As the Fed’s asset purchase program ends, the price of oil plunges, global growth stalls, and the stock market recovers from its fall jitters, this seems like a good time to take a long view of where we are in the post-apocalypse recovery.
The best guide to any such assessment remains Reinhart and Rogoff’s brilliant survey of financial crises, This Time Is Different, published in 2009. In their preface, they write:
“If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by governments, banks, corporations, or consumers, often poses greater systemic risk than it seems during a boom.”
And so it proved in 2007-08.
So what does history tell us about the fallout of such crises?
First, that banking/credit crises trigger far deeper and longer recessions than more common-garden contractions. How long? Seven to eight years, on average, according to Reinhart and Rogoff (and confirmed by a subsequent IMF study). If we take 2009 as the first year of recovery, this is year six, so we should not be surprised that we’re only now seeing sustained upticks in our various measures of economic health.
Second, that when such a crisis is global, rather than confined to one country or region, its effects are typically deeper and more prolonged. When every country is suffering economic contraction there is no healthy engine to pull others out of the swamp, and so recovery is slow and hard. Following the crisis of 2007-08, there was considerable hope that the emerging markets in general, and China in particular, would serve as this engine. And to some extent they did so for a year or two. But relative to the U.S. and Europe, these economies, although still growing fast, simply weren’t yet large enough to offset the plunge in demand of the developed nations. And now their growth is slowing.
Third, when a global credit crisis erupts at a time when “governments, banks, corporations, or consumers” are loaded with debt, a bad situation quickly becomes worse as the over-indebted scramble to reduce their liabilities, leading to a crash in demand for credit. To repair their balance sheets, individual or corporate debtors need income, while governments need GDP growth to generate tax revenue. But as consumers, corporations, banks and governments all attempt to deleverage at the same time, a vicious cycle ensues: growth stalls out, causing the piles of debt to increase faster than the means to repay them. This exacerbates and prolongs recession, and explains why, even six years after the crisis peaked, very little deleveraging has actually been achieved. Among U.S. consumers, yes, some modest improvement. And the U.S. deficit has been contracting at a healthy rate, with higher tax revenues and reduced government outlays. But in Europe, sovereign indebtedness has risen sharply as most governments have failed to address fundamental problems of unsustainable social welfare liabilities, poor demographics, and structural impediments to growth, all of which existed prior to 2007, but have been thrown into sharp relief by the crisis.
Under such circumstances, policy decisions become critically important. In other words, “it’s the economy, stupid!” gets replaced by “it’s the politics, stupid!” And the politics of prolonged recessions are always hazardous and problematic. History tells us to expect the emergence of right-wing populists, eager to whip up nationalist sentiments and exploit the bitterness of workers suffering the brunt of the downturn. These are disenchanted voters who need to channel their anger and are looking for someone to blame: inept government, job-stealing immigrants, globalization, welfare moochers. Hence the Tea Party, the U.K. Independence Party, France’s Front National, Geert Wilders Party for Freedom in the Netherlands, Germany’s AFD, all of which have made significant gains in representation since 2009.
In the U.S., politics prevented the Obama administration from launching more robust fiscal stimulus, in the form of much-needed infrastructure spending, to counteract shrinking private-sector demand. However, there was some fiscal stimulus, launched in the last days of the Bush administration, which combined with the aggressive actions of the Federal Reserve to moderate the decline. Subsequently, the Fed’s successive programs of quantitative easing beat back deflation while its maintenance of ultra-low interest rates stimulated risk-taking, asset-price inflation, and cheap mortgage financing (for those who could get it).
In Europe, where sovereign debt problems loomed large and the integrity of the euro was threatened, the central bank proved more cautious, while national governments consistently dodged difficult decisions, hoping that time would eventually cure all. Which it hasn’t and won’t. The road down which they have kicked the can for the past six years is a cul-de-sac. The can hasn’t yet reached the wall at the end of the street, but could do so pretty soon. In Paris and Rome they realize this all too well, hence the whiff of panic in those capitals. Meanwhile, in a continent desperate for a resurgence in economic demand, Germany continues to drag its heels, preaching continued austerity. Whether this will be shaken by the economic weakness of recent months remains to be seen.
And China? Can China navigate a prolonged contraction in the construction sector, which has been the main driver of GDP growth over the past decade? And will China suffer the same fate as so many emerging economies have suffered over the centuries: as each unit of debt generates less and less growth in output, a tipping point is finally reached where growth is no longer sufficient to support debt repayment, and the economy crashes? Probably not, but further deceleration in China’s stunning rate of GDP growth seems inevitable. This need not in itself prove problematic (although the headlines may suggest otherwise): if consumer income is growing at a healthy rate even as GDP growth slows, this will signal that the authorities are succeeding in their efforts to reorient the Chinese economy from investment to consumption. For now, however, the headlines from China are: rising debt, contracting demand and oversupply of property and all the raw materials that feed into construction. (The Financial Times pointed out recently that a ton of rebar steel in China now costs about the same as a ton of cabbages!).
So what can be discerned as we peer into the murky future?
The global economy remains highly integrated, so it’s not clear that the U.S. recovery can persist unabated if Chinese growth keeps decelerating, Europe slips back into recession, and oil price declines trigger contractions in Russia and other states highly dependent on energy revenues.
Paradoxically, renewed weakness in the U.S. could be a short-term boon to investors since it would almost certainly elicit a response from the Federal Reserve—at the least pre-empting any prospective rate hike.
The bull market in U.S. equities has been driven by corporate stock buybacks (amounting to $2 trillion since 2009), cheap money that has encouraged leveraged investing (margin debt close to all-time highs), financial repression (returns on cash below zero in real terms) and expanding valuations. If the real economy continues on its current upwards trajectory, these conditions will disappear. Companies will start to invest in new plant and equipment to meet rising demand, leveraged investors will get burned (again) when the bull market tide ebbs, and Treasury bonds will again provide real rates of return at very low risk (i.e., bond prices will decline).
As usual, it’s complicated: Will accelerating economic recovery be sufficient to drive the stock market to higher highs? Or will the economy slide back into recession and stock prices hit the skids in response to this unforeseen contraction? Or will continued strength in the real economy result in higher interest rates that prove toxic to equity markets? Will one or more of the rumbling geo-political risks erupt into full-on crisis, causing a stampede to the relative safety of risk-free Treasuries at any price? Will inflation creep steadily higher, forcing the Fed to tighten earlier than assumed?
Who knows? But my bottom line is this: risk-on has proved the right investment strategy since the market bottomed in March 2009. No longer. There’s too much potential trouble out there. Equity valuations are stretched thin and credit risk is underpriced. In a blog written over a year ago, I noted that a huge rise in corporate debt issuance has coincided with a dangerous diminution of liquidity. Since then, this situation has only gotten worse: low-quality, longer-duration bonds are among the riskiest assets today. In short, stock and bond market risk is high and prospective returns are low.
If you have a risk dial, turn it down.