Why Deleveraging Still Rules Markets in 2013
I have structured my investment themes for 2013 in two ways. The first is geared toward the current “risk on” climate, even though I doubt it will endure. The other is a “risk off” scenario that I believe will unfold once investors recognize the unsustainability of what I call the Grand Disconnect between robust securities markets and subdued economic reality.
The investment scene in the U.S. and elsewhere is dominated by a number of forces: the deleveraging of private economic sectors and financial institutions; the monetary and fiscal responses to the resulting slow growth and financial risks; competitive devaluations; the fixation of investors on monetary ease that obscures weak real economic activity; and central bank-engineered low interest rates that have spawned more distortions and investor zeal for yield, regardless of risk.
Deleveraging: The financial sector began its huge leveraging in the 1970s, as the debt-to-equity ratios of some financial institutions leaped. The household sector followed in the early 1980s. That’s when credit-card debt ballooned and mortgage down payments dropped from 20 percent, to 10 percent, to 0 percent. We even reached negative numbers at the height of the housing boom as home-improvement loans added to conventional mortgages pushed debt-to-equity ratios above 100 percent.
The deleveraging process for both of these sectors has begun, though it has a long way to go to return to the long-run flat trends. I foresee about five more years of deleveraging, bringing the total span to about 10 years, which is about the normal duration of this process after major financial bubbles.
I’ve consistently forecast average real U.S. gross- domestic-product growth of about 2 percent in this age of deleveraging. Since the process began in the fourth quarter of 2007, the average growth rate has been 0.5 percent; it has been 2.2 percent since the recovery started in the second quarter of 2009. And note that recoveries from recessions are typically much stronger growth than long-term growth, which averaged 3.6 percent from 1950 through 1999. Yet since 2000, when the up- phase of the long cycle ended and the down-phase commenced, real GDP growth has averaged 1.8 percent annually.
The average current rate of growth is far below the 3.3 percent it takes just to keep the unemployment rate steady. With 2 percent real GDP growth, the jobless rate will rise a little more than one percentage point a year. No government -- left, right or center -- can endure high and rising unemployment. As a result, the pressure to create jobs will remain strong. And so will the huge federal deficits that have been created by increased spending and weaker tax revenue.
Once deleveraging is completed in another five years or so, long-term trend growth of about 3.5 percent a year will resume. Biotech, robotics, the Internet, telecommunications, semiconductors, computers and other relatively new technologies promise tremendous productivity and economic growth.
For now, however, the impact of private-sector deleveraging is severe. Economic growth remains slow at best despite the fiscal and monetary stimulus in the U.S. and elsewhere since 2008. As a result, responsibility to aid the economy has shifted to central banks.
Quantitative easing: First, central banks pushed the short- term rates they control close to zero with little effect. They then turned to experimental stimulus under the label of quantitative easing -- the massive purchases of government and other securities -- an approach that has been tried by the Bank of Japan for years without notable success.
The Federal Reserve, with its dual mandate to promote full employment as well as price stability, is dealing with a very blunt instrument in its attempt to create jobs. It can raise or lower short-term interest rates, and buy or sell securities. But those actions are a long way from creating more jobs.
In contrast, fiscal policy can be surgically precise, aiding the unemployed by extending and increasing benefits. And the Fed is now trying to spur housing by buying residential mortgage-related securities as a way to push down mortgage rates. Yet the effect for prospective homebuyers has been largely offset by a number of negative forces, including tight lending standards, low credit scores, “underwater” mortgages, lack of job security, or unemployment, and the realization that for the first time since the 1930s, house prices can drop substantially on a nationwide basis.
Nevertheless, the Fed hopes that its actions will lead to job creation. First, the central bank buys Treasuries or mortgage-related securities. Then, the sellers reinvest the proceeds in assets such as stocks, commodities and real estate, pushing up prices. These higher asset prices have a real wealth effect by making people feel richer, leading them to spend on consumer goods and services or capital equipment. That spending, in turn, spurs production and demand for labor.
So far, the Fed’s plan hasn’t worked very efficiently. The 7.8 percent unemployment rate is still very high by historical standards. Despite a recovery, payroll employment remains well below the previous peak in January 2008. And cautious employers have turned to temporary employees, who generally are paid less and are easier to dismiss.
Temporary and limited impacts: QE’s effects have been temporary and limited. Each round of easing by the Fed has been accompanied by a jump in stocks that only lasted until a fresh crisis in Europe or the U.S.
Moreover, new debt doesn’t have the GDP bang per buck it once did. From 1947 to 1952, each dollar in additional debt was associated with $4.61 in additional real gross national product. From 2001 through the second quarter of 2012, it was a mere 8 cents.
The European Central Bank’s program to buy one- to three- year sovereign debt is “unlimited,” an extraordinary pledge. The Bank of Japan plans to start its “unlimited” lending program to Japanese banks in June 2013 and expects to disburse more than $175 billion in 15 months.
The Fed’s latest pronouncements are open-ended, too. Operation Twist involved buying $45 billion a month in long-term Treasuries while selling $45 billion in short-term obligations. Now the short-term selling is over and the $45 billion purchases add to the Fed’s $40 billion a month purchases of mortgage-backed securities, the second round of quantitative easing. This means $85 billion a month in additional reserves for member banks.
In addition, the Fed will continue to keep the short-term interest rate it controls close to zero until the unemployment rate drops to 6.5 percent, and as long as the Fed sees long-run inflation expectations close to 2.5 percent. The central bank doesn’t expect these conditions to be met until 2015.
This is transparency at its extreme. Where’s the mystery, the uncertainty over Fed actions that keeps markets honest? The Fed can always redefine its targets, but wouldn’t that seriously impair its credibility? The central bank hasn’t covered itself in glory with its recent economic forecasts, including its estimate in November 2010 for 2012 real GDP growth of 4.1 percent, which was cut to 1.75 percent in December 2012.
And suppose the unemployment rate falls to 7.5 percent and then to 6.8 percent. Markets aren’t likely to wait for it to reach 6.5 percent before Treasuries are dumped and interest rates increase.
Some Fed policy makers may be having second thoughts about the central bank’s open-ended policies. Minutes of the Federal Open Market Committee’s Dec. 11-12 meeting at which it set the 6.5 percent unemployment-rate target show a divided view about quantitative easing.
If the Fed buys bonds at the current pace through the end of the year, it will be adding $1.02 trillion to its $2.9 trillion portfolio. Ending the program could send shockwaves through markets, which have grown accustomed to repeated Fed stimulus.
Strains on the Fed’s credibility: In his Aug. 31 speech in Jackson Hole, Wyoming, Fed Chairman Ben Bernanke said a “potential cost of additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to exit smoothly from its accommodative policies at the appropriate time.”
Even if unjustified, he added, “such a reduction in confidence might increase the risk of a costly unanchoring of inflation expectations, leading in turn to financial and economic instability.”
This is a serious threat. Bernanke has stated that the Fed could easily get rid of excess reserves by deciding, in a 15- minute policy-committee phone call, to sell securities from its portfolio.
Consider what would happen about five years from now when deleveraging is completed and real growth moves from about 2 percent a year to its long-run trend of 3.5 percent or more.
Even then, it would take at least several years to utilize excess capacity and labor. And when Wall Street gets the slightest hint that the Fed is thinking about removing the excess liquidity, interest rates will leap and the danger of an economic relapse will seem very real. Political pressure on the Fed might be intense.
After about 10 years of deleveraging and slow economic growth, the central bank might well be charged with taking away the punch bowl before the party even got started.
(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the first in a five-part series. Read Part 2.)
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