Chief Economist and Strategist for Gluskin Sheff + Associates Inc., and the author of the daily economic newsletter Breakfast with Dave.
We’re inching closer to our recession call coming to fruition. I realize that many folks are perplexed about this forecast. But that’s because they focus exclusively on GDP, which is all about spending, and when such spending is skewed by credit growth, it gives you a distorted view of what is really happening beneath the veneer. This is the most acute Potemkin rally in asset markets, and the economy, of all time.
Without the rapid expansion of debt, there is no global economic growth to speak of. In fact, this 2009 to 2019 cycle makes a mockery of the debt bubble that formed from 2002 to 2007. Central banks are playing the role of all the kings’ horses and all the kings’ men as Humpty Dumpty sits on this dangerous and unsustainable wall of debt. Global debt liabilities at all levels of society – household, business and government – ballooned US$3-trillion alone in the first quarter of 2019 and now totals US$250-trillion (with a big fat T), or an amazing 320 per cent of world GDP.
Ever think that gets repaid? And to think the bright lights in Washington believe that continuous increases in the debt ceiling are a good thing. They clearly don’t know their history, or simply don’t care since they won’t be around to clean up the mess. The bulls say not to worry because interest rates are so low – they are oblivious to the fact that these incredibly low rates are acting as an incentive to blow out balance sheets even further. So we are at a point where even a hiccup in rates at these egregious debt levels will have a potentially huge destabilizing impact on asset markets.
Now this past week, there was much enthusiasm over the lifting of the U.S. debt ceiling and government spending caps. Nobody stops to think why these ceilings are in place to begin with, and the fact there really is no check on government largesse should actually be a really major concern. The mantra that we escaped a fiscal squeeze ignores the non-linearity between public sector spending and debt increases at such egregiously overextended government balance sheets. This is why last year’s tax cuts had such little staying power in terms of a multiplier impact on the economy – bone up on Ricardian Equivalence and you’ll see what I mean.
In fact, at the debt ratio levels we have on our hands today, more government spending and debt actually are counterproductive to the well-being of the economy. They crowd out the private sector, in other words. So what we find is that in the past two decades, there is a negative correlation between the federal debt-to-GDP ratio and real economic growth that has emerged to the tune of -22 per cent; and the statistical relationship between federal expenditure growth in real terms and real GDP growth is -28 per cent.
Finally, who would ever have thought that the S&P 500 would be crossing above the 3,000 mark in the same week that the International Monetary Fund cut its global GDP growth forecast (for the fourth straight time) to 3.2 per cent for 2019? This is a decent-sized haircut from the 3.6 per cent pace we saw in 2018 and 3.8 per cent in 2017 (while taking its estimate of global trading volume growth down 90 basis points to a mere 2.5 per cent).
In fact, this will be the weakest year for the world economy since the 2009 Great Recession, but that hardly resonates in a world of near-zero, zero, or negative interest rates, when central bankers make it near-impossible to value future cash flow streams. Consider this a nutty world we live in now, when the yield on Greek 10-year debt is down to 2.03 per cent, four basis points through Treasuries. Why not? Spain, at 0.31 per cent, and Portugal, at 0.38 per cent, are more like 170 points through Treasuries. The thing about that – Spain is rated A- by S&P, Portugal is a BBB credit, Greece is B+. Treasuries, even with all their warts, scars and pimples, have an average rating of AAA. There is no textbook that teaches you how to invest in this type of environment, where risk is a meaningless concept and evaluating future cash flows only leads to asymptotic results when discount rates get to today’s levels. Today’s interest-rate climate has rendered intrinsic value an oxymoron.
For the first time in recorded history, we hit the peak of the global growth cycle without ever having closed the output gap, which poses a serious problem for central bankers lamenting the decline in underlying inflation from their desired target levels. For assets of all kinds that are valued on discounted future cash flows, one has to assume that this ultrabenign interest rate landscape will merely reinforce this era of price bubbles and financial repression for conservative investors who park their cash in T-bills and bank deposits.
That doesn’t at all mean that being liquid and staying focused on capital preservation are concepts that have been relegated to the history books, because as we saw in last year’s fourth quarter, it doesn’t take much in such a leveraged and expensive marketplace to have things go awry and do so very quickly (in Hemingway fashion). To reiterate, the global output gap failed to close in an expansion phase for the first time ever, and the fact that the OECD leading indicator is down 17 months in a row, to a decade-low, at a time when measured inflation rates are so far below target, means that the subsequent widening in the “gap” in the coming quarters virtually guarantees a mild deflationary backdrop. This is fodder for high-quality long-duration bonds, as in 30-year Treasuries, and those areas of the stock market that are rate sensitive and non-cyclical.