Seven Salient Left Tail Scenarios by Jamil Baz, PIMCO
In the wake of Brexit, eight years after the onset of the great financial crisis, now seems an apt moment to reassess a few economic themes. At PIMCO we do not foresee Brexit leading to calamity for markets or the global economy. Furthermore, even before the historic vote, we had determined at our annual secular-focused investment forum in May that middling global economic growth is likely to continue for the next few years, but with greater risks to the status quo.
Here I would like to expound on what some of these risks to the status quo could be, with a particular focus on seven “left tail” outlier risks. While none of the potential tail events are our base case over the typical investable horizon, these scenarios are worth considering in a time of insecure stability, if only because they offer an alternate viewpoint to market consensus.
Theme #1 – Leverage: Desperate, But Not Serious
One may think, with all the persistent rumors about deleveraging, that leverage within advanced economies has fallen decisively since the beginning of the crisis. Not quite so. With the exception of Germany (down 34 percentage points) and the U.S. (roughly flat), leverage as expressed by the total debt-to-GDP ratio has increased in every country in our sample of 10 advanced economies. At 387%, the GDP-weighted ratio has increased by 19 percentage points since the beginning of the crisis.
On the basis of these numbers, there is good reason to believe that 1) if the global financial crisis was a crisis of excess leverage and leverage has actually increased, the crisis may not have yet begun in earnest; 2) deleveraging will be long-winded, if only because, based on existing literature, we may have to delever by 100 percentage points at a pace no faster than 10 points a year, which means reasonable estimates of the deleveraging process are 10 years at least; 3) the economy will be marred by ugly negative multiplier effects when the deleveraging happens and 4) the stock market will suffer substantially as a result.
It can be argued that leverage is more sustainable in an environment of super-low interest rates. Leverage matters less than debt servicing, does it not? This is only true if low interest rates are sustainable in the face of very loose monetary policy. The jury is still out on this issue. Yet, one needs to remember that it is low interest rates that encouraged debt building in southern Europe before the crisis. The same is true in Japan where, as we shall argue later, fiscal dominance and potentially hyperinflation may be the only way to avoid an explicit default on Japanese government bonds (JGBs). It is difficult to see stable low rates in these conditions.
Worse, anyone inclined to optimism because of the German and U.S. numbers should remember that these numbers exclude social entitlements and other “contingent” liabilities. Laurence Kotlikoff, an expert in generational economics and fiscal policy at Boston University, calculates that the infinite horizon U.S. fiscal gap (defined as the net present value of deficits) stands at $200 trillion – that is 11 times GDP. Of course, this dwarfs the $13–$14 trillion official public debt number, which only accounts for accruals.
What is the annuity equivalent of the U.S. fiscal gap? Kotlikoff estimated this number at 13.7% of GDP in 2012. Note that the same study shows substantially lower numbers in Europe: 5.4% in the UK, 4.8% in Spain, 1.6% in France and -2.3% in Italy. To some, this topic is an old chestnut: It is sometimes said that all the U.S. government needs to do is renege on Medicare and Medicaid commitments. But, it may be objected, if it were that easy, why did no previous administration do it? And besides, if entitlements stopped being paid, wouldn’t the baby boomers’ savings rate have to increase substantially, possibly causing a serious economic crisis? The increase may be sudden, if the government fully reneges, or slow and steady if it gradually ratchets down benefits. Similarly, Germany is plagued with contingent liabilities, not the least of which being the financing of past (Target2 and existing debt write-offs) and future current account deficits in southern Europe.
In the words of an Austrian adage, the situation is desperate, but not serious. It is not serious, as there seems to be a consensus among decision-makers not to take it seriously – and, for a while, at least in policy matters and otherwise, you are who you pretend you are. The situation is desperate because there does not seem to be a way to duck a serious economic crisis should this left tail risk materialize in the real economy.
Theme #2 – Equity Valuations: Ostriches Everywhere
A cursory look at U.S. P/E ratios may inspire confidence. After all, the earnings yield on the S&P 500 is 5.0%. The 30-year real bond yield stands at 0.6%. A 4.4% implied equity risk premium is nothing to sneer at and is close to fair value. However, there are two problems: First, other valuation metrics point to equity market expensiveness; second, the level of earnings is likely unsustainable in the long run.
Figure 2 compares the cyclically adjusted P/E, the dividend yield and Tobin’s Q to their sample average. The dataset start date is 1881 for dividend yields, 1900 for Tobin’s Q and 1901 for CAPE (cyclically adjusted price to earnings). Stocks appear to be expensive to the tune of 46% to 107%. The valuation metrics are in the 86 to 90 percentile range when benchmarked against the entire period. If we restrict the sample to the pre-1996 period, percentiles vary between 94 and 100. Other valuation metrics, such as the market-cap-to-GDP ratio and the price-to-sales ratio, are similarly stretched.
This is only part of the story. When looking at a P/E ratio, investors will often think about the distortion in the price level, given earnings. But what if earnings are distorted? Figure 3 suggests they may well be.
A lot of ink has been spilled on the reasons behind rising profits-to-GDP ratios – and the culprits are many: free trade, outsourcing, robots, quantitative easing, loose tax regimes etc. But leverage has received short shrift.
Why would leverage be a factor? Think about the identity of sector balances in a closed economy (trade balances do not materially affect our conclusions): Private surplus – that is savings minus investment – equals government deficit. However, savings are profits plus household surplus. This boils down to:
Profits = Investments + Household deficit + Government deficit
To a first approximation, government deficit is the change in public debt; household deficit is the change in consumer debt. Then, if leverage is defined as government and consumer debt to GDP:
Profits/GDP = Investments/GDP + change in leverage
If you believe, as I do, that leverage needs to decline steeply over the long horizon, then, all else equal, the share of profits in GDP should also decline.
So in this tail risk scenario, not only are valuations stretched; earnings are as well. And this combination is not auspicious to U.S. equity markets.