Global Economic Overview (Brexit, China, Screwflation, Humility, Patience... )
By Vitaliy Katsenelson, CFA
The following is an excerpt from Investment Management Associates’ second-quarter letter to investors (also published on Institutional Investor)
In this letter we are taking up the ambitious goal of painting a picture of the global economic landscape as we see it, in order to walk you through the investment process that we been fine tuning for this less-than-exciting picture.
The Answer Is Not in Your Econ Book
The Great Recession may be over, but seven years later we can still see the deep scars and unhealed wounds it left on the global economy. In an attempt to prevent an unpleasant revisit to the Stone Age, global governments have bailed out banks and the private sector. These bailouts and subsequent stimuli resulted in swollen global government debt, which jumped 75% from $33 trillion in 2007 to $58 trillion in 2014. (These numbers come from a recent McKinsey study on global debt. They are the latest numbers we have, but we promise you they have not shrunk since.)
A lot of things about today’s environment don’t fit into economic theory. Ballooning government debt should have brought higher – much higher – interest rates. But central banks bought the bonds of their respective governments and corporations, driving interest rates down to… well, today a quarter of global government debt “pays” negative interest.
The concept of positive interest rates is straightforward. You take your savings, which you amass by foregoing current consumption – not buying a newer car or making fewer trips to fancy restaurants, and lend them to someone. In exchange for your sacrifice you receive interest payments.
With negative interest rates something very different happens: You lend $100 to your neighbor. A year later, the neighbor knocks on your door and with a smile on his face repays that $100 loan in full by writing you a check for $95. You had to pay him $5 for foregoing your consumption of $100 for a year. This is what negative interest rates are! Try to explain this logic to your kids. We tried to explain it to ours and failed, miserably.
The key takeaway is this: negative and near-zero interest rates show central banks’ desperation to avoid deflation, and more importantly they highlight the bleak state of the global economy.
In theory, low and negative interest rates were supposed reduce savings, get consumers off their butts, and stimulate spending. In practice the opposite has happened – the savings rate has gone up. As interest rate on their deposits declined, consumers felt that now they had to save more to earn the same income. Go figure.
Some countries resort to negative interest rates because they want to devalue their currencies. This strategy suffers from what economists call the fallacy of composition – the mistaken assumption that what is true of one member of a group is true for the group as a whole. As a country goes to negative interest rates, its currency will decline against others – arguably stimulating its export sector (at the expense of other countries). But there is absolutely nothing proprietary about this strategy: other governments will do the same, and in the end all will experience lowered consumption and a higher savings rate.
The following point is so important we want to repeat it, bold it, italicize it, and underline it: If our global economy was doing great, interest rates would not be where they are today!
As We Zoom in Things Get Worse
Let’s start with Europe, the world’s second largest economy. European political (EU) and monetary (EMU) unions were great experiments that made a lot of sense on paper. Europe, which had roughly the same size population and economy as the US, was at a competitive disadvantage, as dozens of currencies embedded extra transaction costs in cross-border trade, and each currency separately had little chance to compete with the US dollar for reserve currency status.
There were also important noneconomic considerations. Germans were haunted by their past; they had started two world wars in the 20th century, and a united Europe was their way of lowering the chances of future European wars.
EMU sounded like a very logical marriage of all the significant powers of post–World War II Europe. But the arrangement was never really a marriage; it was more like a civil union. EMU members combined their currencies into one, the euro. They agreed to use the same central bank and thus implicitly guaranteed one another’s debts.
Though treaties put limits on budget deficits (limits that, ironically, Germany was the first to exceed), each country went on spending its money as it wished. Some were relatively frugal (like Germany); others (Portugal, Ireland, Italy, Greece, and Spain) went on spending binges like newly hitched college students who had just gotten their first credit card, with an irresistibly low introductory rate and a free T-shirt.
The European Union is a collection of states that are vastly different from each other. They are separated by culture, language (which impedes labor mobility resulting in semi-permanent labor productivity disparity between countries – think Greece and Germany), economic growth rate, total indebtness, and history. (Germany, for instance, suffered through hyperinflation in the early twentieth century and is thus paranoid about inflation.)
Now let’s turn to Brexit – the UK referendum on exiting the EU. Ironically, the UK doesn’t have half the problems that most EU nations are going through. Since it is not part of the European Monetary Union, it has retained its currency and its central bank.
The UK’s main dissatisfaction with EU membership is due to the immigration issue. Since treaties have turned the EU into a borderless union, when Germany accepted refuges from Northern Africa it basically made a unilateral decision on behalf of all EU members to accept those refuges to all EU countries. High unemployment, wage stagnation, and Muslim terrorism are now endemic in the EU, and you can see how the UK citizenry might have a problem with this.
After the Brexit vote, the financial media lit up with opinions on its consequences for the EU and global market economy. They’ve varied from “Brexit is a non-event” to “This is a Lehman moment for the global economy” (referring to Lehman Brothers going bankrupt and almost bringing the financial system to a halt in 2008). The arguments on both sides are quite convincing:
The argument for Brexit being a non-event is simple and straightforward. The UK maintained its currency; thus dis-joining the EU will bring lower complexity. The UK and EU will forge new trade treaties. There is a fear that the EU may impose trade sanctions on UK, not so much to punish the UK as to threaten other EU members that exit will come at a stiff economic cost (effectively turning this voluntary club into a prison). However, the UK is a net importer of goods from the EU; thus any sanctions will hurt remaining EU members more than the UK.
Of course, the UK may never exit the EU. The referendum was not binding; it was there to measure the temperature. The new prime minister may decide to ignore the will of the people and remain in the EU.
The Lehman moment argument is less simple, but it is not unimaginable either. Brexit may provide a spark that will ignite already gasoline-soaked ground. Though the EU and EMU were supposed to unite Europeans, they may have had the opposite effect – they may have caused a groundswell of nationalism.
In all honesty, we are concerned more about Italy than the UK. Italy is the third largest economy in the EU and the second most indebted one. Its debt to GDP stands at 132% (Greece is at 171%). Seventeen percent of Italian bank loans are non-current. In the depths of the financial crisis, that number was 5% in the US. Italian lenders account for nearly half of bad debt in the EU (source WSJ).
If Italy was not part of the European Monetary Union (EMU), it would just print lira and bail out its banks. But it gave up that luxury when it joined the EMU. To make things worse, in 2014 the EU passed a law that prohibits governments from bailing out their banking systems; thus the shareholders, debtholders, and depositors may bear the brunt of the eventual bailout. Unless the EU passes a new law that bends the 2014 law – or the Italian government takes matters into its own hands, violating the EU charter – we may see Italian debtholders and depositors hit with the cost of bank bailouts take to the streets and demand “Italexit.”
Nationalism is a highly emotional, zero-sum, us-against-them sort of business. Add immigration concerns on top of economic ones and it’s not hard to see how Europe has turned into a highly combustible mixture looking for a match. And since emotions are often anti-logical, future decisions by EU countries may not necessarily be beneficial to the European continent.
Since the situation in Europe is so complex and combustible, we don’t know whether Brexit will be just another match that simply burns out or the one that starts the fire. Will it trigger other exits? Will it slow down EU growth, thus straining an already leveraged system? We don’t know, and nobody does.
China is the third largest economy in the world and is living through the largest debt bubble we probably we’ll ever see in our lifetime. From 2007 to 2014 its debt quadrupled from $7 to $28 trillion (according to McKinsey). Over the same time period its economy tripled, growing from $3.5 to $10.5 trillion. These numbers are staggering, and they point to one indisputable fact: all Chinese growth since 2007 came from borrowing. There was no miracle in it.
But it gets worse, much worse. The numbers also show that every $1 of new debt brought only cents of GDP growth.
In the absence of skyrocketing debt, the Chinese overcapacity bubble, which was already fully inflated pre-2007, would have burst years ago.
As the government continues to engineer growth using debt, every yuan of debt will bring less growth. The laws of economics have not been suspended in China. American economist Herbert Stein’s law states that things that cannot go on forever, won’t. When its debt bubble bursts, China will turn from being a tailwind for global growth into a headwind.
This brings us to the world’s fifth largest economy, Japan. It is the most indebted developed nation in the world – its debt to GDP is over 230%. Japan is the proof of Herbert Stein’s law – its economy is still suffering a hangover from what at the time seemed an endless real estate party (bubble) that lasted from the mid ’80s into the early ’90s. Japan has been on the QE and endless stimulus bandwagon longer than anyone else and has nothing (well, except a lot of debt) to show for it.
Japan also has the oldest population in the world – 26% of its population is older than 65 (in contrast to the US, where the figure is only 15%). Rising debt and an aging population are a double negative for the economy, as debt per capita is rising at an even faster rate than total debt. And since the working population is declining at an even faster rate than the population, debt per working person is growing at an even faster rate.
From what we just told you, you might think Japan is paying the highest interest rates in the world, somewhere in the high teens. Wrong! The Japanese ten-year bond yields negative interest.
We just spilled a lot of digital ink to give you a brief overview of what we see around the world. We did not do it to increase your consumption of alcohol or anti-anxiety medicine.
We did it for a few reasons. First, we wanted to show you that stock market performance has not been driven by the improving health of the global economy. Just as negative interest rates are not a positive for the continued health of the economy, nor does current stock market performance augur rosy future returns for stocks. In fact, the opposite is true. The bulk of the stock market gains are due to one variable: the expansion of the price-to-earnings ratio. S&P 500 earnings have stagnated since 2014.
Stock prices have gone up because the Federal Reserve and other central banks have squeezed all investors to the right side of the risk curve. Stocks, and especially high-quality ones that pay dividends, are looked upon as bond substitutes. Investors now look at the dividends of those stocks and compare those yields to what they can earn in Treasuries. This strategy will end in tears, as these bond-substitute stocks are significantly overvalued (see Coke example further on).
Secondly, we wanted to show you the headwinds we are facing and what we are doing to avoid having them deflate the sails of your portfolio. Summarizing, these headwinds are:
The risk of lower or negative global economic growth. If we get higher economic growth, we’ll treat that as a bonus.
Something-flation. Inflation (high interest rates), deflation (low interest rates) or screwflation (higher interest rates and deflation). We don’t know which of these extremes we’ll see and in which order. Nobody does. Despite their eloquence and portrayed confidence, financial commentators arguing one or another extreme point of view on CNBC don’t know, either. In fact, the more confident they are more dangerous they are. The difference between us and them is that we know we don’t know and are therefore trying to construct an “I don’t know” portfolio that can handle any extremes.
And finally, stock valuations will decline.
This is a time for humility and patience. Humility, because saying the words “I don’t know” is difficult for us testosterone-laden alpha male money manager types.
Patience, because most assets today are priced for perfection. They are priced for a confluence of two outcomes: low (or negative) interest rates continue to stay where they are (or decline further) and above-average global economic growth. Both happening at once in the future is extremely unlikely. Take one of them away (only one!) and stock market indices are overvalued somewhere between a lot and humongously (we don’t even try to quantify superlatives).
Take both away and…
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley).
His books were translated into eight languages. Forbes Magazine called him "The new Benjamin Graham". To receive Vitaliy’s future articles by email or read his articles click here.
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