For the last 6 months, the economic narrative has turned to the idea of ‘global reflation’. Strong economic activity and rising corporate earnings have been a theme for the world economy since late last year. Consumer and investor confidence has risen in both the developed and emerging markets.
But has the recovery relied too much on loose credit? Have we learned anything from the financial crisis? It appears that we haven’t. Excess global liquidity has led to mal-investments in China. It has encouraged managers in the United States to load up on debt and buy-back stock rather than invest in their businesses.
Both the People’s Bank of China and the US Federal Reserve have raised concerns about credit and financial stability. However, the spectre of balance sheet reductions and interest rate rises at central banks in China, the euro area, Japan and the United States threatens to take liquidity out of the global system and bring reflation to a halt.
Credit has been growing at an increasing rate relative to GDP in both the US and China. The incremental benefit of additional credit has been falling. Much of that debt has been raised to fund consumption, finance existing structures (such as real estate), and refinance existing liabilities. This is also the case for the UK, where the savings rate is at an all-time low of 1.7% of GDP. With real earnings stagnant or falling for many, consumer credit is growing at a rate of 10% y/y.
In China, the ruling Communist Party has imposed lending ceilings on its banks and is taking action to restrict credit to underperforming State-Owned Enterprises (SOE) and Local Governments. While these reforms have reduced the number of units of credit to produce a unit of GDP from 5.5 to 3.9, the rate is still extremely high. According to Citigroup, credit provision in China is today half as ‘efficient’ in creating productive output than it was in just 2008. It is about 30% less efficient than it is in the United States.
That’s not to say that US financial markets have been allocating resources prudently. The country has progressively become more credit-reliant since the end of the Bretton Woods system of capital controls. The amount of credit required to drive economic growth has doubled since 1980. The Chicago Fed National Financial Conditions Index shows that a prolonged period of easy credit has existed in the US since 2012, and is similar in scale to the periods representing the dot-com bubble (1995-2001) and the housing bubble (2001-2006).
In the current cycle, according to Absolute Strategy Research, US-held debt is concentrated in companies that have high ratios of capital expenditure to sales, relatively lower levels of cash and high levels of employment. Exposed sectors include Oil & Gas, Industrial Goods and Healthcare. For the largest 500 US companies, net debt has grown faster since 2012 than before the financial crisis. As always, the risks of easy money are not confined to financial stability but extend to the real economy as a whole.
While central banks are rightly concerned with keeping credit growth under control, growing debt-to-GDP ratios have reduced tolerance for higher interest rates. A rate rise from say 1% to 2% may not sound like much, but for a company that loaded on credit at rates of 1%, such a change represents a 100% increase in financing costs. With leverage increasing, there is relatively less real activity to support higher interest expenses.
Central Banks therefore face a dilemma between maintaining financial stability and keeping the real economy strong. A further problem they face is that the performance of the global economy and the strength of demand are related not simply to the supply of credit but the acceleration of credit growth. In other words, if the rate of growth of credit growth becomes too slow, economic output and demand can suffer. The problem for the US is that despite its having easy financial conditions, credit acceleration has actually slowed and this will weigh down on demand and inflation.
The Federal Reserve is therefore caught in a bind between putting a lid on an inefficient credit market for the sake of financial stability and keeping those very lines of credit open to an increasingly addicted economy that is arguably not at full employment. Yet it is hard to believe the Fed is simply looking at what their increasingly flawed Phillips Curve models are predicting about core inflation and reacting accordingly.
That appears to be ostensibly what they are doing. Janet Yellen wants to and has started to unwind the Fed’s monetary stimulus, but she seems to be doing so under the cover that core inflation is likely to accelerate in the coming months. That might happen, but if it doesn’t, the risk going into 2018 is astonishingly that the Fed tightens conditions too prematurely. However, the relationship between interest rates and economic stability in conditions of excess liquidity is not linear, and it may be judged prudent to take some fuel out of the economy now to prevent a bigger problem — perhaps another financial crisis — later on.
Meanwhile, with China responsible for a very large part of the period of global credit acceleration since 2014, some are concerned that credit tightening in China will put strong brakes on global growth through credit markets and the inventory cycle. This certainly was the case in 2010-11 when China last squeezed the credit markets, but there is reason to believe that China is now better equipped to absorb tighter conditions. Private sector investment has replaced spending by SOEs. The labour market is tight, keeping private consumption growth high. And export growth projections are up on the back of the strong recovery in emerging markets.
Yet, similar to the US, there are risks for China in cutting credit growth too fast. Corporate debt has risen from a high 100% of GDP in 2008 to 170% last year. Clamping down too heavily on credit, in the name of making the Chinese economy healthier, could instead make things worse.
It would be too much to say that the global recovery is built on sand. Real activity is up. PMIs look good in the US and the Eurozone. Consumer confidence is growing. And while the inventory cycle has turned in Asia there is good reason to believe the correction will be small. But it is right to say that if the lesson from the Global Financial Crisis wasto reduce the role of credit in fuelling non-productive activities and of leverage in driving the business cycle, that lesson has clearly not been learned.
Our investment strategy committee, which consists of seasoned strategists and investment managers, meets regularly to review asset allocation, geographical spread, sector preferences and key global market drivers and our economist produces research and views on global economies which complement this process.
Our quarterly report presents our views on the world economic outlook and equity, fixed income and foreign exchange markets. Please click the link to download.
