Absolute Return Partners letter for the month of February 2016, tilted, “A Frail New World.”
“I may be surprised. But I don’t think I will be.” – Andrew Strauss, Cricketer
A stranger walking in the countryside comes across a shepherd and a huge flock of sheep. He tells the shepherd that he will bet $100 against one of his sheep that he can tell the exact number in the flock. The shepherd thinks it over; “It's a big flock”, he says to himself, so he takes the bet. "973", says the stranger. The shepherd is astonished, because that is exactly right. "OK, I'm a man of my word, take an animal". The stranger picks one up and begins to walk away.
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"Wait", cries the shepherd. "Let me have a chance to get even. Double or nothing that I can guess your exact occupation". The stranger agrees. "You are an economist for a government think tank", says the shepherd. "Amazing!" responds the stranger. "You are exactly right. But tell me, how did you deduce that?" "Well", says the shepherd, "Put down my dog and I will tell you".
Absolute Return Partners - Why economic growth will disappoint for many years to come
Economists are always right, even when they are not, aren’t they? Fat chance. The reality is very different. Writing these letters is akin to being constantly exposed, and – at times - looking rather silly. But I still enjoy it, so allow me to stick my neck out again and go against the consensus, because that is, at the end of the day, how you make money in this industry.
The broad consensus is that DM countries are finally returning to some sort of normality (often called the New Normal), following years of Zombie-like conditions. There is, admittedly, a growing recognition that GDP growth is likely to disappoint for quite a while to come, but I believe that ‘quite a while’ should be measured in decades and not, as most seem to believe, in years.
In the following, I will argue that GDP growth will disappoint for a very long time to come, and that will obviously have an effect on corporate earnings growth as well. As I see things, most investors are still way too optimistic on GDP growth and corporate earnings growth for the next many years. Why is that?
Let me step back for a second. When liaising with our readers, many of them appear to think that a rather bleak demographic outlook is the sole reason why we take such a dim view of the future. Not entirely correct. The demographic outlook is admittedly not great and will almost certainly hold back returns on financial assets in many countries for a long time to come, but that is not the whole story. In this Absolute Return Letter I will attempt to provide a more complete picture.
There are in reality not one but at least four reasons why returns on financial assets will1 disappoint in the years to come, and they are (in no particular order):
- Regulatory changes.
- The end of the debt super-cycle.
- Wealth-to-GDP to normalize.
- A deteriorating demographic outlook.
One could argue that (1) and (2) are two sides of the same story, and that is partly correct, but only partly. Regulatory changes have already had, and will continue to have, a significant impact on overall lending (and hence on GDP growth), but other factors will have an effect as well. More about this later.
Absolute Return Partners - Regulatory changes
The problem in a nutshell is that the balance sheets of most banks, after years of rapid growth, have simply grown too big. One important lesson learned from the Global Financial Crisis (‘GFC’) is that financial leverage is good, but only to a point, and regulatory authorities on either side of the Atlantic are now anxious to reduce the size of those loan books.
In more recent times, the financial system has been used quite extensively to prop up the economy, following recessionary conditions. Not only have interest rates fallen profoundly, but financial leverage has risen as well. It did so after the recession in the early 1980s; it happened again following the 1991 recession, and again following the 2001-02 recession2. Only in 2008, when the world was hit by the GFC, did leverage in the financial sector fall sharply (Chart 1).
Regulatory changes underway on both sides of the Atlantic will almost certainly drive financial sector leverage further down. Not many weeks ago I had lunch with a senior official of a major European bank. He told me that European banks are under tremendous pressure to reduce the size of their loan books. Total bank loans in Europe add up to about €18 trillion, he said3. The equivalent number in the U.S. is apparently ‘only’ $8 trillion, and the two economies are not a million miles apart size-wise. If the regulatory authorities succeed with the downsizing of the banking industry, economic growth will almost certainly be suppressed.
U.S. bank lending is also negatively impacted by regulatory constraints, even if it is less visible to the naked eye. Pre-GFC, personal income and credit card debt grew at approximately the same rate in the U.S. and, once the crisis was (largely) over, one would have expected that trend to resume, but it hasn’t (Chart 2). Even if depressed levels of personal income are taken into account, total credit card debt is still some $350 billion short of the trend line. The most likely cause? Regulatory constraints in the banking industry.
The anecdote from Europe and the credit card example from the U.S. basically tell one and the same story – that regulatory authorities on both sides of the Atlantic are desperate to avoid a repeat of the GFC, which has caused so much damage.
If that anxiety hasn’t already resulted in a lower GDP growth rate, it certainly will. There is no doubt in my mind that the regulatory changes already implemented are only the beginning of a lot more to come.
Absolute Return Partners - The end of the debt super-cycle
Some of the more drama-seeking commentators have called QE the biggest money printing experiment in history but, in reality, it is not. What they did in the Weimar Republic or in Zimbabwe was money printing; QE is not. I have been there before, and do not intend to repeat myself; suffice to say that whilst QE is not money printing, it has still had a rather dramatic effect on asset prices (both bonds and equities), and on financial leverage as well.
Having said that, overall leverage began to rise decades ago, long before anyone had ever heard of QE. Debt super-cycles last 50-75 years on average4, and one school of thought is that the debt super-cycle we are in now started in the aftermath of World War II, as lots of re-construction was needed. However, if one looks at long-term debt charts, one could also argue that the growth in debt didn’t really take off in a meaningful way until the early 1980s – at about the same time as the start of the great bull market in both bonds and equities (Chart 3).
In a debt super-cycle, as the cycle advances, economic growth is increasingly driven by a combination of growth in debt and money (as in money supply). Having said that, there are obviously limits to how much spending growth can be financed by debt and money. When that point is reached, you are at the end of the debt super-cycle. John Maynard Keynes called it Push on a String, when he first described the phenomenon in 1935. Nowadays, it is often called the Liquidity Trap.
What we are now beginning to see are the first signs of Push on a String. When that happens, monetary policy is already so accommodating that further rate cuts will have virtually no effect on economic growth. QE also becomes largely ineffective, as risk premia are too low to drive investors to assume more risk. The very low returns that we currently see across almost all asset classes is a classic sign that we are approaching the end of the debt super-cycle.
Another sign is the no-growth in money supply. The U.S. Fed stopped the third installment of QE in October 2014; at about the same time, the rapid growth in U.S. money supply stopped and has been moving broadly sideways ever since (Chart 4).
With private debt having peaked almost everywhere (Chart 5), and without an ever increasing supply of money, it is no wonder that economic growth is finding it difficult to gather momentum, and nor should we be surprised that risk assets are struggling.
Whether one can conclude that the end of QE equals the end of the debt super-cycle is another question. Very accommodating monetary authorities have certainly contributed to the growth in lending, but one cannot point fingers at only one guilty party. After all, it isn’t enough that banks are willing to lend. Borrowers must also be willing to borrow.
See full PDF below.