What’s the way out of this global debt trap?

Editor of Market Timing Australia
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Here’s a stark and unpalatable truth; the world is drowning in debt and until it deleverages, economic growth, price inflation and interest rates may stay low. The global debt mountain is impervious to whether Trump and Xi sign a trade deal or Johnson averts Brexit. The spectre of “secular stagnation” is what most worries central bank and treasury officials.

The credit boom

The build up of debt started with financial deregulation in the early 1980s, which made credit more accessible. By the 2000s, merchant banks persuaded credit rating agencies to give investment grade status to debt securities (e.g. mortgage backed bonds, credit default swaps) that proved to be junk. When market shorters moved in for the kill in 2008, the consequence was a financial meltdown that threatened bank closures and a great depression like the 1930s.

Fortunately central banks came to the rescue by injecting massive liquidity into banks in return for taking troubled securities off their books. When calm was restored to financial markets in 2009, the central banks should have ceased their adrenaline fix. But fear of slower economic growth post the global financial crisis (GFC) caused them to continue QE (Quantitative Easing), which was a fancy name for printing money to buy bonds and other securities to pump up bank liquidity. The hope was that the banks would lend this for productive investment that would accelerate economic growth.

How QE inflated shares

Here’s a chart showing how major central bank balance sheets expanded with money printing following the 2008 global financial crisis. Observe how the S&P500 stock index soared in parallel. Note also that when QE stalled the stock index usually did so too.

Source: https://www.yardeni.com/pub/peacockfedecbassets.pdf

Banks found that lending for speculation on bonds, property, shares and commodities and to help companies buy back their shares proved easier and more profitable than chasing real investors.

Global debt blowout

By mid-2019, total global debt was almost US$250 trillion, which was 45% higher than what it was before the 2008 GFC, a crisis blamed on excess debt.

Source: https://www.iif.com/Portals/0/Files/Global%20Debt%20Monitor_January_vf.pdf

Here is a breakdown of total global debt by class of borrower. Note that debt rose most strongly in households and financial institutions (e.g. banks) before the GFC and in governments and corporates (non-financial) after the GFC.

Source: https://www.iif.com/Portals/0/Files/Global%20Debt%20Monitor_January_vf.pdf

How to deleverage?

Excessive debt is the main reason governments, corporates and households around the world are now reluctant to take on more credit to spend. Current low interest rates are very attractive, but if for some reason they reverted to normal postwar levels, it would bankrupt many debtors.

So what can be done? The central banks’ favourite tool is QE, but its potency has worn off because there is limited scope to cut official rates further, banks already have excess liquidity and many of their customers are heavily over-geared. Banks are reluctant to further cut mortgage rates because it would squeeze their operating margins. Also in a world drowning in debt, why add more debt?

My economic prescription is debt-free QI (Quantitative Investing), which recently featured in the Australian Financial Review (https://www.afr.com/news/economy/meet-quantitative-investing-the-public-good-qe-20190710-p525sa). QI is designed to prop up growth while debtors save to pay down their debts.

Applying either QE or QI could still see markets gyrate sideways if the economy stumbled along under the weight of slow deleveraging. This is effectively how Japan fared after its credit fuelled property and share market bust of 1990. The Japanese government kept borrowing and spending to buoy a stagnant economy while its citizenry saved and invested in government bonds to make that possible. The Japanese government is now one of the most indebted in the world, yet Japan as a whole is the world’s strongest creditor nation.

Other paths to deleveraging are more painful. One possibility is an unexpected outbreak of hyperinflation, like Germany experienced in the early 1920s that eliminated all debt by making it worthless. It ravaged the German middle class that held bank deposits and war bonds for their retirement. But holders of tangible assets (e.g. gold, shares and property) rode the price escalator.

Another scenario is a Great Depression like the 1930s that would bankrupt debtors thereby extinguishing their obligations. In such circumstances, investors in cash and government bonds would survive, but those with other assets (corporate bonds, shares and property) would lose capital.  An economic depression is too awful to contemplate. In any case, governments and central banks won’t stand by and let unemployment soar.

The best possibility is that the world finds a new engine of growth that generates higher earnings to enable share markets to advance further. That’s a real possibility outside the USA (including Australia and especially Asia and other emerging markets), where share valuations are not as overstretched. But on fundamental analysis, America needs a dramatic stock market reset to regain fair value. That’s a polite way of saying a stock index crash of at least 30%.

Market Timing Australia

Market Timing Australia’s Conservative trading strategy is designed to pull out of the market before it slides into a crash. The exception might be a flash crash, though the Conservative strategy would switch to an Active mode if the market’s upward momentum exhibited the frenzy that preceded the last flash crash in October 1987. The Conservative strategy remains on a Buy signal since the All Ord price index’s seven week trendline is comfortably above its seven month trendline.

Market Timing Australian’s World and Australian Rotation strategies are more speculative, but automatically switch asset classes when the share market’s price momentum slows. Both strategies switched to a Gold bullion fund on the 12th May. Except for a three week interlude (when the Australian Rotation strategy returned to a Property fund), both strategies have remained with Gold which has proven very profitable.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.

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