Category: Debt Levels

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Ultra-low interest rates may lead to a ‘debt trap’

The highly-regarded Stephen Bartholomeusz warns that central bank policies may lead to a ‘debt trap’:

“….With the world apparently re-starting the use of unconventional monetary policies even before central banks have extricated themselves from the legacies of a decade of those policies, there is a real risk that the impacts and the threats posed by their side effects will swell and that the world will be caught within what the BIS has previously described as a “debt trap’’ with no exit.

The other disturbing aspect of the [BIS] report is that it repeatedly says it is too early to assess the longer-term implications of the policies the central banks have employed.

Central bankers respond to the latest data – they respond to short-term signals – but the side-effects of their post-crisis policies have already been building for a decade and will continue to build while they maintain ultra-low or negative policy rates and keep buying bonds and other fixed interest securities to depress longer-term interest rates and suppress risk premia.

How those side-effects are unwound and how the banks extricate themselves from their policies and the legacies of those policies won’t be known until they try, but the potential for another crisis has been increased by the big surge in global leverage and the elevated asset prices the policies have encouraged.

Negative rates and quantitative easing and variations on those themes might, as the BIS report says, be useful additions to central bankers’ toolboxes but the past decade has shown they aren’t by themselves a panacea for economic ills and they bring with them potentially unpleasant side effects the longer they are in place.”

Debt traps occur when the interest rate needed to service the government debt is greater than the growth rate of GDP, according to former Fed governor Robert Heller:

“…In such a situation, debt service obligations grow more rapidly than the economy; eventually, the accumulated debt can no longer be serviced properly. In other words, the dynamics of the situation become unsustainable and a death spiral ensues.”

So far, central banks have responded by driving interest rates to record lows but unintended consequences are emerging, with low interest rates leading to low GDP growth. A feedback loop is emerging:

    • Low interest rates

Australia: 10-Year Bond Yield

    • Low bank interest margins

Australia: Bank Net Interest Margins

    • Low credit growth

Australia: Credit & Broad Money Growth

    • Low inflation

Australia: Underlying Inflation

    • And low economic growth

Australia: GDP Growth

We are venturing where angels fear to tread: central banks trialing new policies without empirical evidence as to their long-term consequences.

Monetary policy should be administered judiciously, intervening only when the financial system is in dire straits, outside the realm of the regular business cycle. Instead monetary policy is treated as a panacea, the constant drip-feed building a long-term dependence on further stimulus.

The problem with ‘traps’ is that they are difficult to escape.

“If you find yourself in a hole, the first thing to do is stop digging.”

~ Will Rogers

[NOTE: I should clarify that Australia has relatively low fiscal debt and is not in any immediate danger of a debt trap. But the ‘lucky country’ would suffer severely from fallout if the US or China were caught in a debt trap.]

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A sobering assessment of the global economy

Donald Amstad from Aberdeen Standard Investments: “the developed world is verging on catastrophe…. we are facing an unprecedented bust in risk-free (bond) markets.”

Hat tip to Marcus Padley

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Australia needs to break the downward spiral

Ross Gittins, Economics Editor at The Sydney Morning Herald, sums up Australia’s predicament:

“The problem is, the economy seems to be running out of puff because it’s caught in a vicious circle: private consumption and business investment can’t grow strongly because there’s no growth in real wages, but real wages will stay weak until stronger growth in consumption and investment gets them moving.

Policy has to break this cycle. But, as [RBA governor] Lowe now warns in every speech he gives, monetary policy (lower interest rates) isn’t still powerful enough to break it unaided. Rates are too close to zero, households are too heavily indebted, and it’s already clear that the cost of borrowing can’t be the reason business investment is a lot weaker than it should be.

That leaves the budget as the only other instrument available. The first stage of the tax cuts will help, but won’t be nearly enough…..”

Cutting already-low interest rates is unlikely to cure faltering consumption and business investment. Low wage growth and a deteriorating jobs market are root causes of the downward spiral and not much will change until these are addressed.

Low unemployment is misleading. Underemployment is growing. Trained barristers working as baristas may be an urban legend but there is an element of truth. The chart below shows underemployment in Australia as a percentage of total employment.

Australia: Underemployment % of Total Employment

How to halt the spiral

Tax cuts are an expensive sugar hit. The benefit does not last and may be frittered away in paying down personal debt or purchasing imported items like flat-screen TVs and smart phones. Tax cuts are also expensive because government is left with debt on its balance sheet and no assets to show for it.

Infrastructure spending can also be wasteful — like school halls and bridges to nowhere — but if chosen wisely can create productive assets that boost employment and build a healthy portfolio of income-producing assets to offset the debt incurred.

The RBA has already done as much as it can — and more than it should. Further rate cuts, or God forbid, quantitative easing, are not going to get us out of the present hole. What they will do is further distort price signals, leading to even greater malinvestment and damage to the long-term economy.

What the country needs is a long-term infrastructure plan with bipartisan support. Infrastructure should be a national priority. There is too much at stake for leadership to take a short-term focus, with an eye on the next election, rather than consensus-building around a long-term strategy with buy-in from both sides of the house.

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Australian bank growth expected to slow

Last week I observed:

…the RBA will resist cutting rates unless the situation gets really desperate. Ultra-low interest rates encourage risk-taking and speculative behavior, offering short-term gain but courting long-term disaster. Walter Bagehot, editor of The Economist, observed more than 100 years ago: “John Bull can stand many things, but he cannot stand 2%.” Sound economic management requires that central bankers make the hard choices, resisting pressure from commercial banks and politicians.

Total assets of the four major banks grew at a much faster rate than nominal GDP from 2004 to 2014. This was only achieved through rapid expansion of debt in the economy.

Major Banks Total Assets and Nominal GDP

The sharp rise in debt pushed households into a precarious position, with record levels of debt to disposable income and a serious bubble in house prices.

Australian Household Debt to Disposable Income

The RBA and APRA have used macro-prudential measures over the last few years to rein in debt growth, with some success. The ratio of major bank total assets, mainly debt, to nominal GDP declined considerably since 2015.

Major Banks Total Assets over Nominal GDP

This is a major policy success by the RBA and APRA and they are unlikely to want to reverse course. But they may decide to slow, or even for a time halt, the decline in order to prevent a downward spiral in the housing market. Expect total asset growth of the big four to match nominal GDP growth, at around 5.0%, over the next decade. Comprising 3.0% real GDP growth and 2.0% inflation. A far cry from the heady days of 10% annual growth between 2004 and 2014.

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Buybacks, interest rates and declining growth

The Fed did a sharp about-turn on interest rates this week: a majority of FOMC members now expect no rate increases this year. Long-term treasury yields are falling, with the 10-Year breaking support at 2.55/2.60 percent. Expect a test of 2.0%.

10-Year Treasury Yields

While the initial reaction of stocks was typically bullish, the S&P 500 Volatility Index (21-day) turned up above 1.0%, indicating risk remains elevated.

S&P 500

The reason for the Fed reversal — anticipated lower growth rates — is also likely to weigh on the market.

Stocks are already over-priced, with an S&P 500 earnings multiple of 21.26, well above the October 1929 and 1987 peaks. With earnings growth expected to soften, there is little to justify current prices.

S&P 500 Price-earnings (PEmax)

The current rally is largely driven by stock buybacks ($286 billion YTD) which dwarf the paltry inflow from ETF investors into US equities ($18 billion YTD). We are also now entering the 4 to 6-week blackout period, prior to earnings releases, when stock repurchases are expected to dip.

Why do corporations continue to repurchase stock at high prices? Warren Buffett recently reminded investors that buybacks at above a stock’s intrinsic (fair) value erode shareholder wealth. If we look at the S&P 500 in the period 2004 to 2008, it is clear that corporations get carried away with stock buybacks during a boom and only cease when the market crashes. They support their stock price in the good times, then abandon it when the market falls.

S&P 500 Buybacks
source: S&P Dow Jones Indices

Shareholders would benefit if corporations did the exact opposite: refrain from buying stock during the boom, when valuations are high, and then pile into the stock when the market crashes and prices are low. Why doesn’t that happen?

The culprit is typically low interest rates. It is hard for management to resist when stock returns are more than double the cost of debt. Buybacks are an easy way of boosting stock performance (and executive bonuses).

Treasury Yields: 3-Month & 5-Year

Corporations are using every available cent to buy back stock. Dividends plus buybacks [purple line below] exceed reported earnings [green] in most quarters over the last five years.

S&P 500 Buybacks & Dividends compared to Earnings

That means that capital expenditure and acquisitions were funded either with new stock issues or, more likely, with debt.

Corporate debt has been growing as a percentage of GDP since the 1980s. The pace of debt growth slowed since 2017 (shown by a down-turn in the debt/GDP ratio) but continues to increase in nominal terms.

Corporate Debt/GDP

Low interest rates mean that stock buybacks are likely to continue — unless there is a fall in earnings. If earnings fall, buybacks shrink. Declining earnings mean there is less available cash flow to buy back stock and corporations become far more circumspect about using debt.

S&P forecasts that earnings will rise through 2019.

S&P 500 Earnings

But forecasts can change. Expected year-on-year earnings growth for the March 2019 quarter has been revised down to 3.5%. Forecasts for June and September remain at 12.0% and 11.4% (YoY growth) respectively.

S&P 500 Year-on-Year Earnings Growth Forecast

If nominal GDP continues to grow at around 5% (5.34% in Q4 2018) and the S&P 500 buyback yield increases to 3.0% (2.93% at Q3 2019 according to Yardeni Research) then earnings growth, by my calculation* should fall to around 8.2%.

*1.05/0.97 -1.

With an expected dividend yield of 2%, investors in the S&P 500 can expect a return of just over 10% p.a. (dividend yield plus growth).

But the Fed now expects growth rates to fall by about 1.1% in 2019 and 1.2% in 2020, which should bring investor returns down to around 9% p.a. Not a lot to get excited about.

I knew something was wrong somewhere, but I couldn’t spot it exactly. But if something was coming and I didn’t know where from, I couldn’t be on my guard against it. That being the case I’d better be out of the market.
~ Jesse Livermore

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Why the RBA shouldn’t cut interest rates

There are growing cries in local media for the RBA to cut interest rates in order to avoid a recession. House prices are falling and shrinking finance commitments point to further price falls. Declining housing values are likely to lead to a negative wealth effect, with falling consumption as household savings increase. Employment is also expected to weaken as household construction falls. Respected economist Gerard Minack thinks “a recession in Australia is becoming more likely”.

The threat should not be taken lightly, but is cutting interest rates the correct response?

Let’s examine the origins of our predicament.

A sharp rise in commodity prices in 2004 to 2008.

Commodity Prices

Led to a massive spike in the Trade-weighted Index.

Australia Trade Weighted Index

And a serious case of Dutch Disease: the destructive effect that offshore investment in large primary sector projects (such as the 1959 Groningen natural gas fields in the Netherands) can have on the manufacturing sector.

Business investment in Australian has fallen precipitously since 2013.

Australia Business Investment

With wages growth in tow.

Wages Index

Instead of addressing the underlying cause (Dutch Disease), Australia tried to alleviate the pain by stimulating the housing market. Housing construction boosted employment and the banks were only to happy to accommodate the accelerating demand for credit.

Leading Index

But house prices have to keep growing and banks have to keep lending else the giant Ponzi scheme unwinds. When house prices and construction slows, the economy is susceptible to a severe backlash as Gerard Minack pointed out.

How to fix this?

The worst response IMO would be to pour more gasoline on the fire: cut interest rates and reignite the housing bubble. Low interest rates have done little to stimulate business investment over the last five years, so further cuts are unlikely to help.

The only long-term solution is to lift business investment which creates secure long-term employment. To me there are three pillars necessary to achieve this:

  1. Accelerated tax write-offs for new business investment;
  2. Infrastructure investment in transport and communications projects that deliver long-term productivity gains; and
  3. A weaker Australian Dollar.

Corporate tax write-offs

Accelerated corporate tax write-offs were a critical element of the US economic recovery under Barack Obama. They encourage business to bring forward planned investment spending, stimulating job creation.

Infrastructure

Government and private infrastructure spending is important to fill the hole left by falling consumption. But this must be productive investment that generates a market-related return on investment. Else you create further debt with no income streams to service the interest and capital repayments.

A weaker Australian Dollar

Norway is probably the best example of how an economy can combat Dutch Disease. They successfully weathered an oil-driven boom in the 1990s, protecting local industry while establishing a sovereign wealth fund that is the envy of its peers. Their fiscal discipline set an example to be followed by any resource-rich country looking to navigate a sustainable path through a commodities boom.

In Australia’s case that would be closing the gate after the horse has bolted. The benefits of the boom have long since been squandered. But we can still protect what is left of our manufacturing sector, and stimulate new investment, with a weaker exchange rate.

I doubt that the three steps are sufficient to avert a recession. But the same is true of further interest rate cuts. And at least we would be addressing the root cause of the problem, rather than encouraging further malinvestment in an unsustainable housing bubble.

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‘It could be on the scale of 2008’ | SMH

Harvard professor Ken Rogoff said the key policy instruments of the Communist Party are losing traction and the country has exhausted its credit-driven growth model. This is rapidly becoming the greatest single threat to the global financial system.

“People have this stupefying belief that China is different from everywhere else and can grow to the moon,” said Professor Rogoff, a former chief economist at the International Monetary Fund.

“China can’t just keep creating credit. They are in a serious growth recession and the trade war is kicking them on the way down,” he told UK’s The Daily Telegraph, speaking before the World Economic Forum in Davos.

“There will have to be a de facto nationalisation of large parts of the economy. I fear this really could be ‘it’ at last and they are going to have their own kind of Minsky moment,” he said.

Read the full article from Ambrose Evans-Pritchard at smh.com.au: ‘It could be on the scale of 2008’: Expert sends warning on China downturn

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Australia: Good news and bad news

First, the good news from the RBA chart pack.

Exports continue to climb, especially in the Resources sector. Manufacturing is the only flat spot.

Australia: Exports

Business investment remains weak and is likely to impact on long-term growth in both profits and wages.

Australia: Business Investment

The decline is particularly steep in the Manufacturing sector and not just in Mining.

Australia: Business Investment by Sector

But government investment in infrastructure has cushioned the blow.

Australia: Public Sector Investment

Profits in the non-financial sector remain low, apart from mining which has benefited from strong export demand.

Australia: Non-Financial Sector Profits

Job vacancies are rising which should be good news for wage rates. But this also means higher inflation and, down the line, higher interest rates.

Australia: Job Vacancies

The housing and financial sector is our Achilles heel, with household debt climbing a wall of worry.

Australia: Housing Prices and Household Debt

House prices are shrinking despite record low interest rates.

Australia: Housing Prices

Broad money and credit growth are slowing, warning of a contraction.

Australia: Broad Money and Credit Growth

Bank profits remain strong.

Australia: Bank Profits

But capital ratios are low, with the bulk of profits distributed to shareholders as dividends. The ratios below are calculated on risk-weighted assets. Raw leverage ratios are a lot weaker.

Australia: Bank Capital Ratios

One of the primary accelerants of the housing bubble and household debt has been $900 billion of offshore borrowings by domestic banks. The chickens are coming home to roost, with bank funding costs rising as the Fed hikes interest rates. In the last four months the 90-day bank bill swap rate (BBSW) jumped 34.5 basis points.

The banks face a tough choice: pass on higher interest rates to mortgage borrowers or accept narrower margins and a profit squeeze. With an estimated 30 percent of households already suffering from mortgage stress, any interest rate hikes will impact on both housing prices and delinquency rates.

I continue to avoid exposure to banks, particularly hybrids where many investors do not understand the risks.

I also remain cautious on mining because of a potential slow-down in China, with declining growth in investment and in retail sales.

China: Activity

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12 Charts on the Australian economy

Australian GDP grew at a robust 3.1% for the year ended 31 March 2018 but a look at the broader economy shows little to cheer about.

Wages growth is slowing, with the Wage Price Index falling sharply.

Australia: Wage Price Index Growth

Falling growth in disposable income is holding back consumption (e.g. retail spending) and increasing pressure on savings.

Australia: Consumption and Savings

Housing prices are high despite the recent slow-down, while households remain heavily indebted, with household debt at record levels relative to disposable income.

Australia: Housing Prices and Household Debt

Housing price growth slowed to near zero and we are likely to soon see house prices shrinking.

Australia: Housing Prices

Broad money growth is falling sharply, reflecting tighter financial conditions, while credit growth is also slowing.

Australia: Broad Money and Credit Growth

Mining profits are up, while non-mining corporation profits (excluding banks and the financial sector) have recovered to about 12% of GDP.

Australia: Corporate Profits

But business investment remains weak, which is likely to impact on future growth in both profits and wages.

Australia: Investment

Exports are strong, especially in the Resources sector. Manufacturing is the only flat spot.

Australia: Exports

Iron ore export tonnage continues to grow, while demand for coal has leveled off in recent years.

Australia: Bulk Commodity Exports

Our dependence on China as an export market also continues to grow.

Australia: Exports by Country

Corporate bond spreads — the risk premium over the equivalent Treasury rate charged to non-financial corporate borrowers — remain low, reflecting low financial risk.

Australia: Non-financial Bond Spreads

Bank capital ratios are rising but don’t be fooled by the risk-weighted percentages. Un-weighted Common Equity Tier 1 leverage ratios are closer to 5% for the four major banks. Common Equity excludes bank hybrids which should not be considered as capital. Conversion of hybrids to common equity was avoided in the recent Italian banking crisis, largely because of the threat this action posed to stability of the entire financial system.

Australia: Bank Capital Ratios

Low capital ratios mean that banks are more likely to act as “an accelerant rather than a shock-absorber” in times of crisis (2014 Murray Inquiry). Professor Anat Admati from Stanford University and Neel Kashkari, President of the Minneapolis Fed are both campaigning for higher bank capital ratios, at 4 to 5 times existing levels, to ensure stability of the financial system. This is unlikely to succeed, considering the political power of the bank sector, unless the tide goes out again and reveals who is swimming naked.

The housing boom has run its course and consumption is slowing. The banks don’t have much in reserve if the housing market crashes — not yet a major risk but one we should not ignore. Exports are keeping us afloat because we hitched our wagon to China. But that comes at a price as Australians are only just beginning to discover. If Chinese exports fail, Australia will need to spend big on infrastructure. And infrastructure that will generate not just short-term jobs but long-term growth.

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