We Are Entering The "Quantitative Failure" Narrative

For a decade, the world brushed off any concerns about soaring global debt under the rug for a simple reason: between the Fed, the ECB and the BOJ, there was always a buyer of last resort, providing an implicit or, increasingly explicit backstop to bond prices, in the process creating the biggest asset bubble in history as investors seeking return were forced to buy first fixed income securities and then equities and other, even riskier securities.

However, as BofA's Barnaby Martin is the latest to point out, "early 2019 will be uncharted territory for the market" because after years of central bank purchases crowding investors into risky assets, this dynamic will now reverse. As Zero Hedge readers have observed on countless occasions, the yearly growth of central bank balance sheets is now turning negative as shown in the following chart.

The upshot of this, in Martin's view, is that markets will continue to experience more “corrections” than normal, leading to bigger and fatter trading ranges for credit spreads in Europe this year.

However, as recent market events demonstrated, the deteriorating liquidity backdrop will weigh on economic growth according to the BofA strategist. As the next chart highlights, global money supply has declined rapidly over the last year and a half, and in fact, global money supply growth (using M1) is flirting with the lows seen in mid-2008. This is a key observation because "while some economies, such as China, are now pivoting back to supportive measures, high global debt will constrain economies’ enthusiasm for engaging in further rounds of stimulus" Barnaby suggests. And as chart 4 suggests, lower money supply growth has often pointed to weaker global economic momentum going forward, suggesting that absent a major change, a recession is indeed inevitable as Albert Edwards will be quick to add.

Which brings us to the other key topic, the one which to Martin will server as a natural brake for any future major stimulus - debt.

Not coincidentally, the IMF dedicated its latest blog to the topic of soaring global debt, writing that "global debt has reached an all-time high of $184 trillion in nominal terms, the equivalent of 225 percent of GDP in 2017. On average, the world’s debt now exceeds $86,000 in per capita terms, which is more than 2½ times the average income per-capita."

Why the renewed focus on global debt all of a sudden by some of the world's most important financial institutions? Because, as Martin explains, "a more uncertain inflation outlook would risk the market pivoting back to worrying about global debt levels again, especially with QE over" and adds "this would be the “Quantitative Failure” narrative."

Meanwhile, as Jeff Gundlach noted in his latest webcast when he asked if, as a result of the record surge in debt in recent years, we had GDP growth or merely "more debt", the other unpleasant question emerges - did anything actually change after the global financial crisis? To the BofA strategist, the simple answer is "no" because there are still many market fragilities after years of loose monetary policy post Lehman. In fact, as he goes on to note, the latest BIS data shows:

  • Global debt is still close to a record high, and currently stands at $179tr. (as of Q2 ’18). This represents 230% of global GDP.
  • US, China and Japan account for more than half of global debt today.
  • Since the end of ‘08, however, global debt levels have risen by $62tr. (a jump of 53%). In GDP terms, the increase has been 33%.
  • While advanced economies remain the most heavily indebted – with a debt-to-GDP ratio of 260% – EM debt has soared since the crisis and more than offset the modest deleveraging of advanced nations (this peaked in Q3 ’09).
  • Non-financial corporations have contributed significantly to global debt growth in the last decade, with the bulk concentrated among Chinese companies. Yet, since late 2017, a major shift has occurred in China where private debt growth has decelerated somewhat (on the back of the government crackdown on shadowbanking).

Which brings us to the chart of the day, which shows total non-financial sector debt by country, split by government, corporate and household debt.

It shows that while the US, Euro Area and China all have total debt/GDP bunched around the 250% mark, many countries have total nonfinancial debt in excess of this level, and in particular a number of European countries have high debt vulnerabilities (with these vulnerabilities having emerged in the last 10yrs). Specifically, Martin highlights i) Household debt in Denmark, Netherlands, Switzerland and Norway; ii) Corporate debt in Ireland, Netherlands, Belgium, Sweden and France, and iii) Government debt in Japan, Italy and Portugal.

Needless to say, none of this should be a surprise to anyone, but the question is why are major NGOs and banks once again focusing on the one biggest legacy of the financial crisis (and, arguably, its cause) that was never resolved? Because with QE off the table and the system attempting to "normalize", what comes next is relatively simple: not just a recession, as Albert Edwards claims, but also a debt crisis for the simple reason that the inflation the central banks had hoped to create to "inflate away" the debt never appeared, and instead the record debt load is now the biggest deflationary force pressuring the world.

It is also the reason why the neutral rate in both the US and the rest of the world, is the lowest it has ever been; it explains why with the Fed Funds rate at a paltry 2.25% the Fed is now actively contemplating pausing rate hikes while the market is convinced the Fed's next move will be to cut rates as the world simply can not sustain interest rates that are any higher without unleashing another global recession.

Of course, there is a distinct sense of deja vu about all of this, because while the next global easing cycle and/or QE will merely make the debt problem worse, it will kick the can for a little longer, until such time as even more imbalances build up at which point central banks will find they are fully out of ammo and only directly buying risk assets can preserve the illusion that the western financial system is still viable. When that happens is anyone's guess, however a good advance indicator will be, as Martin suggested, to keep an eye on "experts" talking about "quantitative failure" - once that becomes a household word, it will be time to quietly get out of Dodge.