Submitted by Paul Brodsky of Macro Allocation, Inc [23].
The Man in the Moon – Part 1 of 5
Summary: The Man in the Moon studies the pathology of Earth’s global economy and markets from a distance where there’s no gravitational pull towards empiricism or consensus. His findings: 1) the global economy is over-leveraged, fragile, stagnating, and increasingly centrally managed; 2) capital markets and asset performance have been captured by the perception of the ongoing value of money, and so; 3) unconventional investment analysis is prudent.
In Part 1, TMITM identifies the point of tension driving global output growth lower: ubiquitous leverage. Part 2 discusses “The Great Leveraging.” Part 3 explores the inevitable “Great Reconciliation”. Part 4 projects economy-saving exogenous influences one should expect. Part 5 builds a general investment framework for asset allocation.
Lunar View
The moon is about 239 thousand miles (384 thousand km) from Earth, many times more distant than the 30,000 foot level most investors think of as perspective-inducing. If an all-sentient Man in the Moon were to cast his eye upon Earth, interested only in building wealth for himself, where might his investment process begin? (With apogee-down analysis, no doubt.)To begin, he would surely grasp the gravity of disruptive innovations within telecommunications, logistics, robotics, transportation, farming, energy, payment services, and health care sectors. Breathtaking leaps forward have benefitted the global economy through creative destruction, a natural process pushing productivity gains.
When combined with an expanding global work force, innovation should have naturally driven the global economy to…well, economize, in turn driving consumer prices lower and affordability higher. Alas, deflation that benefits consumers would have been highly disruptive to entities that produce goods and services and to those that rely on inflation for sustainability, like banking systems.
Almost Copacetic
Entering 2015, the global economy seemed poised to expand. According to the World Bank:
”Global growth in 2014 was lower than initially expected, continuing a pattern of disappointing outturns over the past several years. Growth picked up only marginally in 2014, to 2.6 percent, from 2.5 percent in 2013. Beneath these headline numbers, increasingly divergent trends are at work in major economies…Overall, global growth is expected to rise moderately, to 3.0 percent in 2015, and average about 3.3 percent through 2017”
Despite such official optimism, the first quarter of 2015 is not providing hope that output is improving. Real GDP growth in the U.S. – among the growth leaders in developed economies last year – rose only 0.2 percent in the first quarter, significantly below expectations. The Atlanta Fed – the most accurate predictor of Q1 growth – further estimates Q2 output to be only 0.7 percent, implying weakness stretching beyond bad weather and port strikes. 2 And China, the world’s second largest economy and, with India, a reliable leader in output growth among emerging economies, reported Q1 nominal growth of 5.8 percent, a record low, and its Q2 trade figures show further deterioration.
To investors, future output growth seems to be just another input into asset allocation decisions, and not a very important one at that. Equity prices – corporate and property – are generally firm across domains. Bond prices remain well-bid; official funding and sovereign interest rates remain near record lows – in fact negative in some domains – implying either economic contraction is on the horizon or there’s a relative paucity of bonds (or both). And commodity prices (determined mostly by leveraged financial players trading leveraged derivative instruments rarely taking delivery) have dropped significantly, further implying lethargic global production.
Meanwhile, multinational businesses, each with an economy it calls home and a government to do its bidding, are aggressively allocating capital to boost short-term share values – abetted, it seems, by monetary authorities actively keeping economies and markets liquid. And although regional wars are taking human lives, confounding politicians, and adding volatility to the cost of energy, trade channels for resources remain mostly open. Lasting peace and prosperity? Hopefully...
The Dark Side
…but fundamental factors lie beneath the surface that pose significant threats to economies and investors. Balance sheets across the spectrum remain highly leveraged and continue to expand at a clip well beyond the rate of global output growth.
For median households, debt levels continue to rise more than wage growth; for governments, obligations are rising more than tax revenues; for publicly-owned businesses, debt is rising faster than revenues; and for investors, debt could easily grow more than income and asset appreciation, suddenly and without warning should markets stall or fall. (If only interest rates were high enough to support another refinancing wave then monetary policy makers would know what to do!)
Growth and bull markets may come and go, but compounding debt is forever. There is not enough existing currency for debt extinguishment. This is why debt, per se, is not the fundamental problem – leverage is. Debt simply needs to be serviced, not necessarily repaid. Leverage ratios are most troubling however one chooses to calculate them: debt-to-GDP, debt-to-income, debt-to-base money, or, the most technically accurate (and the most telling indicator so far of central bank policy), bank assets-to-base money. (More on this in TMITM Part 3.)
Leverage reduction is generally discouraged by economic policy makers because it would create major structural problems. Indeed, in the U.S., even as bank balance sheets were de-leveraged from 2009 to 2014 through reserve-creating Quantitative Easing (QE), total credit market liabilities rose 17 percent.
Most economists today believe economies require constant credit growth for demand and output growth. As we are seeing, however, easy credit conditions do not necessarily lead to increasing production and capital formation, both of which would provide sustainable debt-servicing capabilities.
Increased savings rates would be just as bad to highly-leveraged economies, as it would decrease economic activity, in turn pressuring governments to invest money they don’t have and central banks to stimulate demand growth through even more credit creation, defeating the original purpose.
Global monetary authorities are boxed. Is it any wonder they fear deflation and see improving affordability as failing to create sufficient demand through credit growth? So much for economies economizing…
As it stands
The marginal buyers of sovereign debt today are:
- leveraged liquidity providers, such as private banks and hedge funds, that do not care about ROIs in real terms, preferring to use sovereign debt to fund themselves with zero risk-weighted assets and produce nominally-positive net interest margins;
- central banks with infinite, un-scrutinized balance sheets looking to keep their economies liquid and their private banks solvent;
- currency reserve holders, like China and Japan, that cannot easily spend their reserves to buy corporate equity, and;
- buy-side portfolios with relative return investment mandates forcing them to stay invested in assets guaranteeing losses in absolute terms.
While this line-up makes it easy to intellectualize low and negative interest rates, perhaps there is another, more fundamental driver: an underlying state of global economic dis-equilibrium in which:
- there is too much money and credit per unit of production, and therefore;
- real output is turning negative, and so;
- Equilibrium Real Interest Rates are also turning negative?
Are negative real rates implying that credit must contract so that real production, capital formation, and employment might grow? Perhaps nominal (non-inflation adjusted) risk-free rates actually deserve to be negative given such bleak prospects for real output growth? (What would this imply about interest rate “normalization” currently contemplated by the Fed – a rate hike or a rate cut?)
If this real-contraction premise has merit, then it might explain why interest rates are lowest (or negative) in domains most susceptible to output contraction, and why global equity markets are firm. Where else can one hope to generate risk-adjusted positive real rates of returns, especially given the likely antidote to nominal output contraction: inflation?
Whether or not fundamentals matter, global monetary authorities must now ensure liquidity remains sufficient so that asset prices – as the collateral for systemic credit – do not fall. This is something on which TMITM can reliably bet.
Goodnight Boom
The global economy seems to be suffering from a late-stage paradox in the financial leveraging cycle in which nominal output growth has become counter-cyclical to real output growth. The more commerce and trade rely on credit growth and asset appreciation, the more the ultimate benefit of growing economies is diminished.
Despite this paradox, the pursuit of demand growth and nominal GDP growth through credit growth has been immortalized into global monetary policy orthodoxy, and growth (not affordability) remains the primary metric scrutinized by most economists and investors. Such is Earth’s epic economic battle presently. In this corner, naturally occurring economic productivity gains and deflation. In that corner, policy-manufactured inflation to maintain asset values and liquidity. Ding! Ding!
The inescapable conclusion is that real output is quickly withering, whether we deflate nominal output for contemporaneous inflation (i.e., CPI, PCE, PPI), 2% inflation targets policy makers hope to produce (e.g., the Fed, BOJ and BOE), or far more significant future inflation (via currency purchasing power loss), the seeds of which are currently being planted, that would flare suddenly in the next leveraging cycle.
It seems clear that output growth in the future must be negative in real terms, and, ultimately, that there will have to be some kind of leverage reconciliation.
If weaker GDP growth currently in the U.S. China, and elsewhere (and deflation in the UK) is foreshadowing a secular global economic contraction, then perhaps the course of this reconciliation will present itself sooner than most think?
With apologies to Margaret Wise Brown:
In the great green room
There was a printing press
And a television
And a picture of –
Global growth in distress.
And there were three central banks, shooting economic blanks
And global depositories
And political suppositories
Seventy years of coordination
Forty years of subordination
Thirty years of financialization
Goodnight boom
Goodnight soon
Hello Man in the Moon
TMITM - Part 2 will explore “The Great Leveraging”.
Paul Brodsky
Macro Allocation Inc.
pbrodsky@macro-allocation.com [24]
www.macro-allocation.com [23]
