(This is the first in a four-part series.)
Last year, Federal Reserve largesse was the dominant influence on investments. Monetary policy will continue to be an important ingredient in 2014. Still, global financial deleveraging remains the overarching driver of monetary policy and related financial-market distortions, particularly for the euro area, the U.K. and Japan. It also will affect fiscal policies, U.S. consumer behavior, whether we have inflation or deflation, protectionist tendencies, the strength of the dollar, financial regulation and developing-country growth.
The U.S. and other economies continue to deleverage in the aftermath of the global recession that capped 25 years of debt accumulation, especially by households and the financial sector. The ratios of debt to gross domestic product in these two areas leaped three- and fourfold from the early 1980s to the onset of the 2007-2009 global crisis. Both households and financial institutions have reduced their leverage since then, but they still have a long way to go to reach their previous trend relationship to GDP. I am a strong believer in reversion to long-established trends. We face about four more years of deleveraging, bringing the total span to about 10 years -- the normal duration of this process after major financial bubbles.
Nevertheless, the huge drag produced by private-sector deleveraging is made clear by the fact that, even with the immense fiscal stimulus earlier and the more recent enormous monetary expansion, real GDP growth has averaged only 2.3 percent in the recovery that started in the second quarter of 2009, well below the 3.4 percent in the post-World War II era until the recession.
Last year, real GDP is estimated to have advanced only 1.9 percent, compared with 2.8 percent in 2012 and 2.3 percent since 2009. At best, we should expect more of the same this year, even though the chronically overoptimistic Fed is betting on 3 percent growth.
I’ve been forecasting 2 percent average real growth for the duration of deleveraging because of several specific drags on economic growth. First and foremost is deleveraging. This is manifest not only in ongoing debt reduction but also in the shift by consumers from a two-decade-long borrowing and spending binge to a saving spree. That earlier spending drove down the household saving rate . But a number of forces suggest that trend is reversing, and chronically.
Retail investors remain wary of stocks, even though the Standard & Poor's 500 Index rose 30 percent in 2013. Last year, these investors put just $60 billion net into U.S. stock mutual funds, the first gain since 2005. Many homeowners relied on the housing boom's price appreciation, which they extracted through home equity loans and cash-out refinancing, to fund oversize spending. But after those withdrawals and the collapse in house prices, the home equity of those with mortgages fell on average from almost 50 percent of the house’s value in the early 1980s to 25 percent today, even with the recent rise in house prices.
Demographics also favor a U.S. household saving spree. The postwar baby boomers are in their 50s and 60s, still in their peak earning years and close enough to retirement to need to save.
Persistent weak job markets should encourage saving for contingencies among those who have jobs. The headline unemployment rate, which was 6.6 percent in January, was an improvement compared with the peak of 10 percent in October 2009, but it remains very high by historical standards. And the decline is more than accounted for by the retirement of the postwar generations, early retirements, and discouraged workers who have dropped out of the labor force and no longer are tallied among the unemployed. If the labor participation rate were still at its February 2000 peak, the unemployment rate would be 13 percent.
The household savings rate fell to 2 percent in the mid-2000s from 12 percent in the early 1980s , a drop of about 0.5 percentage point a year. This was offset by consumer spending, which grew 0.5 percentage point faster than disposable personal income each year. Because consumer spending accounts for 68 percent of GDP -- and it’s generally believed that each dollar of consumer outlays generates an additional 50 cents in GDP as it is spent and respent -- the total effect of that 20-year decline in the savings rate was to increase GDP growth about 0.5 percentage point per year.
The increase in the savings rate that I foresee will have the opposite effect, with a 1 percentage-point rise a year translating into a 1 percentage-point decrease in GDP growth. And the swing from a 0.5 percentage-point annual addition to GDP growth to a 1 percentage-point subtraction is 1.5 percentage points. Subtracting this swing from the annual 3.7 percent real GDP growth in the 1982-2000 salad days reduces it to 2.2 percent.
This shift by U.S. consumers will slow global growth significantly. With few exceptions, foreign countries are net exporters, while the U.S. is the net importer of the goods and services for which foreign countries have no other ready markets. For each 1 percent rise in U.S. consumer spending, U.S. imports have risen 2.9 percent on average in past decades. The U.S. consumer drove international economic growth in the past, and the opposite will be true in the years ahead. Since the recession, Chinese leaders have reflected this dynamic by moving to shift their economy from a reliance on exports and the capital spending to produce them to a more domestic-spending-driven, consumer-oriented model.
With muted economic growth and risks on the downside, the burden of stimulating the economy remains with the Fed, as it has for most of the economic recovery. Fed Chair Janet Yellen has shown that she is just as committed as her predecessor, Ben Bernanke, to continuing to keep monetary policy loose while scaling back on monthly security purchases -- as long as the economy and labor markets keep improving. Keep in mind, however, that the central bank’s forecasting record is far from perfect. In November 2010, the Federal Open Market Committee forecast real GDP growth of 4.1 percent for 2012 but ended up reducing the outlook in December 2012 to 1.75 percent.
In any event, tapering means the Fed is providing decreasing amounts of the fuel that has propelled equity prices for almost five years. It’s no wonder then that global stock and bond markets reacted negatively in May and June when the Fed first started its talk of tapering. And when it began reducing its asset purchases in January, equity markets around the world -- especially those in emerging markets -- plunged. Markets have since recovered, but the worry now is that the Fed could increase short-term rates if the economy shows any signs of overheating and there are signs of inflation.
The Fed is committed to keeping interest rates low until economic growth revives and labor markets improve, but it would prefer short-term rates that are well above the present near-zero level. Near-zero rates mean the Fed can only raise them and is powerless on the other half of the spectrum. Furthermore, the central bank likes to reduce rates to spur borrowing when the economy softens, but it can’t do so when interest rates are already at near zero.
Inflation has virtually disappeared, as consumer prices rose only 1.5 percent last year. Excluding volatile food and energy, the increase was 1.7 percent. Similarly, producer prices rose 1.3 percent -- 1.4 percent when excluding food and energy.
Treasury Inflation Protected Securities, which offset the effects of inflation, lost 6.7 percent in 2013, the biggest drop since they were introduced in 1997. The yield spread between five-year TIPS and equivalent Treasuries indicates that investors anticipate just 1.76 percent annual inflation over the next half-decade. The Fed’s preferred measure of inflation, the personal consumption expenditures deflator, was up only 1.1 percent last year and, when excluding food and energy, 1.2 percent -- both well below the central bank’s 2 percent target.
There are many global deflationary forces, including falling commodity prices, aging and declining populations, economic output well below potential, globalization of production and the resulting excess supply, developing countries' emphasis on exports and saving to the detriment of consumption, growing protectionism (including competitive devaluation in Japan), declining real incomes, income polarization, declining union memberships, high unemployment, and downward pressure on federal, state and local government spending.
Very low inflation rates are found throughout the world with few exceptions -- 0.9 percent in the euro zone last year, 2 percent in the U.K. and 1.6 percent in Japan after the government’s push to reinflate the economy. Five years ago, China's consumer prices were climbing at an 8 percent rate, but they rose 2.6 percent last year. With China’s legendary excess capacity, even-lower inflation if not deflation is probable.
Aggressive monetary and fiscal stimulus probably have delayed chronic deflation in producer and consumer prices. Still, this year may see the onset of falling prices worldwide. And it will probably be a combination of the good deflation spurred by new technology and globalization-driven excess supply as well as the bad deflation of deficient demand.
The fiscal outlook is highly uncertain, with persistent gridlock in the U.S. and the midterm elections approaching in November. Our government only acts when it has no alternative. A collapsing stock market always gets attention, but a market rally, in effect, tells politicians and policy makers that all is well or at least that no immediate action is needed.
Furthermore, the U.S. has avoided increases in Medicaid, Medicare and Social Security benefits. But as members of the baby-boom generation retire, the Social Security trust fund is paying out more than it takes in and will go broke in 2033, according to Congressional Budget Office estimates. The longer the government waits, the more traumatic an adjustment will have to be because small changes compound over time. These include raising the age of eligibility for Social Security payments and reducing the inflationary adjustments for benefits.
Medicare is a much bigger problem, with exploding medical costs and a system designed to be about as expensive as possible. First, with government- and employer-provided health insurance, very few Americans pay for medical care themselves, and if they do have their own policies -- as more are forced to do under the Affordable Care Act -- they want to get their money’s worth. Second, new medical technology is very expensive, but when one's own life is at stake, the best is none too good. And third, medical providers get paid for procedures, which only encourages them to perform more.
(Gary Shilling is a Bloomberg View columnist and president of A. Gary Shilling & Co. He is the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” This is the first in a four-part series.)
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