Five years after the collapse of Lehman and six years since the beginning of the financial crisis, following a debt-financed credit boom, we want to have a closer look at the leverage of the global economy. We want to answer the following questions: Which countries and which economic sectors are most advanced in the deleveraging process? Are there any lessons to be learned from previous periods of post-bubble deleveraging? Which conditions for solid economic growth during a period of deleveraging have to be fulfilled? What are the implications of deleveraging for capital markets? Has easy monetary policy in the developed world led to the build-up of leverage in other parts of the world? Throughout this article, we define leverage as the ratio of funded gross debt/GDP (gross domestic product); we opt for gross debt, as opposed to net debt, as it is gross debt that ultimately has to be served and is precisely known, while asset values are not fixed by definition.
Let us start with some fact finding. Total non-financial sector debt/GDP in the developed world is currently in the range of two to four times GDP, with Germany, Australia, and Canada at the bottom end of the list, and Japan, Ireland and Portugal at the top end (Figure 1). If we undertake a more detailed breakdown, we find a wide range in public debt/GDP ratios: in Australia, Korea, Norway, Switzerland and Sweden, public sector leverage is less than 50 per cent of GDP; in EMU (European Monetary Union) core countries, the figure is between 70 per cent and 90 per cent. However, by far the highest public debt/GDP ratios can be observed in Japan, which records a number close to 250 per cent. If we included estimated non-funded health and pension liabilities, sovereign debt ratios in the developed world would rise by around 100 per cent of GDP on average. When analyzing the private sector leverage ratios, we notice that household sector leverage is, on average, significantly lower in the euro area compared to the Anglo-Saxon world, while the opposite holds true for the non-financial corporate sector.
Leverage ratios have picked-up since the beginning of the crisis in 2007 in almost all countries. Nevertheless, total non-financial debt/GDP ratios have come off from peak levels observed during the past few years in the US, UK, Ireland, Germany, Netherlands, Spain and Japan. Deleveraging, though, is hardly taking place in the public sector. The one country where public debt/ GDP has fallen most is Greece, as many investors have learned the hard way. The situation is different for the private sector: both household and non-financial corporate sector leverage ratios have started to come down recently in most developed economies, in particular in the US, but also in the UK, Ireland and Spain (Figure 2). In France, Portugal and Switzerland leverage still continues to rise. The same holds true for Canada, one of the few countries to have avoided a financial crisis. Still, compared to previous periods of post-bubble deleveraging, the decline in debt/GDP ratios in the private sector is moderate. In the US, the country where, compared to starting levels, debt/GDP has fallen the most, leverage ratios have come down by a tenth only. In comparison, in the Nordic countries during the early 1990s, the private debt/GDP ratios fell by around a quarter, and in Asia in the late 1990s/ early 2000s they fell by a third on average. Hence, it is fair to say, that the deleveraging process in the developed world is still in early stages (indeed it has not even started in some countries, as mentioned above) and is likely to continue.
There are some more interesting lessons that we can draw from previous post-bubble deleveraging periods for today. First, once a debt-financed bubble bursts, the economy recovers after around two years. Its long-term new trend growth is very much dependent on the way deleveraging is being achieved. If debt ratios come down via public and private sector “belt-tightening”, i.e. savings, the new trend growth is typically – albeit not always, as the Nordic countries in the 1990s showed – lower than before the crisis.
Second, the private sector credit cycle only picks up after a couple of years into the deleveraging process. In other words, the economic recovery is typically a creditless or credit-light one. Third, public sector deleveraging is a very long-term process and usually ends many years after the private sector has stopped deleveraging. Finally, and most important from an investor point of view, asset markets turn long before the deleveraging is complete. Hence, arguing that too much debt is weighing on asset prices is misleading. We will discuss this in more detail.
With deleveraging in developed economies today very much happening via public sector spending cuts and a rise in the private sector net savings rate, are we doomed to enter a period of new trend growth lower than before 2007? How did the Nordic countries manage to return to relatively strong economic growth after a few years? We think that, for economic activity to remain strong after a debt-financed asset bubble bursts, nine criteria have to be in place: monetary policy support, strong private sector cash positions, a turn in the capital expenditure (capex) cycle, a stabilization of the housing market and the banking system, growth enhancing structural reforms, progress in private sector deleveraging, low public sector debts and strong demand from abroad, also supported by a weak currency.
At this juncture, monetary policy is, no doubt, highly accommodative in all industrialized economies and, hence, provides a positive backdrop for economic growth as it reduces the cost of capital and provides enough liquidity for the banking system. Also, since the private sector, both households and non-financial corporates, is running a positive net savings rate again, it could spend out of cash flow and need not rely on new debt. Consequently, investment activity has started to pick-up in the US, albeit only moderately so. After years of underinvestment, both in the US and in Europe, we expect at least some pent-up demand for investment spending, which should support investment activity going forward. The housing market has turned the corner in the US and UK, too. In the euro area, house prices continue to decline except in Germany, which did not suffer from a housing bubble in the first place. However, prices have already fallen substantially, especially in countries like Ireland and Spain where they have declined by more than a third in real terms, i.e. by more than during other deleveraging periods in the past. Given how advanced the house price declines are already, we may see a stabilization in housing markets in the euro area as well during the coming quarters. A stabilization in house prices would be a further support for the healing of the banking sector. In any case, we think the banking sector recovery is quite advanced in the US and on a good track in Europe: according to loan officer and lending surveys, stress in the financial system is no longer a major constraint for credit supply. Finally, in many European countries, structural reforms are leading to an improved international competitiveness, i.e. lower unit labour costs (France and Italy are the major exceptions to the rule). As pointed out, private sector deleveraging is work in progress.
In conclusion, we can make a tick – at least a small one – next to seven out of the nine criteria, which we deem to be relevant for the future growth outlook. There are two criteria, however, which suggest an ongoing headwind to economic growth: first, public sector debt ratios are high. There is ample academic work showing a negative correlation between public sector leverage and economic growth, with 90 per cent debt/ GDP being an important threshold level (even the critics of the Reinhart & Rogoff studies came to the same conclusion). Correlation is not the same as causality. Nevertheless, with developed economies trying to implement fiscal austerity measures, we think that, at this juncture, fiscal policy is definitely having a negative impact on economic growth. The situation was different twenty years ago in Sweden, Finland and Norway. At the time, public leverage ratios were significantly lower than in most developed economies today (<80 per cent in Sweden and <60 percent in Norway and Finland at peak levels), giving all three governments more scope to manoeuvre.
Second, unlike small open economies, which went through a deleveraging period, neither the US nor European countries today can rely only on foreign growth stimulus, thereby also benefiting from currency devaluation. As around half of the world – the industrialized economies – need to reduce total leverage, the effects of monetary policy in their jurisdictions on their respective currencies to some extent cancel each other out. Just look at the EUR/USD exchange rate over the last years: it has been hovering at around 1.30 to 1.35. In real terms, neither the US dollar nor the euro has depreciated. In contrast, the Nordic countries in the 1990s managed to devalue their respective currencies by around a quarter in real terms, while Asian currencies, on average, devalued by around a third during their crisis (Figure 3). In addition, the other half of the world, the emerging markets, are currently slowing down for various reasons (revaluation against the Japanese yen, export growth slowdown as developed economies are showing growth weakness, tighter monetary policy dampening domestic demand). Hence, this group of countries can hardly be the locomotive for exports out of industrialized economies.
In conclusion, we think that trend growth in the developed world will remain moderate and below the pre-crisis period. On the other hand, we should not expect too gloomy a growth path either, as several conditions for decent growth are in place. Intuitively, one would expect equity returns to be weak during a period of deleveraging, as investors anticipate low growth in the years to come. In reality, equity returns and the relation between leverage and equity returns are much more complex, as US data show: investors who entered the equity market in the late 1920s or early 1930s, i.e., during a period of high total debt/GDP ratios, indeed had very poor, often negative rolling 10-year equity returns when adjusted for inflation. In the 1960s and 1970s, though, when total leverage ratios were low, long-term equity returns were poor as well. In the 1990s, however, a period when debt/GDP ratios were similar to those in 1930, rolling 10-year real equity returns were very strong. Hence, what matters for equity returns is not so much the overall leverage in the economy, but other factors, notably valuations and the medium-term growth outlook. Growth, as explained above, is likely to be “pedestrian”, albeit not overly gloomy, in the years to come in the developed world. Valuations, based on our preferred valuation measure, Shiller price earnings, suggest that global real equity returns could at least be at long-term average levels (above long-term average in Europe, below average in the US). In sum, we are likely to see long-term real equity returns close to average in developed markets. The composition of total equity returns may change, though. If the past is a guide for the future, we should expect price earnings multiples to be, on average, lower during a period of deleveraging than during periods of leverage increase. This implies that total equity returns will depend more on dividends and earnings growth rather than on multiples expansion – price earnings ratios may even contract.
While a large part of the developed world has started to deleverage, in some countries debt/GDP ratios have actually increased since the burst of the bubble. In some euro-area countries, notably France and Portugal, this is because of a weak economy and insufficient belt-tightening so far. However, this trend of rising leverage ratios is the result of lax monetary policy in conjunction with strong capital inflows from abroad in other countries, notably in the emerging world. With monetary policy in the developed world being ultra-loose since the burst of the bubble, capital has been flowing to higher yielding markets in fast growing economies, thereby stimulating credit growth in the region. There, central banks have been unable – to some extent unwilling – to lean against the rapid increase in leverage and, as a consequence, there has been a sharp rise in housing prices. As a result, private sector debt ratios in China, as well as in Hong Kong and Singapore, are now at levels observed in other economies on the eve of a financial crisis. In addition, as history shows, it is not only the level of debt that matters, but also the pace of debt increase: The faster the debt build-up, the higher risk of overheating. Looking at the deviation of debt/GDP from the long-term trend (i.e. the credit-to-GDP gap) as one measure of excess credit, the same three economies are sending a warning signal (Figure 5).
Clearly, only the minority of credit booms end in a crisis. In many cases – especially when the starting point of leverage was low, as is typically the case of fast growing economies – the final outcome is a “benign” one. In addition, authorities in the three countries, especially in China, have various tools and the means to intervene if necessary. Nevertheless, we clearly have to monitor developments in emerging economies, in particular in the three mentioned countries, very closely going forward, as we cannot rule out that these economies are overheating, just as the developed world did in the middle of the last decade.