Hoisington
Quarterly Review and Outlook
– First Quarter 2015
John Mauldin
Apr 17, 2015
I
think it was almost two years ago that I was in Cyprus. Cyprus had just come
through its crisis and was still in shell shock. I was there to get a feel for
what it was like, and a number of my readers had courteously arranged for me to
meet with all sorts of people and do a few presentations. A local group
arranged for me to speak at the lecture hall of the Central Bank of Cyprus in
Nicosia.
There
were about 50 people in the room. I was busily working on Code Red at the time and had
money flows, quantitative easing, and currency wars at the front of my brain.
As part of my presentation, I talked about how countries would seek to use
currency devaluation in order to gain an advantage over other countries – that
we were getting ready to enter an era of currency wars, which would be
disguised as monetary policy trying to create economic growth. Which is exactly
what we have today. Every now and then I get a few things right.
After
my short presentation, during the question and answer period, I pointed to a
distinguished-looking gentleman to ask the fourth question. Before he could get
his question out, my host stood up and said, “John, I just want to give you
fair warning. This is Christopher Pissarides. He recently won the Nobel Prize in
economics and is a professor at the London School of Economics, as well as
being a Cypriot citizen.”
Professor
Pissarides preceded his question by citing a great deal of literature, some of
it his own, which showed that a country could not gain a true advantage by engaging
in currency manipulation. “So why do you think there would be currency wars?
What would it gain anybody?” he asked.
We
proceeded to have a conversation that basically boiled down to the old Yogi
Berra maxim: In theory, theory
and practice are the same thing. In practice they differ.
Dr.
Pissarides was of course absolutely right. Beggar-thy-neighbor policies end up
making everybody worse off at the end of the day. However, there is a
short-term first-mover advantage. In a short-term world, people do things to
show they are being “proactive.” And in a world of “every central banker for
himself,” where central banks are essentially trying to position their
countries to prosper, you wind up having multiple iterations of tit for tat.
And
that is just one of the points that our old friend Lacy Hunt of Hoisington
Management makes in this week’s Outside
the Box:
In our review of historical and present cases of
over-indebtedness, we noticed some overlapping tendencies with less regularity
that are important to mention.
First, when all major economies face severe debt
overhangs, no one country is able to serve as the world’s engine of growth.
This condition is just as much present today as it was in the 1920-30s.
Second, currency depreciations result as
countries try to boost economic growth at the expense of others. Countries are
forced to do this because monetary policy is ineffectual.
Third, devaluations do provide a lift to
economic activity, but the benefit is only transitory because other countries
that are on the losing end of the initial action retaliate. In the end every
party is in worse condition, and the process destabilizes global markets.
Fourth, historically advanced economies have
only cured over-indebtedness by a significant multi-year rise in the saving
rate or austerity. Historically, austerity arose from one of the following:
self-imposition, external demands or fortuitous circumstances.
I’m
increasingly convinced that central banks have distorted the entire
macroeconomic landscape to such an extent that we have entered uncharted
waters. That will be the theme of my letter this upcoming weekend, but Lacy’s
quarterly serves as a good introduction.
The
weather has turned exceedingly nice in Dallas, Texas. The trees have filled
out, the flowers are blooming, and we have had enough rain (thank goodness) to
make everything green.
I
pretty much enjoy all sports, and Dallas is generally blessed with having one
or two of our teams actually play well in any given year. I think I like
professional basketball the most. At the professional level it is the most
beautiful of all sports. For a brief time in their life, these young gods of
the court can do things that mere mortals can never experience. But it is such
a joy to watch. I’ve had season tickets for 32 years, and in the last few years
have finally have been able to work my way down from the very top-corner row to
where my seats are now “most excellent.”
Tonight
is the unofficial beginning of the NBA playoffs for the Western Conference. I
say “unofficial” because, technically, the playoffs start this weekend; but
only two teams in the West actually know their seed positions.
Dallas is locked
in at number seven, but there are still four mathematical possibilities for the
number-two seed to face us. It all comes down to who wins and loses tonight.
This is the closest basketball race that I can remember. Two or three teams
vying for a playoff spot, sure, that’s common. But there are seven or eight
teams in the conference this year that could get hot during the playoffs and
make it to the top. The Mavericks have the deepest bench of any team in the
NBA, but there are a lot of new players who have been added recently, and it
sometimes feels like you want to introduce them to each other. We could be one
and done or go all the way. It’s just really hard to figure this team out from
night to night. But that’s what makes it fun.
Have
a great week, and I wherever you are, I hope your weather is treating you well,
too. I guess we should be grateful that a group of 12 people don’t get to sit
around a big conference table and vote on what the weather should be like and
then try to adjust it. Actually, that’s a good analogy. Think about it.
You’re
hoping to be watching playoffs in late May analyst,
John Mauldin, Editor
Outside the Box
Hoisington Quarterly Review and Outlook – First Quarter 2015
Characteristics of Extremely Over-Indebted
Economies
Over the more than two thousand years of
economic history, a clear record emerges regarding the relationship between the
level of indebtedness of a nation and its resultant pace of economic activity.
The once flourishing and powerful Mesopotamian, Roman and Bourbon dynasties, as
well as the British empire, ultimately lost their great economic vigor due to
the inability to prosper under crushing debt levels. In his famous paper “Of
Public Finance” (1752) David Hume, the man some consider to have been the
intellectual leader of the Enlightenment, wrote about the debt problems of
Mesopotamia and Rome. The contemporary scholar Niall Ferguson of Harvard
University also described the over-indebted conditions in all four countries
mentioned above. Through the centuries there are also numerous cases of less
prominent countries that suffered a similar fate of economic decline resulting
from too much debt as a percent of total output.
The United States has experienced four bouts of
great indebtedness: the 1830-40s, the 1860- 70s, the 1920-30s and the past two
decades. Japan has been suffering the consequences of a massive debt over-hang
for the past three decades. In its first of three thorough studies of debt, the
McKinsey Global Institute (MGI) identified 32 cases of extreme indebtedness
from 1920 to 2010. Of this group, 24 were advanced economies of their day.
The countries identified in the study, as well
as those previously cited, exhibited many idiosyncratic differences. Some were
monarchies or various forms of dictatorships. Others were democracies, both
nascent and mature.
Some countries were on the Gold Standard, while others had
paper money.
Some had central banks and some did not. In spite of these
technical and structural differentiations, the effect of high debt levels
produced the clear result of diminished economic growth. Indeed, the fact that
the debt impact shows through in these diverse circumstances is a clear
indication of the powerful deleterious impact of too much debt. Six
characteristics seem to be uniform in all circumstances of over-indebtedness in
historical studies, and these factors are evident in contemporary times in the
U.S., Japanese and European economies.
Six
Characteristics
- Transitory upturns in economic
growth, inflation and high-grade bond yields cannot be sustained because
debt is too much of a constraint on economic activity.
- Due to inherently weak
aggregate demand, economies are subject to structural downturns without
the typical cyclical pressures such as rising interest rates, inflation
and exhaustion of pent-up demand.
- Deterioration in productivity
is not inflationary but just another symptom of the controlling debt
influence.
- Monetary policy is ineffectual,
if not a net negative.
- Inflation falls dramatically,
increasing the risk of deflation.
- Treasury bond yields fall to
extremely low levels.
The
Non-Sustainability of Transitory Gains
Nominal GDP is the most reliable of all the
economic indicators since, as the sum of cash register receipts, it constitutes
the top line revenues of the economy. From this stream, everything must be
paid. Current nominal GDP growth shows the economy’s inability to sustain
progress in growth (Chart 1).
The change over the four quarters ending December
31, 2014 was only 3.7%, which is barely above the average entry point for all
recessions since 1948.
Nominal GDP can be sub-divided into two parts.
First is the implicit price deflator, which measures price changes in the
economy, and the second is real GDP, which is the change in the volume of
goods. Both of these components are volatile, but the recent data shows a lack
of strong momentum in economic activity. The year-over-year change in the
deflator has accelerated briefly in this expansion, but the peak remained below
the cyclical highs of all the expansions in every decade since the 1930s (Chart
2).
In the past fifteen years, real per capita GDP
(nominal GDP divided by the price deflator and population) grew a paltry 1% per
annum. This subdued growth rate should be compared to the average expansion of
2.5%, which has been recorded since 1940. The reason for the remarkably slow
expansion over the past decade and a half has to do with the accumulation of
too much debt.
Numerous studies indicate that when total indebtedness in the
economy reaches certain critical levels there is a deleterious impact on real
per capita growth. Those important over-indebtedness levels (roughly 275% of
GDP) were crossed in the late 1990s, which is the root cause for the
underperformance of the economy in this latest expansion.
It is interesting to note that in this period of
slower growth and lower inflation, long-term Treasury bond yields did rise for
short periods as inflationary psychology shifted higher. However, the slow
growth meant that the economy was too weak to withstand higher interest rates,
and the result was a shift to lower rate levels as the economy slowed. Since
the U.S. economy entered the excessive debt range, eight episodes have occurred
in which this yield gained 84 basis points or more (Chart 3). Nevertheless,
none of these rate surges presaged the start of an enduring cyclical rise in
interest rates.
Downturns
Without Cyclical Pressures
Many assume that economies can only contract in
response to cyclical pressures like rising interest rates and inflation, fiscal
restraint, over-accumulation of inventories, or the stock of consumer and
corporate capital goods. This idea is valid when debt levels are normal but
becomes problematic when debt is excessively high.
Large parts of Europe contracted last year for
the third time in the past four years as interest rates and inflation
plummeted. The Japanese economy has turned down numerous times over the past
twenty years while interest rates were low. Indeed, this has happened so often
that nominal GDP in Japan is currently unchanged for the past twenty-three
years. This is confirmation that after a prolonged period of taking on excessive
debt additional debt becomes counterproductive.
Faltering
Productivity is Not Inflationary
Falling productivity does not cause faster
inflation. The weaker output per hour is a consequence of the over-indebtedness
as much as the other five characteristics mentioned above. Productivity is a
complex variable impacted by many cyclical and structural influences.
Productivity declines during recessions and declines sharply in deep ones.
Nonfarm business productivity has grown at an average rate of 2.2% per annum
since the series originated in 1952 (Chart 4). As a general rule the growth
rate was above the average during economic expansions and lower than the
average in recessions.
Over the past four years, nonfarm productivity
growth has slumped to its lowest levels since 1952, with the exception of the
severe recession of 1981- 82. Such a pattern is abnormally weak. Interestingly,
the Consumer Price Index was unchanged in the past twelve-month period (Chart
5). In an economy purely dominated by cyclical forces, as opposed to one that
is highly leveraged, both productivity and inflation would not be depressed.
Monetary Policy
Is Ineffectual
Monetary policy impacts the overall economy in
two areas – price effects and quantity effects. Price effects, or changes in
short-term interest rates, are no longer available because rates are near the
zero bound. This is a result of repeated quantitative easing by central banks.
It is an attempt to lift overly indebted economies by encouraging more
borrowing via low interest rates, thus causing even greater indebtedness.
Quantity effects also don’t work when debt
levels are excessive. In a non-debt constrained economy, central banks have the
capacity, with lags, to exercise control over money and velocity. However, when
the debt overhang is excessive, they lose control over both money and velocity.
Central banks can expand the monetary base, but this has little or no impact on
money growth. Further, central banks cannot control the velocity of money,
which declines when there is too much unproductive debt. This happened in
the1920s and again after 1997 and is continuing to decline today (Chart 6).
Monetary policy can be used to devalue a
country’s currency, but this benefit is short-lived, and to the extent that it
works, conditions in other countries are destabilized causing efforts at
currency devaluation to invoke retaliation from trading partners.
Inflation Falls
So Much That Deflation Risk Rises
Extremely high levels of public and private debt
relative to GDP greatly increase the risk of deflation. Deflation, in turn,
serves to destabilize an economy that is over-indebted since the borrowers have
to pay back loans in harder dollars, which transfers income and wealth from
borrowers and creditors.
Such a deflation risk is present in the United
States and other important economies of the world. During and after the mild
recessions of 1990-91 and 2000-01, the rate of inflation in Europe and the United
States fell by an average of 2.5%. With inflation near zero in both economies
today, even a mild recession would put both in deflation.
Real Treasury
Bond Yields
In periods of extreme over-indebtedness Treasury
bond yields can fall to exceptionally low levels and remain there for extended
periods. This pattern is consistent with the Fisher equation that states the
nominal risk-free bond yield equals the real yield plus expected inflation
(i=r+E*). Expected inflation may be slow to adjust to reality, but the
historical record indicates that the adjustment inevitably occurs.
The Fisher equation can be rearranged
algebraically so that the real yield is equal to the nominal yield minus
expected inflation (r=i–E*). Understanding this is critical in determining how
unleveraged investors fare. Suppose that this process ultimately reduces the
bond yield to 1.5% and expected inflation falls to -1%. In this situation the
real yield would be 2.5%. The investor would receive the 1.5% coupon but the
coupon income would be supplemented since the dollars received will have a
greater purchasing power. A 1.5% nominal yield with real income lift might turn
out to be an excellent return in a deflationary environment. Contrarily,
earnings growth is problematic in deflation. Businesses must cut expenses
faster than the prices of goods or services fall. Firms do not have experience
with such an environment because deflation episodes are infrequent. If this
earnings squeeze eventuated, then a 1.5% nominal bond yield and 2.5% real yield
might be very attractive versus equity returns.
Global Concerns
In our review of historical and present cases of
over-indebtedness, we noticed some overlapping tendencies with less regularity
that are important to mention.
First, when all major economies face severe debt
overhangs, no one country is able to serve as the world’s engine of growth.
This condition is just as much present today as it was in the 1920-30s.
Second, currency depreciations result as
countries try to boost economic growth at the expense of others. Countries are
forced to do this because monetary policy is ineffectual.
Third, devaluations do provide a lift to
economic activity, but the benefit is only transitory because other countries
that are on the losing end of the initial action retaliate. In the end every
party is in worse condition, and the process destabilizes global markets.
Fourth, historically advanced economies have
only cured over-indebtedness by a significant multi-year rise in the saving
rate or austerity. Historically, austerity arose from one of the following:
self-imposition, external demands or fortuitous circumstances.
Overview of
Present Conditions
Our expectations for the economy in 2015 are
that nominal GDP should grow no more than 3% this year. M2 appears to be
expanding around a 6% rate, and velocity is falling at a trend rate of 3%. The
risk is that velocity will be even weaker this year; thus, 3% nominal GDP
growth may be too optimistic. The ratio of public and private debt to GDP rose
last year and economic growth softened. The budget deficit was lower in 2014
than 2013, but gross government debt rose again last year and a further
increase is likely in 2015. This is not a positive signpost for velocity. The
slower pace in nominal GDP in 2015 would continue the pattern of the past two
years when nominal GDP decelerated from 4.6% in 2013 to 3.7% in 2014 on a
fourth quarter to fourth quarter basis. Such slow top line growth suggests that
both real growth and inflation should be slower than last year.
Many factors can cause intermittent increases in
Treasury yields, but economic and inflation fundamentals are too weak for
yields to remain elevated.
Therefore, the environment for holding long-term
Treasury bond positions should be most favorable in 2015.
Van R. Hoisington
Lacy H. Hunt, Ph.D.
Lacy H. Hunt, Ph.D.
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