Global Debt: Schumpeter’s Creative Destruction by Steve Blumenthal, CMG Capital Management
“What beat me was not having brains enough to stick to my own game – that is to play the market only when I was satisfied that precedents favored my play”
Jesse Livermore – Reminiscences of a Stock Operator
There has been a lot of debate on the Reinhart-Rogoff hypothesis. When debt becomes excessive, growth slows. Most of the academic work tends to support their conclusion.
Today we take a sobering look at debt across the globe. It has increased by more than $57 trillion since the 2007 crisis and remains a significant headwind. Some countries are better positioned than others (stronger capital markets, currency advantages, underlying wealth, etc.). Deflation is gaining traction.
Reinhart and Rogoff suggested that problems accelerated when debt reached 100% of GDP. I’ve seen studies suggesting the number is more like 40% to 50% and others suggesting it is much higher. The following chart, from one such study, looks at U.S. debt-to-GDP and suggests growth begins to decline when Debt/GDP reaches approximately 45%. Today, total U.S. debt/GDP is 269%.
While it would be nice to find a magic debt-to-GDP threshold number that signals a crisis, such findings have proven allusive. However, what I believe we can do is look at debt from a risk measurement perspective. For example, just as Median PE quintiles can tell us a lot about probable 10-year forward returns (high PEs equal low returns and low PEs equal high returns), I believe excessive debt can equally signal periods of high risk.
Like PE, we don’t know if the market will do this year or next but we do know today is that the stock market is expensively priced and 10-year forward returns will likely come in far below what most investors hope them to be. I look at the debt-to-GDP debate much the same way. Debts “a drag man” and we should factor this into our portfolio construction thinking.
If your client wants to jump on a speculative rocket (i.e. throw the chips “all in” stock such as “IVV” the S&P 500 Index), suggest a diversified cab ride instead. The time to hop on that rocket will present itself again; whether it be a recession, cyclical bear and/or crisis.
As Livermore suggests in the lead quote above, stick to the game plan and position more aggressively when you are satisfied that precedents favor your play.
The evidence today suggests otherwise – prices are high and too much debt is slowing growth. See Earnings Estimates Sink – Valuations Remain High.
This week let’s take a look at debt around the globe. I share a great piece from McKinsey & Company that shows just how much more debt, county by country, has been piled on since the 2007 debt induced financial crisis. Evidence is apparent in the commodity market and I also share a few ideas how you may risk manage those allocations.
Grab a coffee, this one prints longer than normal (many charts) and enjoy the holiday weekend.
Included in this week’s On My Radar:
- Debt and (not much) Deleveraging
- Commodity Bear Market – A Quick Look at the Long-Term Trend
- Lower Gas Price Savings – Who’s Benefiting
- More on Deflation – From CMG’s Kevin Auerbach
- And in Case You’re Wondering Who’s Benefiting From Lower Gas Prices – It’s Restaurants
- Trade Signals – Not Greedy Not Fearful, Trend Evidence Positive
Debt and (not much) Deleveraging – McKinsey & Company
Summary of findings:
- We find that deleveraging since 2008 remains limited to a handful of sectors in some countries and that, overall, debt relative to GDP is now higher in most nations than it was before the crisis.
- Not only has government debt continued to rise, but so have household and corporate debt in many countries.
- China’s total debt, as a percentage of GDP, now exceeds that of the United States.
- Higher levels of debt pose questions about financial stability and whether some countries face the risk of a crisis.
- One bright spot is that the financial sector has deleveraged and that many of the riskiest forms of shadow banking are in retreat.
- But overall this research paints a picture of a world where debt has reached new levels despite the pain of the financial crisis.
- This reality calls for fresh approaches to reduce the risk of debt crises, repair the damage that debt crises incur, and build stable financial systems that can finance companies and fund economic growth without the devastating boom-bust cycles we have seen in the past.
SB here: “Reduce the risk of debt crises”? To that point I say good luck. Look back to all that set the stage for the last crisis. I remember writing about the probable failure of Fannie and Freddie, the insanity of no-doc mortgages and Greenspan’s “there is not a bubble” in the housing market.
Think back to the seemingly endless amount of available liquidity with Wall Street’s derivative sausage-making machine – CMOs and CDOs with layers of tranches and endless slices and dices of repackaged risk. Here was Paul Krugman in a 2002 New York Times editorial: “To fight this recession the Fed needs…soaring household spending to offset moribund business investment. [So] Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.” Source.
The point isn’t to pick on Greenspan or Krugman, the point is that we do go through expansion and contraction and boom and bust for centuries. Not everyone gets a trophy but to have the opportunity to create, compete and advance; that is what makes for a healthy state. Governments have become too large a part of the equation. Somehow, Joseph Schumpeter’s creative destruction sneaks into my mind.
Joseph Schumpeter (1883–1950) coined the seemingly paradoxical term “creative destruction” and generations of economists have adopted it as a shorthand description of the free market’s messy way of delivering progress. In Capitalism, Socialism, and Democracy (1942), the Austrian economist wrote:
The opening up of new markets, foreign or domestic, and the organizational development from the craft shop to such concerns as U.S. Steel illustrate the same process of industrial mutation—if I may use that biological term—that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. (p. 83). More here.
Not a bad thing. It is perhaps an important and healthy part of the process to get us to a better place. Put me firmly in that camp.
Ok – sorry for that detour. The next picture below sets the stage and I’ve included a few more select excerpts:
After the 2008 financial crisis and the longest and deepest global recession since World War II, it was widely expected that the world’s economies would deleverage. It has not happened. Instead, debt continues to grow in nearly all countries, in both absolute terms and relative to GDP. This creates fresh risks in some countries and limits growth prospects in many.
- Debt continues to grow. Since 2007, global debt has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points. Developing economies account for roughly half of