Macro Strategy Review, May 2015
by Jim Welsh with David Martin and Jim O’Donnell, Forward Markets
The global economic pie is shrinking relative to the growth rates of the past and that’s a problem. According to the International Monetary Fund’s (IMF) World Economic Outlook database, worldwide gross domestic product (GDP) growth during 2013–2014 averaged 3.10%, compared to 2006–2007, which averaged 5.15%.
While GDP growth has declined, the chasm between growth in advanced economies and developing countries has not changed much. GDP growth in advanced economies has slowed -47.37% from 2.85% in 2006–2007 to just 1.50% in 2013–2014 while growth in developing countries has downshifted -45.06% from 8.10% to 4.45%, respectively. As this data indicates, the worldwide slowdown in growth has been evenly distributed and not merely concentrated in either advanced or developing countries.
The widespread impression that the global economy has deleveraged in the wake of the financial crisis is a fallacy—it is more leveraged now than it was prior to the financial crisis, based on the ratio of total global debt to GDP. In February, the McKinsey Global Institute published an extensive review of debt levels in 22 developed and 25 developing countries. The McKinsey analysis found that global debt had increased from $142 trillion in 2007 to $199 trillion in 2014. The $57 trillion increase in global debt represents a surge of 40%, far exceeding the 23% gain in global GDP during the same period. The global debt-to-GDP ratio rose from 269% at the end of 2007 to 286% as of June 30, 2014. The title of the McKinsey study was apt: “Debt and (not much) deleveraging.”
Although total global debt has increased 40% since 2007, the McKinsey Global Institute did find a couple of silver linings. The growth rate in global household debt slowed from 8.5% during the period of 2000–2007 to 2.8% in 2007–2014. Lax mortgage lending standards contributed to the excessive addition of mortgage debt prior to 2007 while tighter standards after the financial crisis curbed growth. The net result is that household debt is now growing in line with global GDP growth as compared to the debt binge prior to 2007. When household debt grows in line with GDP growth, household incomes are more likely to grow fast enough to prevent a rise in defaults on mortgage, credit card and auto debt.
The increase in debt and leverage by banks prior to 2008 was a major contributor to the financial crisis. A number of U.S. investment banks increased their leverage ratio from 12-to-1 in 2004 to almost 30-to-1 in 2007. A number of large European banks had leverage ratios of almost 40- to-1 just prior to the financial crisis. When home values fell in many countries, the excessive leverage decimated bank balance sheets and threatened the global financial system. Financial institutions have significantly lowered the growth rate of debt since 2007 from 9.4% to 2.9%. The deleveraging of bank balance sheets in the wake of the financial crisis is a strong indication that the global financial system is in far better shape than it had been and is capable of handling the next business cycle downturn and any unanticipated economic shock.
The same cannot be said about government debt and leverage. In response to the financial crisis, governments around the world increased spending to offset the decline in private demand as unemployment soared, consumers stopped shopping and businesses slashed spending. Much of the increase in government spending was financed with debt, which grew 60% faster in the seven years following the crisis than the precrisis level (9.3% versus 5.8%). The growth rate in government debt poses a perilous challenge for the global economy in coming years since the current level of government debt is already high enough to impair its capacity to deal with the next economic slowdown. Faced with another recession, we have no doubt that politicians around the world will respond with another round of deficit spending to minimize its impact—as that’s how they have repeatedly responded every time a recession threatened their reelections.
Mae West famously said too much of a good thing could be wonderful, but we don’t think debt is one of those things. We don’t know how much debt is too much, but the economic engine of the global economy is certainly more at risk now than it was 30 years ago, even though global interest rates were far higher back then.
Most governments consider a deficit of 3% of GDP to be healthy, but the flaw in this perspective is it ignores the impact of “healthy” deficits over time. Total debt as a percentage of GDP doubles in just 24 years if a country maintains a “healthy” 3% annual deficit, meaning the long-term threat from continually running “healthy” annual deficits is that cumulative debt reaches a level that can hardly be described as healthy. However, any slowdown in government deficit spending will dampen growth in the short term unless household and corporate spending picks up the slack. That’s not likely in the short run since the global economy is suffering from a lack of demand due to a combination of high unemployment and underemployment, weak wage growth and excess capacity that has depressed business investment.
The Congressional Budget Office has estimated that a 1.0% increase in Treasury yields across the maturity spectrum would add $150 billion in interest expense to the annual U.S. government budget. Debt-to-GDP ratios in Europe and Japan are far higher than in the U.S., so their budgets and economies are even more vulnerable to higher interest rates. Any meaningful rise in global interest rates in coming years could accelerate budget deficits to well above 3% of GDP as interest expense on the mountain of accumulated sovereign debt soars—one reason central banks, especially in advanced economies, will find it extraordinarily difficult to normalize interest rates in coming years. This situation exposes an inherent conflict of interest between fiscal and monetary policy that has never been so pronounced and has the potential to further compromise central banks’ independence.
The level of GDP growth impacts the amount of cash flow generated in the form of personal income, corporate profits and government tax revenue. As economic growth accelerates, the ability to service debt becomes easier and the risk of defaults on mortgages, auto loans, corporate bonds and bank loans declines. Debt levels are higher now than in 2007 while global economic growth has slowed significantly and is only expected to reach 3.50% in 2015, according to the IMF. Even with that improvement in growth compared to the last two years, it will still be more than 30% slower than in 2007. In this respect the leverage in the global economy is more precarious than in 2007.
In the next few years, the global economy will be vulnerable to either a slowing from current growth levels or an increase in interest rates. Navigating these issues amounts to the economic equivalent of threading the needle since even a modest increase in interest rates is likely to disproportionately weigh on future growth as a larger share of cash flow will be needed to service debt. Any slowdown in the global economy would push central bankers even deeper into the uncharted territory of negative interest rates, unlimited quantitative easing (QE) and currency depreciation. The risk of deflation will continue to lurk in the shadows until the ratio of global debt to GDP actually declines.
Even though interest rates, especially in advanced economies, have spent years at their lowest levels in history, economic growth has fallen far short of historical norms. Big deficits and cheap money have failed to engender sustainable growth. This economic reality provides an insight into just how difficult it will be for the Federal Reserve (Fed), European Central Bank (ECB) and Bank of Japan (BoJ) to ever “normalize” short-term interest rates. Any increases are likely to be modest and stretched out over an extended period of time. Beginning in June 2004, the Fed increased the federal funds rate at 17 consecutive meetings. Nothing close to that will happen in this cycle. The pace of central bank rate increases in the next few years is likely to make a tortoise look like the Road Runner. The BoJ may never increase rates in our lifetime and the first increase the ECB effects will be to raise rates from below zero percent to zero percent. Welcome to the brave new world of modern monetary policy that is more effective in distorting market outcomes than generating actual economic growth.
Eurozone
Charles Plosser, president of the Federal Reserve Bank of Philadelphia, said in an interview with the New York Times in early February, “If monetary policy…is distorting what might be normal market outcomes…” In the March Macro Strategy Review (MSR) we wrote that we found this statement to be exceedingly disingenuous as the purpose of the Fed’s monetary policy since the financial crisis has been the intentional manipulation of Treasury yields and inflating the wealth effect of the stock market. It would be fair to say that the ECB has taken the distortion of market outcomes to a new level through its QE program launched on March 9. As of April 22, more than half of eurozone government bonds have negative yields, according to Bank of America Merrill Lynch. In other words, investors that purchase a seven-year German bund will pay the German government 0.07% a year for the privilege, or they will pay the government of Spain 0.116% for owning a one-year Spanish bond.
Negative interest rates are forcing banks throughout Europe to rebuild computer programs, update legal documents and reconstruct spreadsheets to account for negative rates. The Euro Interbank Offered Rate, or Euribor, is the base interest rate used for many banks loans in Spain, Italy and Portugal. More than 90% of the 2.3 million mortgages outstanding in Portugal have variable rates linked to Euribor. Portugal’s central bank recently ruled that banks would have to pay interest on existing loans if Euribor or any additional spread falls below zero percent. Spanish-based Bankinter has been forced to pay some customers interest on mortgages by deducting that amount from the principal the borrower owes.
