• David Cockfield

Deleveraging – Slowly Making Progress


In previous issues of the Artisan the problems of an over leveraged Western World were outlined. The process of deleveraging, paying down excessive debt, and its impact on economic growth were described. Consumption must be reduced to match actual income, or below it, if debt is to be repaid. In the U.S., individuals have in the last four years paid down debt, with credit card debt balances reduced and mortgage debt either paid down or defaulted. In Canada individuals have increased their debt loads – a cause for concern. However the Canadian Government is expecting to have a balanced budget in 2015 which means no more increases in debt. While the U.S. Government’s stimulation programs have kept economic momentum going in the U.S., they have been financed by increased government deficits - that is more debt with no firm plans for reduction. The upshot of this is that four years into this deleveraging process only minimal progress has been made in both the U.S. and Europe and real solutions are still lacking. The only conclusion one can reach is that years of further restructuring remain ahead. While Canada has so far avoided the worst effects of this major economic dislocation, our major trading partner, the U.S., is still experiencing significant difficulties. Canada is too closely tied to the U.S. to be unaffected by economic problems there.

The present situation the Western World faces is not unsolvable. Canada in the early 1990s faced a huge government debt problem. At that time projections showed that if government spending continued at the current rate of that time, and revenues were unchanged in five years, the annual interest payable on government debt would be in excess of 50% of government revenues. Draconian measures were put in place. Government expenses and government jobs were cut and the Canadian public was handed the much hated G.S.T. Fortunately it all worked and in five years Canada was in good economic health.It should be recognized that while Canada was restructuring, the rest of the world was in much better shape than it is today.

Once we accept that we are in an economic restructuring that will take years, the next step is to attempt to predict what this means for financial markets and individual investors. Deleveraging is not uncommon - as pointed out earlier, Canada went through such a process some twenty years ago. The world has seen the process at work in recent years in Central and South America, and historically in the Western World in the Great Depression. Once it became apparent that deleveraging was in process it became the focus of many economists and financial market theorists. From a historical standpoint some common threads emerge. The first, which we have already mentioned, deleveraging, to completion takes three to four times as long as a typical recession. Eventually governments offset this long and arduous process by printing money, which creates inflation and results in devaluation of currency. There is a transfer of wealth from the wealthy to the less wealthy as savers earn little on their investments and borrowers pay little on their loans.

In describing deleveraging there can be good deleveraging or bad deleveraging. This is not to say that the so called good deleveraging is without pain, it is just that a bad deleveraging can be economic catastrophe. In a good deleveraging, governments move in early to stabilize a collapsing financial system, injecting capital where needed, and managing the takeover of failing financial institutions by more viable counterparts. Interest rates are driven lower and held low. Once the financial systems are stabilized, a combination of economic fiscal stimulus (paid in part by tax increases) and austerity measures (to reduce government costs)eventually brings government deficits under control.However the fiscal stimulus must be aimed at creating real assets that have lasting economic value. Simply handing out these funds for social programs, while politically attractive, will have little long term positive effect on economic progress. In time this approach will bring the economy back to a condition where normal balanced growth can begin. It is in this latter period where governments historically still faced with large debt loads, turned to the printing presses.

There can be two types of bad deleveraging. In the first type, austerity alone is used to fight government deficits. Government cutbacks further add to economic woes and a depression occurs. In the second type, governments react by printing money immediately to solve their deficit problems and allow the excess funds to stimulate the economy. The inflation caused is at first seen in a positive light as the economy begins expanding. Inflation then accelerates to the point that the currency becomes worthless and economic collapse occurs.

The U.S. and Great Britain have accomplished the first part of the good deleveraging. The U.S. is now at the point where the politicians must construct a program of fixed stimuli, tax increases and government austerity. The upcoming elections will decide who will carry this out and how. In Europe the lack of a truly empowered central banking system is hampering progress and so far only austerity measures are being implemented. This may well lead to political upheaval and social problems – only time will tell!

What does this all mean for financial markets? With Central Banks holding down interest rates, and slow economic growth, interest rates will remain low.

Fixed income investors will find returns on fixed income portfolios will fall to prevailing coupon yields as capital gains no longer occur. This means returns in the 2% to 3% range on an annual basis - hardly enough to cover inflation.

This is an example of savers transferring wealth to the borrowers. In this type of environment the secure high quality dividend stocks, income producing real estate, infrastructure and opportunistic credit trading strategies become even more attractive. With economic uncertainty a worldwide fact of life, equity market volatility will remain with us to test the courage of equity investors. With the U.S. pledging to hold interest rates down until 2015 the pattern of financial markets today is likely to continue at least until then. Painfully slow economic growth, relatively high unemployment, low interest rates, and volatile sideways equity markets will be the order of the day. This dictates investment strategies that emphasize secure cash flows from high quality sources. A moderate investment should be deployed in gold bullion funds or gold stocks as insurance against any unforeseen significant economic trauma in the U.S. or in Europe.

For investors the environment described is hardly encouraging. However there are bright spots. So far for North America the deleveraging has been handled successfully. In Canada we have experienced only a mild recession, no housing meltdown an confirmation that our banking system is one of the best in the world. In the U.S., the added weight of sub-prime mortgages and financial institution misdeeds caused considerably more economic damage. However recent signs of revival in the U.S. housing market and improving employment numbers seem to be signaling better economic growth ahead. Another significant difference in this deleveraging process is that a major part of the economic system – the corporate sector - is in excellent shape with flush balance sheets. Many corporations, with markets outside Europe and North America that are growing rapidly, are still showing increasing earnings. Hopefully the positive influence of the corporate sector health will soften the negative elements of deleveraging for individuals and governments.


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