As I have been telling anyone that I can buttonhole at drinks parties for some time, we are living in the age of Alice in Wonderland Economics.
Alice in Wonderland Economics is the weird world where investors, such as pension funds, pay to lend to governments which are crippled by debt. (Germany, Japan, Denmark and Sweden can raise new debt at negative interest rates.) It is a world where long-term yield curves are flat – so it costs the same for governments to borrow for 10, 20, 30 years as for three months. It is a world where increasingly scarce commodities fall in price, yet lack-lustre equities rise on flimsy earnings projections. A world where unelected central bankers call the shots and elected ministers of finance are virtually impotent (though they do love to re-arrange the deck chairs as the liner sinks – bless them). It is a world where interest rates (fixed at zero) have nothing to do with the equilibrium of savings and investments, as mainstream economic theory insists. It is a world where the chattering classes castigate austerity; yet where the budget deficit and the national debt only go up. A world in which countries – Britain at the forefront – borrow money from the international markets in order to give it out as “aid” to spurious consultants (I can tell you about consultants – I’m bloody one of them) while haemorrhaging money from our armed forces at a time of increasing geopolitical risk.
If you think economics is complicated (which it can be) then thank God you were buttonholed by me. Because it’s all incredibly simple really: we are drowning in a sea of debt. If you owe your bank manager £100, as the great Keynes said, you have a problem; but if you owe him £1 million, then he has a problem. Now imagine that everyone owes everyone else £1 million and you see that we are all in Tight Street.
The Credit Crunch of 2008 was ultimately something to do with the fact that Western banks went on binge lending sprees to people or weird synthetic entities (often rated AAA by the rating clowns) which could never pay the money back. The Chinese, who have been the motor of the world economy since the late 1990s, then decided to mitigate the effects of the slowdown by engineering a credit boom. That credit boom has now become a bubble. And the thing we all know about bubbles is that, eventually, they burst.
And when the Chinese bubble finally bursts, the major demand-pull factor in the world economy will suddenly slacken like a busted halyard. Just look at the impact of a Chinese slowdown from a level of 8 percent GDP growth to 6-or-so percent has had on Australia… The Ozzie Dollar fell precipitously last summer after perturbations on the Shanghai market (though it is actually now back to where it was a year ago vis-à-vis the Dollar and the Pound). Stocks in Australian miners which feed China’s appetite for natural resources have slumped. That’s just an amuse-bouche of what a real Chinese slowdown would be like.
Last month Fitch warned that “a remarkable build-up in leverage across China’s economy” made the current growth target of 6.5 percent “extremely challenging”[i]. While China’s national debt-to-GDP ratio stood at 55 percent (as against about 89 percent for Britain and around 75% – depending on how it is calculated – for the USA), the overall “true ”level of debt (including corporate debt) was closer to 250 percent of GDP. And credit is growing faster than GDP. Apparently, for every 1 yuan in Chinese growth nearly 5 yuan of new credit was required last year[ii]. That said, Fitch thought that a “hard landing” – where Chinese growth shrinks to nothing – was unlikely.
Moreover, Fitch thought that China’s banks at least were funded by retail deposits (thanks to a robust savings ratio – unlike in the US and UK). China kept it’s A+ rating with Stable outlook, but those curmudgeons couldn’t resist a parting shot: that “a sharp and sustained rise in government indebtedness would be negative”. Thanks guys: you can go now.
And just as we were thinking that Q2 2016 was turning sunnier than chilly Q1, the Institute for International Finance (IIF, based in Washington) has come up for air. It discerns a five-fold increase in corporate debt in emerging markets to US$25 trillion over the past decade. Add to that the manic junk bond issuance in the US and Europe over the same period where companies often raised new debt to buy back shares and/or to engage in M&A activity of questionable value added. (A sleight of hand surely only made possible by QE.) Meanwhile, capital spending declines. The IIF said that, for American corporates, the ratio of net debt to EBITDA had doubled from 0.7 in 2007 to 1.4 today[iii]. US corporates are continuing to borrow like crazy even though their profits peaked in 2014.
Meanwhile, the recovery rate on defaulted bonds has declined from 44 percent two years ago to 29 percent today. And yet, there are a relatively small number of top corporates which have oodles of cash – like Apple Inc. (NASDAQ:AAPL).
What is interesting is that the so-called emerging markets, which we thought were nothing if not cash-generative, are catching up with their indebted European and American peers as their relative advantage in terms of return on capital declines.
You might suppose that the debt figures for emerging markets are under-estimated, or at least that the headline figures for their banks’ non-performing loans (NPLs) are under-valued. Apparently, state-owned banks in China are being told “to evergreen” problem loans[iv] (by which I think is meant that they hold them without impairment indefinitely until the borrower finally croaks). It is interesting to note that two very different countries with a very similar problem – namely, Italy and India – are in the throes of reforming their inadequate insolvency regimes precisely because it is awkward for banks to write down loans if an insolvent borrower is not formally in some kind of judicial administration. The Reserve Bank of India (RBI) is ordering banks to clean up their books. Last month’s cut in the key RBI discount rate will not help a number of major Indian corporates who are being forced into fire-sales by their lenders[v].
I have written extensively in these pages about how, under the Cameron-Osborne pantomime horse, amid much tough talk of “cuts”, national spending just goes up as pensioners, and other paramilitary groups, are indulged – and yet Ms Sturgeon and co. shriek endlessly about “austerity”. But actually, it seems that, in this malady at least, Britain is not alone. Excessive debt and obsessive-compulsive government spending have become an international plague.
The roots of this problem are complex but I think most commentators would agree that they grow out of our woefully inadequate international monetary system – one that has been further de-stabilized by the shenanigans in the Eurozone, which can only get worse. (I won’t repeat some of the points arising from my review of Lord King’s book in the April edition of MI magazine – but people like King are on the case). And I have to say that I am coming to one of those junctures where I might actually have to change my mind.
I have always been anti-gold. As I asked Jim Mellon recently: “Why would any investor want to hold an asset with significant cost-of-carry and no return stream?” But I am finally coming to see that gold is an insurance policy in a world that might soon sink into negative growth and deflation under the unsustainable weight of its own debt. Quite how best to get exposure to gold will be the subject of a future reflection.
There’s a Japanese proverb which goes something like: a prince [or a writer for that matter] has the right to change his mind. Alice in Wonderland Economics is where we are. But I now see a crock of gold at the end of the rainbow.
[i] Daily Telegraph, 07 April 2016, page B4. Article by Szu Ping Chan.
[ii] As explained by Jim Mellon in his address to the Master Investor Show on 23 April. His slides can be downloaded from the MI website.
[iii] See Banking Watchdog warns of new debt bubble, by Ambrose Evans-Pritchard, Daily Telegraph Saturday, 07 May 2016.
[v] See: India hopes push to rid banks of bad loans will shift balance of power, Financial Times page 32, 13 April 2016, by Henny Sender.