Policymakers have been striving to answer it in the affirmative ever since Lehman 2008 with an assorted array of bazookas and popguns: 0% interest rates, sequential QEs with a twist, and of course now the EU grand plan with its various initiatives involving debt write-offs for Greece, bank recapitalisations for eurozone depositories and the leveraging of their rather unique “EFSF” which requires 17 separate votes each and every time an amendment is required.
What a way to run a railroad. Still, investors hold to the premise that once a grand plan is in place in the eurozone and for as long as the US, UK and Japan can play scrabble with the 10-point “Q” letter, then the markets are their oyster. Not being one to cast pearls before swine or little eurozone PIIGS for that matter, I would tentatively agree with one huge qualifier:
As long as these policies generate growth.
All eyes on growth
Growth is the elixir that seems to make every ache, pain or serious ailment go away. Sovereign debt too high? Just grow your way out of it. Unemployment rates hitting historical peaks? Growth produces jobs. Stock markets depressed? Nothing a lot of growth wouldn’t cure. But growth is the commodity that the world is short of at the moment. No country has enough of it – not even China – and many of the developed countries (specifically in the eurozone) seem to be shrinking into recession.
The lack of growth, as explained in prior outlooks over the past few years, is structural as opposed to cyclical, and therefore relatively immune to interest rate or consumption stimulative fiscal policies. Globalisation, technological innovation, and an ageing global demographic have all combined to dampen policy adjustment post Lehman and will inexorably continue to work their black magic going forward.
The situation, of course, is compounded now by high debt levels and government spending that always used to restart capitalism’s private engine. However, as economists Rogoff & Reinhart have shown in their historic text, This Time Is Different, sovereign debt at 80-90% of GDP acts as a barrier to growth because debt service and interest rate spreads start to rise at these debt levels, a greater and greater percentage of a nation’s output must necessarily be diverted to creditors who in turn become leery of reinvesting in a slowing economy.
The virtuous circle becomes vicious in its reflexive counter reaction, spiralling into a debt/liquidity trap á la Japan’s lost decades if not stopped in time.
Halting the downward maelstrom is what current monetary policy is attempting to accomplish. With fiscal policy in most developed countries incredibly restrictive instead of stimulative, central banks have assumed the helm on their own – but it has been a long and relatively futile watch. Structural growth problems in developed economies cannot be solved by a magic penny or a magic trillion dollar bill, for that matter.
If globalisation is precluding the hiring of domestic labour due to cheaper alternatives in developing countries, then rock-bottom yields can do little to change the minds of corporate decision makers. If technological innovation is destroying retail book and record stores, as well as theatres and retail shopping centres nationwide due to online retailers, then what do low cap rates matter in terms of future store expansion?
If US and eurozone boomers are beginning to retire or at least plan more seriously for retirement, why will lower interest rates cause them to spend more? As a matter of fact, savers will have to save more just to replicate their expected retirement income from bank contract for differences or Treasuries that used to yield 5% and now offer something close to nothing.
Debt creation not the answer
My original question – “Can you solve a debt crisis by creating more debt?” – must continue to be answered in the negative, because that debt – low yielding as it is – is not creating growth. Instead, we are seeing: minimal job creation, historically low investment, consumption turning into savings and GDP growth at less than new normal levels. The Rogoff/Reinhart biblical parallel of seven years of fat followed by seven years of lean is not likely to be disproven in this cycle. The only missing input to the equation would seem to be how many years of fat did we actually experience? More than seven, I would suggest.
The investment implications are numerous although far from certain. Equity markets should be dominated by dividend yields and the return of capital via share buybacks, as opposed to growth. A market P/E ratio of 15X is actually a 6.5% earnings yield – not a bad return compared to 2% 10-year Treasuries, but actually a little bit short when placed against Baa and High Yield corporate bonds, which represent a senior claim against earnings in a rather uncertain global economic environment.
Despite 2% 10-year Treasuries, low economic growth rates are usually supportive of high quality sovereign debt and they may likely continue to be as long as QEs continue. Investors should be mindful of the global bond market’s most recent historical example of sovereign debt returns in a slow/no growth environment – Japanese JGBs.
In sum, with both earnings and bond yields near historic lows as a result of a lack of real growth in developed economies, investors will need to find lots of pennies to produce asset returns much above 5% in bonds or equities. Pension funds, Washington politicians, and indeed Main Street investors are likely expecting much more. One of the big problems of an asset-based economy is that once interest rates inch close to zero and discounted future cash flows are elevated in price, it’s difficult to generate much more if economic growth doesn’t follow. Such appears to be the case today.
