February 16, 2016
In periods of heightened market volatility, one of the great challenges for investors is keeping their eye on the big picture. While there are many immediate and much discussed threats to the global economy, including weakness in China, geopolitical conflict in the Middle East and a possible banking crisis in Europe, the key threats to the long-term economic prosperity of the Western World have changed little over the past few months.
The view of The Money Enigma is that the United States, Europe and Japan have balance sheet problem. Over the past twenty to thirty years, policy makers have attempted to “borrow growth” from future periods through a combination of unsustainable monetary and fiscal policy. This “frontloading” of economic growth and the distortions associated with this frontloading represent the greatest threat to the economic future of these regions.
In the first section of this week’s article, we will discuss some of the long-term charts that illustrate this point. Avid followers of macroeconomics will be familiar with many of these long-term economic charts. However, while familiarity may breed complacency, familiarity doesn’t make these charts any less extraordinary.
In the second section of this article, we will consider the implications of these problems for financial markets more generally, including a handful of key charts that indicate extraordinary divergences and extremes by historical standards. Some of these charts may be less familiar and hopefully they will cast some light on the opportunities that are present in the markets today.
The Big Economic Picture: Trouble in Paradise
The first chart may not seem to shout “trouble” but if you look closely it does highlight a serious issue: the rate of long-term economic growth appears to have slowed markedly in the United States.
Over the past ten years, the US has struggled to reach previous trend levels of economic growth: recent peaks in growth are lower, while the recent trough in growth was the worst in 50 years. Put simply, trend growth seems to have fallen by roughly 1% per annum over the past decade.
While the difference between 2% and 3% real economic growth might not seem like much, a small difference in the economic growth rate compounded over a long period of time makes a tremendous difference to general economic wellbeing. As Nobel Prize winning economist Robert Lucas, Jr. noted when he was discussing the difference in economic growth rates across different countries, “The consequences for human welfare involved in questions like these are simply staggering: once one starts to think about them, it is hard to think about anything else.”
This pattern of lackluster growth can be seen more clearly in other major countries such as France. France is a relative success story in Europe, i.e. it is doing better than Spain, Italy and the other Mediterranean states, and yet economic growth is anaemic.
More notably, Japan has spent the past twenty years struggling to generate any sort of sustained economic growth.
Source: Trading Economics, Japan GDP Annual Growth Rate
What makes this slowdown in economic growth all the more remarkable is that it has largely occurred during a time when unprecedented fiscal and monetary policy has been implemented, policy explicitly designed at boosting rates of economic growth. In simple terms, the Western World has been taking huge risks with its balance sheet in order to keep its income statement looking healthy.
We can see this marked balance sheet deterioration across a range of charts. First, let’s look at the explosion of government debt in the United States.
While the chart above will be very familiar to most, it is still a remarkable chart. In the wake of the 2008 economic crisis, Federal government debt in the United States skyrocketed to levels not seen since the end of WWII. Nearly eight years since the crisis began, there has been no significant reduction in that debt.
This situation is echoed in Europe where, despite all the talk about austerity, virtually no progress has been made in reducing public debt.
Concerns about the sustainability of the fiscal situation in Europe have begun to resurface again as indicated by CDS spreads across a range of countries. In the chart below, Deutsche Bank calculates the annual probability of default on government debt using the yield on 5-year CDS spreads.
Source: Deutsche Bank
Meanwhile, the fiscal situation in Japan goes from the absurd to the ridiculous with total public debt as a ratio of GDP continuing to surge higher.
Source: Trading Economics
While many (Keynesian) economists believe that current levels of government across the Western World are sustainable, the view of The Money Enigma is that these levels of government debt do pose a real risk to the value of the fiat currencies issued by these major nations (“Does the National Debt Impact the Value of the Dollar?”).
Government debt plays a critical but complex role in the determination of the rate of inflation (“Government Debt and Inflation”). If the markets suddenly decide that current levels of public debt are not sustainable, then it could result in a sudden surge in the rate of inflation across the Western World.
Meanwhile, not only have governments issued more debt, but they have also issued more “equity”. Over the past eight years, the US monetary base has quintupled in size. The view of The Money Enigma is that this expansion in the monetary base represents, in effect, a massive issuance of equity (see “Money as the Equity of Society”). More specifically, the Fed has massively expanded the number of claims against the future economic output of the United States.
Critically, while the Fed argues that it has begun the process of “normalizing” monetary policy, the Fed has made no progress to date in reducing the size of the monetary base. Indeed, the view of The Money Enigma is that the current round of interest rate rises by the Fed are largely just a distraction from the real issue, namely, the size of the US monetary base (“The Interest Rate Rabbit and the Base Money Elephant”).
In summary, the West has a balance sheet problem. The explosion in government debt and base money that has occurred over the past ten years is unprecedented in peacetime history. Not only has this balance sheet recklessness failed to drive a marked acceleration in the rate of economic growth, but it has also created an environment of increasing reliance upon government intervention in the financial markets.
The Markets: Some Fascinating Charts
In last week’s post, “The Markets Go to Rehab”, we discussed the increasing reliance of markets on the easy money policies of the major central banks. Nowhere is this dependency seen more clearly than in a chart of the S&P 500 relative to the US monetary base.
A quick look at this chart would suggest that fundamentals no longer matter, i.e. the direction of the equity market is solely determined by Fed policy. However, if fundamentals still do matter (and eventually they will), then the US equity markets do have one key problem ahead of them: valuation.
The problem for equity markets is not so much that the price/earnings ratio of the market is still relatively high by historical standards, but that corporate profit margins are extended at a time that revenue growth is hard to come by. More specifically, profit margins not only appear to have peaked, but remain very high when judged against historical standards.
While the US equity market is close to one extreme, the global commodities market is flirting with another. Unfortunately, long-term indices than can accurately present a clear picture of the overall commodities market are rare. Nevertheless, the following inflation-adjusted chart of the oil price does provide some sense of where commodities are in a long-term historical context.
While it is true that the oil price is not at all time record lows in inflation-adjusted terms, the point needs to be made that “Peak Oil” is still a real phenomenon in the sense that large, low-cost deposits are becoming harder to find and those that exist are being gradually depleted. In this context, the price of oil does look low by historical standards. [Those that would argue that shale represents a source of low cost oil clearly have never read a cash flow statement or balance sheet].
Oil also looks cheap in the context of gold. The gold to oil ratio is at a new high, indicating that oil is very cheap in gold terms, at least measured by history.
Source: MacroTrends, gold to oil ratio
The flipside of this coin is that gold is expensive in crude oil terms. However, gold appears to be cheap relative to other major financial assets, most notably, equities
Source: MacroTrends, gold to S&P 500
Finally, a good measure of the pessimism in the gold sector is the performance of gold stocks relative to the commodity itself.
Source: MacroTrends, XAU to gold ratio
This last chart indicates that gold stocks are very cheap relative to gold, at least measured by this rough historical standard. More surprisingly, gold stock valuations remain subdued despite the fact that the oil price, a major input cost, has collapsed.