| Welcome to Schwab | Investment Products | Research & Strategies | Advice & Retirement | Active Trading | Banking & Lending |
|
 Call us at 866-232-9890  Send us an email |
| Welcome to Schwab | Investment Products | Research & Strategies | Advice & Retirement | Active Trading | Banking & Lending |
|
Call us at 866-232-9890Send us an email |
|
On Strategy Liz Ann Sonders Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc. February 1, 2010 Key points
Throughout the past year, although I've been very optimistic about both the economy and the stock market, when asked what concerns me most, my answer has been consistent: debt. As you can see in the table below, which is broken out by decade, it took $1.36 of debt to create $1 of economic growth during the 1950s. The acceleration began in the 1960s and 1970s with the Vietnam War and the "Space Race," and continued in the 1980s and 1990s with the leveraged buyout boom and the Internet bubble. Fast-forward to the most recent decade (through September of last year) and it's taken nearly $6 of debt to create $1 of economic growth. This is clearly not sustainable, and is a threat to the long-term stability of the US economy. Unsustainable debt growth
I'm a big fan of the work of economists Carmen M. Reinhart, of the University of Maryland, and Kenneth S. Rogoff, of Harvard University. They're the authors of a new book, "This Time Is Different: Eight Centuries of Financial Folly" (Princeton, 2009), which I've just begun to read. It highlights what happened in more than 250 historical crises in 66 countries, and it's a fascinating read. They also recently published a paper titled, "Growth in a Time of Debt," which looks at the relationship between debt and growth/inflation among 44 countries during the past 200 years. 90% … the tipping point "Growth in a Time of Debt" main findings:
Higher debt, lower growth
Human nature is constant If you read Reinhart and Rogoff's works, you'll likely find their conclusion sums things up perfectly, especially in today's environment: There's always a temptation to stretch the limits within a financial system; yet greed and politics will often conspire to cause the system to collapse under its own weight. Human nature doesn't change much, nor does the ability of humans (including politicians) to delude themselves. Complacency often becomes rampant … then it can get wiped out in a speck of time with a trigger event (like Lehman Brothers' demise). The span between euphoria and despair is often short and almost always painful. Confidence can be very, very fickle. Like this article? Listen to Liz Ann's related audio.  Recorded February 1, 2010 Public debt high … total debt stratospheric The United States' public debt-to-GDP number is high (84%) and rising (set to jump to more than 90% this year). We're not the worst though; there are a couple of countries with even higher figures: Japan (182%) and Greece (119%). If you look at total credit-market debt (not just government), the numbers are really glaring. According to a recent McKinsey Global Institute report, US total debt doubled from 2000 to 2008, from $26 trillion to $53 trillion, and rose again in 2009. This represents more than 370% of US GDP—the highest since the Great Depression, when it reached 260%. US total debt skyrocketing  Click to enlarge Source: Ned Davis Research, Inc., as of September 30, 2009. But on this metric, we're in "good" company: The United Kingdom's total debt-to-GDP is a whopping 470%, Japan's is 460%, Spain's and South Korea's are 340%, Switzerland's is 315%, France's and Italy's are about 300%, Germany's is 275% and Canada's is 245%. These are all records. The "BRIC" countries (Brazil, Russia, India and China) all have total debt-to-GDP under 160%. However, since this study ended in 2008, we have to add in China's stimulus package, which was three times the size of the US package, not to mention China's banks lending out $1.3 trillion during 2009. Some believe China could now be more leveraged than the United States. What's the problem? When debt becomes excessive (whether in the private or public sector's hands), countries can no longer grow their way out. Instead, they must begin the painful process of deleveraging. Regardless of the cultural, political, educational or demographic differences among countries, the economic consequences of over-indebtedness among countries have been remarkably similar. According to Reinhart and Rogoff, government actions (even when sizeable) are typically less helpful than they might appear. Trying to solve a debt problem with more debt has not been a successful strategy. A burning question the book and the paper both attempt to answer is whether debt crises are inflationary or deflationary. The general consensus (based on my own queries and investor feedback) is that they're inflationary. However, according to the authors, the norm is that major economic contractions accompanied by debt crises are deflationary. This remains my view, and I believe the risk of a sharp rise in inflation is presently very low. Aside from the aforementioned conclusion of the study, inflation tends to fester when the "velocity of money" is rising. Indeed, the Fed has pumped a massive amount of liquidity into the financial system; but due to weak demand and supply constraint, it's not getting into the real economy through a pick-up in lending. Also absent are rising wage pressures, rising capacity utilization and rising unit labor costs, all of which are typically present when inflation risk is rising. What's the solution? Historically, when a country's total debt rose to unsustainable levels, it typically debased its currency in the interest of boosting exports and "creating" rapid economic growth. This becomes more treacherous and less likely when multiple nations are trying to do the same thing. Nations have also been saved in the past from post-war "peace dividends," like in the United States following World War II. Not only are the wars in Iraq and Afghanistan not over, they're unlikely to offer the kind of peace dividend our economy received after World War II. Countries can also attempt to inflate their way out of the crisis. Reinhart and Rogoff found this to be the case in about one-third of the countries they tracked that had currency depreciation rates above 15% a year. This only works for debt denominated in the home currency, and only if the inflation comes quickly and unexpectedly. If investors are forewarned, they will price the inflation into yields. US private-sector deleveraging has begun There is a little good news. Since the crisis started, US private-sector debt has declined sharply while financial sector leverage has also fallen dramatically. But it's been offset by the upward spiral in public debt. Deleveraging is happening, but most of it remains to come. Private-sector deleveraging, public-sector leveraging  Click to enlarge Source: FactSet and Federal Reserve as of September 30, 2009. Three choices McKinsey suggests three options for getting us out of this debt crisis: outright default, inflation or belt-tightening. We believe the likelihood of outright default is extremely low. A little inflation might not be a bad thing but, as noted, the conditions for its emergence in a significant way remain absent. That leaves belt-tightening. The Obama administration's announcement of a spending freeze might be a step in the right direction, but it's a very, very small step. PIMCO's Bill Gross recently wrote that the most vulnerable countries faced with the biggest debt burdens represent a "ring of fire," in which the United States resides. Spending restraint to date is nothing more than a few ice cubes thrown at the debt bonfire. Much more will be needed, including sheer will. The private sector has begun … the public sector, not yet. Important Disclosures The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. (0210-1027) Return to Top |
Subscribe to Liz Ann Sonders
Receive Schwab's latest market analysis via email:
| |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Facebook
LinkedIn
Twitter
Digg
