• David Cockfield

The Great Deleveraging


When looking at the economic woes facing the world economy it is important to understand the basic forces that are at work. The slow-down being experienced in Europe and North America are not the typical recessions that we have experienced over the last 60 years or so.

Past recessions normally resulted when the corporate sector over-expanded to meet rising individual demand, fueled by easy credit conditions. Inflation would begin to rise and to combat this, Central Banks tightened by raising interest rates. As a result, economic growth not only slowed, but several quarters of economic decline would ensue. Central Bank easing and falling interest rates, would encourage growth and the next up cycle would begin.

The present economic situation, while having the characteristics of a typical recession (high unemployment and slow economic growth), has important and very different elements that present a new set of problems for governments and individuals. Simply put, in Europe and North America both individuals and governments have leveraged their balance sheets far too much to finance immediate consumption. In the U.S. the political push to offer everyone a house of their own regardless of their ability to pay, has resulted in a housing bubble. Housing prices rose and an excess supply of housing was created. Rising house prices encouraged U.S. individuals to borrow against their homes, particularly since mortgage interest is tax deductible. The funds created were usually spent on consumption, creating unsustainable economic growth. With the onset of the financial meltdown of 2008 the situation changed dramatically.

U.S. banks and investors found that a number of mortgages or mortgage products they held were worth significantly less than face value. Banks became reluctant to lend and the system tightened. Unemployment rose as bankers, builders and all the industries involved in the housing sector found themselves out of work. The slowdown spread through the U.S. economy as individuals who were employed began to save rather than spend. Credit card debt also began to shrink as many individuals began to deleverage and pay back their debts. Government stimulus programs have helped the U.S. economy move back into a slow growth mode. However, the money used to stimulate has come from government borrowing, so the deleveraging of individuals has been offset by the leveraging up of governments through deficits. Eventually these bills will have to be paid, either through higher taxes, or reduction of services and entitlements, or all of these measures. At the present time the U.S. is at a political impasse as to which solution to take, which is simply postponing the problem.

In Europe, the same situation also exists, but in a somewhat different form. Within the European Union, some countries, particularly in Southern Europe, used the Union financial structure and the common currency to spend in excess of the real economic output of their economies. Politicians in those countries typically promised benefits of various sorts to become elected, and paid for those benefits through borrowing. Government employees grew in number as did salaries and pensions promised. Government programs of all types for the population multiplied and life was good - unfortunately built on borrowed money. A newly elected government in Greece found the previous government had emptied the coffers and left the country basically bankrupt. European banks who owned Greek debt, and governments who also had been overspending, became suspect to investors and the crisis began. The crisis continues with some observers predicting the end of the European Union and the Euro. It is too early to tell what the outcome will be as valiant efforts on the part of the solvent members of the Union to save it are ongoing. Needless to say the process of reducing consumption and paying down debt to manageable levels will have to take place for their efforts to be successful.

The situation in Canada is certainly better. Our banking system is not burdened with sub-prime mortgages as in the U.S., or questionable government debt as in Europe. Our government stimulus programs have been modest and our government deficits manageable. Our recent annual federal deficits are scheduled to end by 2016.

However we are not immune to the world’s financial problems. Canadians as individuals are carrying significant debt loads. The Province of Ontario is not in great financial shape. While we tend to be pleased about our stable but high-priced housing market, young individuals are taking on heavy mortgage loads that could be unsustainable if interest rates move up even moderately.

Despite the uncertainties ahead, the future is not without its bright spots. Corporations in general are in excellent shape both here and in the U.S. with strong balance sheets loaded with cash. In other parts of the world outside Europe and North America emerging economies continue to grow and provide markets for our goods and services.

The deleveraging that is going on in North America and Europe will take years to complete. Uncertainty will continue to dominate financial markets and volatility will be with us for the foreseeable future. Our investment strategy will focus on the preservation of capital and the use of cash flows from high quality corporate dividends and coupons to build portfolio values.


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