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Defusing the Credit Boom

In addressing the Global Financial Crisis (GFC), the world’s central banks have inflated the largest private sector credit boom in history. When the GFC began in 2008 with the Lehmann Brothers collapse, we wondered if another Great depression lay ahead. Since then, the US adopted an ‘Easy Money’ policy that was eventually adopted by the rest of the world. Interest rates reduced to near zero, causing rising asset prices. Official interest rates are actually negative in Europe and Japan to encourage activity by extra borrowing.

Income yields on assets like shares and property generally did not fall, so their prices rose compared to the now lower risk-free cash rate. When fairly priced, growth assets must pay income sufficiently above risk-free cash rates to justify the risk involved. But the risk premium that investors need above the risk-free cash has shrunk. So when global rates rise, this risk margin could increase again, possibly causing more stock market volatility from uncertainty about the effect of higher interest rates.

Interest rates should only rise significantly if inflation finally rises and economic growth is needed to support share prices. However, Central bank bond buying globally has also had a big role in interest rates. As this buying unwinds (independent of interest rate settings) bond prices may fall significantly. This Quantitative tightening may have begun with China selling foreign exchange reserves to protect its slowing economy. Low oil price and ballooning budget caused Saudi Arabia to also reduce and last year Switzerland unpegged its Franc from the Euro and stopped accumulating reserves.

Despite the private sector boom in asset prices, the GFC recovery isn’t yet convincing because people remain cautious about their spending. This has reduced demand and with stagnating productivity improvement, is causing governments to consider stimulating jobs and confidence by borrowing to target infrastructure spending. Until now, the lack of infrastructure spending in USA, Europe and Australia may be why we’ve had anemic growth.

Governments either lack conviction or are overly focused on reducing debt to spend on infrastructure, which should create jobs (short term) and lift productivity (long term). It is a golden opportunity to borrow at historically low interest rates to invest wisely. Money supply is better but apart from construction, demand for goods and services is not. Asset prices that fell post GFC have re-inflated in a jobless recovery that is yet to restore public confidence.

Employment has been growing in the US for several years but many people have left the workforce, while many others are underemployed (not working in their preferred field or working multiple part-time jobs). This has suppressed wage growth, though we see hints this will improve over the next year or so. Europe has been creating jobs in the last two years but unemployment remains horribly high, so wages inflation remains subdued. Japan’s shrinking workforce encourages more women to work and better productivity.

Why has years of easy money not provided a convincing recovery? For centuries until President Nixon abandoned the gold standard in 1971, creating new money needed the backing of a monetary standard (typically gold, silver, etc). But since 1971 the value of money relies simply on faith in the capacity of each Government to pay and is no longer anchored against a ‘gold standard’ that might constrain excesses.

Since 1971 commercial bank assets and loans have significantly grown compared to underlying economies (GDP). Commercial banking in China and other emerging economies has grown threefold in recent years. At the same time, private debt has rapidly grown for most major economies against their national income. Because central banks can create money without anchoring against a ‘gold standard’ and global indebtedness has risen, asset prices have dramatically risen in most major economies.

To facilitate capital flows that create national wealth, financial systems should facilitate capital lending to promote trade and industry – linking savers (capital lenders) with borrowers (capital investors). But rather than promoting trade and industry, large western banks have become self-interested in recent decades. They’re less focused on connecting lenders with borrowers but more on trading assets – that is they’re preoccupied with wealth rather than output.

Cheap money has obstructed natural recessionary processes. Though good for social harmony, it creates overcapacity, undermines profitability, incentives and thus investment and productivity growth. Risk is rising in our globalised financial system, enlarging global banks and huge private sector debt. The antidote is renewed focus on productivity growth and enduring wealth creation based on technological progress and innovation-driven growth.

In managing our highly leveraged global economy, a flood of money that is not anchored to any gold standard is being used to buy financial assets and fund fiscal stimulus. A better policy may instead encourage ways to soak up excess capacity, reduce debt, shrink banking back and seek improved productivity growth. The trick will be to do it while retaining social harmony and if so, normal economic growth might resume. There are serious questions about whether further stimulus efforts in Europe and Japan will have the impact of past efforts.

In all this, what’s an investor to do? We seem to be in a post GFC asset price boom, though prices are not yet ‘expensive’. Markets are volatile awaiting sustainable policy to deal with the ‘demand’ side of money. Without this to improve demand and consumer confidence, investors must be selective.

More than ever, it is important to focus portfolios on high-quality companies that can still grow earnings, despite the weak growth and volatility. A number of health care companies are prime examples as they benefit from ageing western populations that must spend more on health. This is coupled with governments motivated to ease pressure on their finances by supporting private healthcare activity. Overweighting health care is relatively ‘expensive’ but is more insulated from global shocks.  Investing in emerging markets is difficult as the US$ and interest rates rise, but should be rewarded by medium term consumer demand there.

Some exposure to alternatives that make money whether markets rise or fall may help. Avoiding investments artificially inflated by derivatives or unsustainably low interest rates is also prudent. It also makes sense to prefer companies with relatively high dividend yields, as capital growth may be subdued for some time. However, dividends must be sustainable and we want to avoid stocks that become too expensive as we are not alone in seeking yield. True diversification with enough reliable cash to weather short periods of market anxiety seems wise.

One thought on “Defusing the Credit Boom

  1. john head and odette thorney

    hi simon, Odette and I came to see you a few months back for a general chat.things have moved on and we are expecting money around and june\july .need to have another informal chat if that is ok.in the first instance like to come by myself as we did find a 3 way talk a bit hard.no doubt the budgetmay effect super,so would it be best to leave it till after, thanks john head

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