Dear All,
The latest Steen's Chronicle – on the old chestnut of debt again and why a Minsky moment could be getting closer. Pretend-and-extend is still the playbook prefered as we will hear and see from ECB this week, but the return on debt financed assets is now close to returning marginal loss' due to compressed spreads, complacency and simple ignorance.
My main position remains the same: Major markets yields will go to new lows in Q2-2015 followed by big move in inflation and growth into 2016. For that to happen a Minsky moment (or a war) needs to happen. Good luck this week.
London, 26 September, 2014
Debt - The Elephant in the Room
By Steen Jakobsen
'Interest on debt grows without rain' – Yiddish proverb
This proverb explains most of what goes on in policy circles these days. We are now watching Extend-and-Pretend, Episode VI: Promises for improvement amid ever growing debt levels.
Short put, we're still working with the same dog-eared script we were introduced to all of five years ago, when markets had stabilized in the wake of the financial crisis: maintain sufficiently low interest rates to service the debt burden. Pretend to have credible plan, but never address the structural problem and simply buy more time. But while we were able to get away with this theme for an awfully long time, the dynamic is now changing as the risk of low inflation (and even deflation) is a brick wall for the extend-and-pretend meme. Yes, interest does grow without rain, and the cost of maintaining and servicing debt grows especially fast in a deflationary regime.
Mads Koefoed, Saxo Bank's macro economist projects US growth at around 2.0% for all of 2014. That will be the sixth year with US growth near 2.0% - so despite lower unemployment, despite a record high S&P500, the economy has a hard time escaping that 2.0% level. Any talk of higher interest rates is hard to take seriously when US growth is going nowhere and world growth is considerable weaker than expected in January or as recently as July, for that matter. It seems everyone has forgotten that even the US is a part of the global economy.
The fourth quarter is always the most politically interesting time of year. Countries need to get their new budgets in order. The EU, IMF and World Bank will need to pretend they agree or accept the weaker data, which has to mean bigger deficits. It's a tiresome exercise to watch denial-in-action as EU governments and other policymakers try to make something so obviously unpalatable go down easy in their internal reporting. It's obvious that buying more time (extending) is always the number one priority, followed by projecting (pretending) the forward looking growth will reach an ever higher trajectory in order to make the budget fit within the supposed constraints. Or in France's case, the recent unilateral abandonment of meeting budget targets for the next two years is already a fait accompli.
Who's next?
Such behavior would cost you your job in the private sector, but in the economic model of 2014, which reminds us more of Soviet Union than a market based economy, its par for the course. But, many would protest, it would be even worse if we hadn't done so much to "save the system", right?
Well maybe, except for the fact that those economies where belief in State Capitalism is strongest: Russia, China and France, are all at the end of the line. Time has caught up. Negative productivity, capital flight and a system built on protecting the elite is failing. France is now moving from recession to depression. China is moving quickly from denial towards a mandate for change, Russia's future has not looked this bleak since the late 1990's. Meanwhile the US continues on sluggish 2.0% growth. Investors and pundits seem to have forgotten that we were promised 2014 would be the end of the crisis. Instead, we are speeding towards the inflection point at which debt becomes harder to service because pretend-and-extend policy making have created a depression in investment and consumption.
The public debt loads continue to inflate across Europe: Portugal's public debt has ramped to a staggering 130% of GDP – up from about 70% in 2007. Greece's public debt load, even after the restructuring of Greek debt a few years ago, has swelled to 175% of GDP. The EU now has far more systemic risk than at the beginning of the crisis. With zero growth or as our economist Mads sees it, 0.6% with the arrow pointing down, debt levels continue to rise relative to GDP. And most importantly, the current flirt with deflation will make servicing the growing debt even more expensive. The nightmare for ECB and world is deflation as it's a tax on debtors and a boon to net savers. The new reality is that we currently stand face-to-face with the very deflation risk that just about everyone denied could ever happen when Q1 outlooks were written.
Two other global threats, or time bombs, if you will, outside of the EU are risks from the growing costs of servicing debt in China and the USA. In China, the governments national and local have piled up considerable debt, but it is the overall debt service costs in all of China that are the real concern, which have only grown so large with the dangerous assumption by Chinese banks, companies and citizens that they can count on a public bailout. According to a Societe Generale analyst, total debt service costs (including maturing debt and roll overs) in China area at nearly 39% of GDP. Compare that with the closer to 25% of GDP for the USA in 2007.
In the US, interest on US government debt cost over 6% of budget outlays in 2013. This is relatively down from its worst levels when interest rates were much higher, but only because FOMC has so drastically lowered the costs for the US government to issue debt with a zero interest rate policy. And now the debt load is vastly larger than it was before the financial crisis – at 80% of GDP (net debt according to IMF) versus 45% of GDP a mere 10 years ago. So are we actually to believe that the Fed can lift the entire front-end of the curve from 0-1% (current rates out to three years) to 2-4% over the next two years without massive further stress on the deficit and only adding to the debt? Servicing 2% interest when growth is 2% means you are doing worse than standing in place if you also have a budget deficit.
Whatever the timing, the USA, China and Europe are all headed for another Minsky moment: the point in debt inflation where the cash generated by assets is insufficient to service the debt taken on to acquire the asset. The US productivity growth last year was +0.36%. The real growth per capita was about 1.5%. Anything which is not productivity is consumption of capital. So, the only way to grow an economy without productivity growth is temporarily with the use of debt – about 75% debt and 25% productivity growth in this case.
Since the 1970s, US productivity growth rates have fallen 81% - the move onto the internet has ironically made us bigger consumers and less productive. Had we remained at pre-1970s productivity, the US GDP would have been 55% higher and the outstanding debt to GDP would be easily fundable.
I just returned from Singapore on business – Singapore, to me, used to be the most rational business model around. Its founder Lee Kuan Yew was one of the greatest statesmen in history. Now, productivity is collapsing in Singapore. They are, like us, becoming the Monaco of the world, an economy based on consumption and not on productivity and growth. The developed economies are growing old in demographic terms, but we're still not wise enough to realize that our current model is a Ponzi scheme rushing toward its inevitable Minsky moment. No serious policymaker or central banker is talking about the truth told by simple maths and hoping that things turn out well. Hope is not good policy and it belongs in church, not in the real economy.
This paper was prepared for Saxo Capital Market's Media Round Table in London on Friday, 26 September, 2012.
Med venlig hilsen | Best regards
Steen Jakobsen | Chief Investment Officer
Saxo Bank A/S | Philip Heymans Allé 15 | DK-2900 Hellerup
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