that with projected write-offs, the US banks are currently some $400 Bn underwater and that they will need at least $1.4 Tn to bring the capital of banks back to the levels they were prior to the beginning of the crisis.
Clearly the Fed and the Government are doing everything in their power to support the financial system. These measures include the increase in spreads due to the ultra-low Fed funds rate, creating money out of thin air, swaps for toxic waste as well as transfers via the likes of AIG.
Unfortunately several recent developments in the US signal a return the bad old days of Wall Street and the Financial Mafia. These developments include major question marks over the quality of recent earnings of the major banks as well as the recent backflip by the FASB in relation to mark to market accounting (a.k.a. mark to make believe). The reality is that if a market, whether it is for commercial paper or house prices is illiquid then prices should fall to a level where it becomes liquid again. Moreover the true value of the assets should be reflected in the underlying accounts. The changes suggest that all is not well on Wall Street and that the Government is supporting yet another cover-up.
The reality is that continuing to gloss over these problems through dodgy bookkeeping only encourages greedy Wall Street operatives to continue their giant immoral heist from the American people and ultimately slows the adjustment process. We can only live in hope that one day soon a number of these shonks are brought to justice and the industry cleaned up.
In short I don’t see sufficient evidence at this stage to suggest that either Wall Street has reformed its nauseous ways, the government is on top of the situation or more importantly that the financial system has stabilized in terms writing off losses and stabilizing its capital base.
3. Assets Return to Fair Value - Another indication that deleveraging has run its course will be when asset prices return to levels supported by economic fundamentals. For example in a recent weekly commentary, Comstock Partners (www.comstockfunds.com) showed that at their zenith, house prices in the US reached a peak of 5.25 times median family income compared to the long-term average (since 1965) of 2.75 times. They estimate that house prices have declined to 3.45 times median family income which is still 20% above the long term average. And this doesn’t take into account any overshooting to the downside where prices could reasonably get down to 2.25 times median family income before reverting to the mean. So despite the Government’s recent attempts to modify mortgages and forestall foreclosures, with a significant overhang in inventories, increasing unemployment putting pressure on people at all levels of the socio-economic spectrum as well as a significant bulge in resets looming over the next several years it seems that the housing market still has a couple of years to go before a bottom is reached.
Of course the US was not alone in inflating house prices. In the UK house prices reached a high of 5.7 times average incomes. Ditto Ireland, Spain, Australia, Canada and New Zealand. House prices will need to revert to more affordable levels before stability can be restored and a base re-established for more sustainable growth. And equally affordability has to be measured by interest rates at more realistic levels rather than current levels driven by panic-lead, massive pump-priming around the world.
Despite the recent share market rally and what some analysts are saying, it appears to me that stock prices are still not great value despite the already large declines in world stock prices. The latest estimates from the S&P 500 (from S&P website), puts the forecast As Reported earnings at $28.51 for 2009 and $35.31 for 2010. With the S&P 500 index currently at about 900, this puts the forecast P/E ratios at 31.7 for 2009 and 25.6 for 2010. These are not only well above the long-term average but are certainly not the levels from which new bull markets are born.
As an alternative measure of share market value, a number of analysts use 10 year smoothed earnings. With their estimates currently hovering around $55, this would put the estimated P/E ratio at about 16.4. This is double the P/E ratio that has generally marked the bottom of bear markets. So it seems to me that despite this being the most severe recession / depression since the Great Depression the price of shares in general do not represent the values one would expect at the beginning of a new bull market. More importantly share prices never really reached the puke point that would mark the level of capitulation that one would expect in such a severe bear market.
There are several further comments I would like to add at this point. In the long-run stock prices should only grow in line with nominal GDP growth, namely real GDP plus inflation. There are at least five strong head-winds that are likely to work against strong GDP growth in the foreseeable future. These are:
- Firstly, massive debt build-up throughout the world which still has to be liquidated. Repayment of this debt and ongoing debt servicing commitments are going to detract from GDP growth;
- Secondly, the demographic time-bomb awaiting many parts of the western world. This is going to put immense pressure on the US (and other nations) given its already large level of unfunded liabilities;
- Thirdly, the fact that the past 10 year’s earnings have been pumped up by excessively loose monetary policy which has fed through into excessive profits, particularly in the financial sector. This was also reflected in the profit share of GDP which reached record levels during this period;
- Fourthly, with the recent loss of “wealth” and massively under-funded pensions, many baby-boomers are going to move into savings overdrive which is likely to lead to a significant reduction in consumption; and finally
- With the recent decline in GDP and asset prices many companies will have under-provided for their employees’ superannuation obligations. This will put a drain on future profitability as companies are forced to top up these funds. Alternatively companies will seek to reduce these obligations which will reduce retirees’ income levels and thus lead to reduced aggregate demand.
The other issue likely to influence GDP growth is whether one has deflation, or high inflation. Deflation would likely impact company profits as it reduces pricing power whilst strong inflation would reduce consumer’s purchasing power. So either way the upcoming period of price instability is likely to impact GDP growth moving forward.
The final asset class which bears mentioning is US Treasuries, which have risen strongly in price with the recent flight to quality. Once again it is almost impossible to predict how prices and thus yields will move in the medium term. Without wishing to sound like an economist (i.e. on the one hand this and on the other hand that), there are some very strong opposing forces currently in play. On one side we have significant deleveraging, a weak world economy and declining asset prices, all of which are deflationary and which are therefore keeping Treasury prices high. Conversely we have unprecedented Government spending, aided and abetted by the Fed’s monetary printing which could potentially lead to inflation and thus a reduction in Treasury prices (i.e. an increase in yields which would surely snuff out any green shoots).
With the need to fund the creation of new debt as well as roll-over maturing debt, one has to ask how much further Treasuries can rise or whether the authorities have created yet another bubble. Alternatively one would need to assess what impact a sustained fall in their prices would have on GDP if inflation is seen to pick up or growth unexpectedly rises.
It seems to me that we still have a great deal of pain to come as values for all asset classes come back to more normal levels, supported by longer-term income streams and higher capitalisation rates which include more normal premiums for risk.
Consumer Retrenchment and the State of the Real Economy
It was interesting to see the Ben Bernanke this week forecast a return to growth, albeit weak, by the end of 2009. Personally given the Fed’s role in creating this crisis and poor forecasting record I would put little faith in these comments. Having said that I retain an open mind to all possibilities and will try to use basic analysis to guide my investment decisions.
I would like to start by looking at a composition of the GDP. The table below shows the breakdown of the key components of GDP for Qtr 1 2009 GDP in “annualized”, nominal seasonally adjusted and percentage terms as well as for 2008.
The following comments can be made in relation to the above table and underlying figures:
- Personal Consumption - As most are aware, personal consumption is currently the main determinant of GDP, particularly expenditure on services. The main components of services are medical care (13% of total GDP), housing (10.9%), household operations – electricity and gas etc (4%), transportation (2.6%), recreation (3%) and other (10.3%).
Expenditure on nondurable goods is also a significant component and includes items such as food, clothing and footwear, gasoline and other basic necessities.
In October last year I wrote an article entitled “Recession or Depression” www.financialsense.com/fsu/editorials/2008/1027.html where I listed a number of structural headwinds that would severely impact the US consumer and thus the US / world economy moving forward. These included:
- A savings rate that had fallen to negative territory and therefore must be restored to historical levels of 8-10%;
- A reduction in mortgage equity withdrawals which near their peak totaled $800 billion per annum;
- Mounting housing foreclosures;
- Consumers living beyond their means and maxed out on their credit cards;
- Tightening credit forced on banks by the economic downturn, large losses and a reduction in their capital bases;
- Increasing unemployment that would reduce aggregate demand; and
- Negative wealth effect due to losses in housing and the stock market.
All of these factors remain as current now as they did back then and will impact consumption for at least the next 12-18 months, particularly as unemployment continues to grow. However these factors will in part be offset by lower energy prices and the government stimulus package.
- Private Investment – This category includes IT equipment and software (3.4% of GDP), other equipment (2.6%), investment in nonresidential structures (3.5%), residential investment (2.7%) and changes in private inventories (-1%). The downturn has hit private investment particularly hard over the past 12 months, taking over $400 Bn from GDP in this period. All component areas have been hit resulting in the overall percentage contribution to GDP falling from 14% in 2008 to 11.2 % in Qtr 1 2009. It would seem that even if the economy is stabilizing, and that remains to be seen, with increasing vacancy rates in all categories of property, an overhang in residential housing stock, the financial sector still consolidating and industrial utilization running at a low 69% that fixed private investment is not going to contribute significant growth any time soon. The only segment that may add to growth is an up-tick in inventories as the current de-stocking runs its course.
However changes in inventory levels have contributed on average only 0.5% to GDP from 1929 to 2008 with a maximum contribution of 2.9% coming in 1937 and 1951. With ongoing uncertainty over the recovery and improved inventory management techniques the contribution from re-stocking is likely to be far more modest when it does return.
- Net Exports and Imports– The above table highlights how the trade gap has narrowed over the past 12 months. This has resulted from a large reduction of over $650 Bn in imports, which has overshadowed a $300 Bn reduction in exports. With the IMF forecasting key economies such as Japan, Russia and Europe continuing to remain deeply mired in recession this area is not likely to contribute any significant growth in the coming year. Moreover ongoing weakness in the US will keep exporting nations in the Middle East and Asia under pressure.
- Federal Government Expenditure – Despite the recent commitment of trillions of dollars support by the Government, Federal Government expenditure makes only a modest contribution to overall GDP. I think one needs to differentiate between the large amount of funds and guarantees made available to prop up the financial system versus actual expenditure which contributes to GDP. Moreover defense expenditure is by far the largest contributor to Federal Government expenditure. However the forthcoming stimulus package of nearly $900 Bn will contribute positively to GDP over the next 12 months. The question remains as to how much slack it can take up from the other areas. It is a large amount of money so clearly some.
- State and Local Governments– This category also makes only a modest contribution to overall GDP. Moreover with its revenue sources under threat from the property and economic downturn this sector is unlikely to grow quickly anytime soon.
The Income Side of the National Accounts
Another way of looking at the national accounts is through the income side. By far the largest component of income is employee compensation which comprises 57% of total national income. This is followed by consumption of fixed capital (13%), proprietor’s income and corporate profits (16.4%), taxes (6.9%) and finally interest and miscellaneous payments (5.1%). With high unemployment, low industry utilization and profits under pressure it would seem that none of these areas is set for significant growth over the short term.
So are they the first green shoots of the season, a lonely swallow or a slam dunk as winter resumes and snuffs out the shoots. I think the above analysis suggests that:
- The overall debt level in the US remains at historically high levels and it is doubtful that it can continue to climb much higher without risks to bond prices and the dollar. When one includes unfunded liabilities the overall debt to GDP ratio goes from just the worst in history to absolutely unsustainable. Bringing this back into balance will require radical and at times unpalatable actions with the upshot being an overall reduction in the standard of living for many US citizens. Interestingly governments generally shy away from making radical and unpalatable decisions and I think the crisis at this stage hasn’t impacted enough people that really matter (i.e. those on Wall Street) for radical policies to be enacted.
- Other major economies in the world, namely Europe and Japan remain deeply mired in recession, harboring massive debt loads and impaired banking systems. With protectionism creeping in there is no way that the US, nor other countries for that matter, can export their way to prosperity. Moreover the state of these other economies could be sources of potential exogenous shocks to the US banking system and underlying economy.
- House prices still seem to have up to another 20% to fall to get back to historic valuation levels.
- The recent rally in shares has pushed P/E ratios back to medium to high levels, certainly not the base from which sustainable bull markets normally commence.
- With increasing unemployment, limited / no wage growth, the loss of asset-fuelled consumption and the consumer needing to reduce debt and more importantly to save, consumption is not going to be the driver of economic growth that it has been over the past 2 decades.
- Given low capacity utilization and deflationary forces, company profits are also likely to be under pressure for the foreseeable future. Combine this with increasing vacancy rates for all areas of real estate, then private fixed investment is not likely to pick up significantly in the next 12-18 months.
- With changes to the mark to market rules the US Government is basically instituting a massive cover-up of the extent of the potential losses in the financial system. The authorities are clearly seeking to buy time in the hope that credit markets can repair themselves and thus avoid / delay the massive losses still in the pipeline. The simple fact is that without this slight of hand it would visible to all that the US financial system is still in very deep trouble.
- Whilst the US economy might be stabilizing from the significant falls of the past 2 quarters the adjustment process still seems to have quite some time to run. I see nothing in the current set of data that is going to drive the economy along a more sustainable path to growth, at least in the short run.
- With the stock market not cheap, the recent rally seems to more like a dead cat bounce rather than the beginning of a new bull market.
- Significant risks to the economy remain, the chief amongst them being:
- the ability of the US to fund its burgeoning deficits;
- the potential collapse in the bond market and / or the US dollar;
- greater than expected losses from the housing and property markets; and
- ongoing deleveraging in the financial market.
Just like Alan Greenspan I have a conundrum. Barack Obama hit on it the other day when he suggested that the US might have lost its moral compass. I think he’s right. How can anyone justify the theft of $3.8 billion by Merrill Lynch executives as bonuses just prior to their being taken over? Or Secretary Paulson and Ben Bernanke allegedly heavying the CEO of a publicly listed firm (Bank of America) to withhold information from their shareholders. Or Secretary Paulson arranging transfers of taxpayer funds to support AIG and then flow through to his comrade mates on Wall Street. Or PIMCO being a major advisor to the government, only to see that bond-holders won’t need to take a hair-cut on their investments, but instead that burden will fall onto current and future generations, or more likely foreign investors in US treasuries and bonds. Surely these must be regarded as some of the biggest cons and heists in American history. The less well connected get 3-5 years for low-level theft and yet these schmoozers get away with grand larceny. How can the Obama government allow this to occur without full accountability? Unless the US re-aligns its moral compass it won’t matter which direction it goes as it will be wrong.
By Phil Williams
Phil Williams is a Managament consultant, originally trained and worked as as a Bank Economist
© 2009 Copyright Phil Williams- All Rights Reserved
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