In a time when every strategist has put together a "hot take" on the causes of the financial crisis and its aftermath, with BCA going so far as to suggest that some $400 trillion in assets are at risk should the Fed tighten too hard, many have missed the core culprits for the series of rolling bubble that emerged in the aftermath of "The Great Moderation" and which resulted in the dot com bubble first in 2000, the bigger housing bubble in 2007 - of which Lehman was just a symptom - and the "everything bubble" that was formed in its aftermath, and which is where we find ourselves now. These, of course, as the unholy trinity of debt, interest rates and the dollar.
And while much of the financial commentariat celebrates the passage of the decade that marked the fallout of the Global Financial Crisis, suggesting that the coast is finally clear - which judging by the sheer euphoria with which retail investors have been buying up stocks in recent years, mostly in the form of ETFs is probably accurate - one bank writes that even though policy makers have averted the economic downturn in the immediate aftermath of the GFC from spiralling into a debt-deflation collapse last seen since the 1930s’ Great Depression, they do not believe the ‘coast is clear’ as many proclaim.
IUn a report by Neels Heyneke and Mehul Daya of Nedbank, the analyst duo warns that the world remains vulnerable because of soaring debt levels, growing imbalances, protectionist policies and overvalued asset prices. In short, "the shadow cast by the GFC has not gone away."
Echoing a comment we noted earlier today, namely that "An Economic Recovery Based Around High Debt Is Really No Recovery At All", Nedbank notes that since 2008, global debt levels have soared, but economic growth of many countries remains lower than post-GFC levels; it is this growth in debt that is masking and hiding balance sheet problems and has fuelled asset prices at the expense of the real economy.
As key signposts of the crisis aftermath, Nedbank first highlights the global velocity of money (the number of times a US dollar is used to purchase goods or services) which is currently at or near an all-time low, and certainly less than one.
This collapse in dollar velocity - a culprit for moribund economic growth - has taken place despite the efforts of global CBs to lower interest rates to record-low levels and pump excess liquidity into the financial system. And while the low VoM reflects balance sheet constraints, subdued animal spirits and socioeconomic problems, it is mostly a function of global QE which has soaked up excess reserves and prevented money creation using the convention, commercial bank loan channel.
"We believe that the excess liquidity pumped into the global economy drove asset prices higher, perpetuating the credit cycle at the expense of the global economy" Nedbank writes.
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More important even than the role of monetary velocity is the reserve currency role of the dollar in today's global economy: since the 1980s, the US economy (trade deficit) has supplied the world with a large US dollar monetary base (a cumulative total of $12 trillion in M0). As a result of the US dollar deluge, the the US dollar monetary base as a percentage of global GDP has grown from 3% in 1980 to 16% currently.
This is important, because the globalization was largely a byproduct of this global dollarization, which combined with growth in the US dollar monetary base, was a structural tailwind for global trade and also for the financial system. As a result of these two structural tailwinds (and other factors, of course), the trend in global trade and global growth has always been healthy amid falling consumer prices (disinflation).
More importantly, the role of the dollar was a boon for asset prices and the financial sector, as the monetary base kept growing without much concern from the authorities. On top of this, the world found new ways of creating leverage in the financial system (an unregulated shadow-banking system), which fuelled asset prices. However, after the GFC - and for the first time since the 1980s - both these structural tailwinds have lost momentum, becoming headwinds for the global economy and financial system.
Looking ahead, the reversal of globalization, and the rising role of geopolitics (protectionist policies from the US and China competing for hegemonic power) are likely to starve the world of US dollars, leaving the global economy and financial markets vulnerable to deflationary pressures.
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Closely tied to the dollarization of the world has been the relative price of the dollar. After the Plaza Accord which sent the USD to its all time high versus the rest of the world's currencies following the Volcker fight with inflation in the early 80s, the dollar has been on a downtrend (likely due to its reserve-currency status) but with bouts of volatility amid the expansion and contraction in the US dollar monetary base.
Whatever the reason, a stronger US dollar has always indicated tighter financial conditions (the opposite has also been true). Generally, this is because of the US Federal Reserve’s tight monetary stance; however, we believe it has become slightly more complex in the aftermath of the GFC.
While the dollar plunged in the aftermath of the financial crisis thanks to ZIRP and QE, the US dollar has been a bull market since 2012/2013 as the market started pricing in normalization of the Fed's balance sheet; a side effect of this has been to slow down the growth of the USD monetary base. Ironically, as Nedbank notes, this is also when covered interest parity began to breakdown(also according to research from BIS). "We believe the lack of US dollars is the force behind the disconnect between currency and interest rate movements" for the dollar but also all other major currencies, Nedbank writes and make the following claim:
We believe that movements in the US dollar (and other asset prices) ever since the slowdown in the global supply of US dollars are due to factors such as the pool of US dollars and the ‘quantum of money’ circulating in the global financial system, rather than just the US Federal Reserve’s monetary policy.
This nuanced interplay between the value of the dollar and interest rates resulted in an unprecedented financialization of global assets starting in the late 1980s and extending beyond. Specifically, from 1900 to 1980, global stock markets as a ratio of global GDP fluctuated from 25% to 60%, never exceeding 100%. In other words, the global stock market cap never surpassed global GDP. But, as Nedbank shows in the next chart, "all that changed in the 1990s."
The 1990s, when deregulation policies of the financial sector started to be implemented on Wall Street ( Clinton-Rubin era) was the beginning of ‘financialisation’. Deregulation and the process of ‘financialisation’ made virtually any commodity or asset tradable, with the intention of hedging risks for market participants.
The blistering expansion in the value of financial assets also allowed excessive levering to take place in financial markets and, as a result, financial assets began to exceed the economy, ushering in a more volatile and vulnerable financial system (as BCA wrote recently, the total value of all financial assets has now climbed to $400 trillion, or five times the size of the global economy).
The result of all this is a positive feedback loop as most of the money today is being created against collateral (assets) which, coupled with rising assets prices, fuels further leverage in the system. Of course, when asset prices fall, credit creation slows rapidly - or goes into reverse - creating a liquidity squeeze in the financial system and the real economy, also known as a deflationary "crash". This has been the case for decades, but the build-up and crash in 2008/2009 was the most damaging to the global economy.
But the most important observation of this is that as a result of the credit cycle, changes in asset prices have become a major driver of the real economy – "the dog is wagging the tail." Another way of saying this: don't look for the next recession in the economy, look for it when the global central banks start shrinking their balance sheets, which as a reminder will begin some time in the fourth quarter.
A consequence of this financialization is that since the late 1980s, the gap between net wealth (asset performance) and the real economy has been growing amid low interest rates and immense growth leverage in the financial system. As a result, every downturn starts in the financial markets (credit cycle) because of excess leverage, spilling over into the real economy.
While the mean reversion of this process is only a matter of time, Nedbank believes that the next downturn will be worse from a socioeconomic perspective because policies since the GFC have led to the wealth effect being concentrated in the top 90%, with the rest of society still overburdened with balance sheet problems. This ties in to the point made recently by Ray Dalio who warned that when the next crisis hits, it will have a far greater social impact with potentially lethal results.
Adding to Dalio, Nedbank also notes that this is not unique to the US amid its protectionist policies, as the rise of populism and growing socio-economic tensions with and within countries that have become part of the current global landscape.
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Which brings us to the last piece of the puzzle: the record levels of global debt, which continue to grow to alarmingly high levels in both the regulated and unregulated sectors (shadow-banking sectors). As the IFF recently disclosed, global debt (regulated) has now soared to USD247 trillion (318% GDP), more than USD96tn higher than a decade ago. Meanwhile, largely thanks to China, the shadow-banking system has grown from USD60tn in 2007 to the current USD99tn, according to the global FSB.
The relative size of total debt is shown in the chart below.
Amid this debt deluge, dollar-denominated debt issued by non-US countries ballooned from USD10tn to USD34tn since the GFC. And, in the current environment of increasing US dollar scarcity, Nedbank believes this debt is very vulnerable to changes in Global dollar liquidity –this was evident during 2018. As Nedbank puts it...
Excessive debt levels and highly interconnected financial markets leave world economic growth and financial markets vulnerable to a sudden slowdown in credit creation and debt growth – the vicious credit cycle that feeds into the real economy.
Putting all this together, Nedbank correctly concludes that the change in money supply and credit creation (the credit cycle) is the dominant driver of the economy and financial markets; this cycle will also define the next cycle, as has been the case since the 1980s.
In terms of what comes next, Nedbank posits that its various Global $-Liquidity indicators (shown in the chart below), which measure the change in the global US dollar monetary base, "are probably some of the most important macroeconomic drivers of the credit cycle, as measuring the different layers of the debt pyramid can be very challenging at the best of times."
The reason why a cross-asset approach in evaluating the state of the global economy and market is key, is because for a long time, the traditional method of understanding and forecasting the macroeconomic environment was determined by interest rate cycles (price of money). However, in the current environment, arguably the most important variable has become the analysis of changes in the pool of liquidity, or what Nedbank dubs the quantum of money.
In conclusion, Nedbank writes that there is a risk that the lack of Global $-Liquidity will constrain and even add pressure to an already overleveraged global real economy and financial system, posing a real risk to the economic and asset performance outlook. In this environment, the bank recommends defensive income-generating assets, rather than growth-related assets amid the global deflationary forces persisting.