Perspectives

December 16, 2011

As European debt woes continue to dominate headlines, it’s hard for this not to have an impact on our mood and our outlook.  The equity market recovery is taking longer than hoped.  From most of the analysis I’ve read the short term continues to be daunting – and this negativity is already priced into stocks.  The mid to long term global outlook is more positive.

One of the best speeches heard in a long time was delivered Dec 12th by our own Mark Carney, Governor of the Bank of Canada. Titled Growth in an Age of Deleveraging, Carney pulled few punches in laying out the background to today’s issues in blunt language not usually associated with central bankers.  A summary of his points are listed here and a link to the entire speech below.  I’ve read the entire speech and it provided me with an excellent picture of how the world got to where it are, the challenges we face and the likely solutions:

The end of the debt super cycle and a new era of deleveraging

Advanced economies have steadily increased leverage for decades. That era is now decisively over. The direction may be clear, but the magnitude and abruptness of the process are not. It could be long and orderly or it could be sharp and chaotic. How we manage it will do much to determine our relative prosperity.
Accumulating the mountain of debt now weighing on advanced economies has been the work of a generation. Across G-7 countries, total non-financial debt has doubled since 1980 to 300 per cent of GDP. Global public debt to global GDP is almost at 80 per cent, equivalent to levels that have historically been associated with widespread sovereign defaults.
As a result of deleveraging, the global economy risks entering a prolonged period of deficient demand. If mishandled, it could lead to debt deflation and disorderly defaults, potentially triggering large transfers of wealth and social unrest.

Big challenges for Europe

In Europe, a renewed crisis is underway. An increasing number of countries are being forced to pay unsustainable rates on their borrowings. With a vicious deleveraging process taking hold in its banking sector, the euro area is sinking into recession. Given ties of trade, finance and confidence, the rest of the world is beginning to feel the effects.
Debt tolerance has decisively turned. The initially well-founded optimism that launched the decades-long credit boom has given way to a belated pessimism that seeks to reverse it.
In Europe, a tough combination of necessary fiscal austerity and structural adjustment will mean falling wages, high unemployment and tight credit conditions for firms. Europe is unlikely to return to its pre-crisis level of GDP until a full five years after the start of its last recession.
In most of Europe today, further stimulus is no longer an option, with the bond markets demanding the contrary. There are no effective mechanisms that can produce the needed adjustment in the short term. Devaluation is impossible within the single-currency area; fiscal transfers and labour mobility are currently insufficient; and structural reforms will take time. Actions by central banks, the International Monetary Fund and the European Financial Stability Facility can only create time for adjustment. They are not substitutes for it.
The route to restoring competitiveness is through fiscal and structural reforms. These real adjustments are the responsibility of citizens, firms and governments within the affected countries, not central banks. A sustained process of relative wage adjustment will be necessary, implying large declines in living standards for a period in up to one-third of the euro area. We welcome the measures announced last week by European authorities, which go some way to addressing these issues
Austerity is a necessary condition for rebalancing, but it is seldom sufficient. There are really only three options to reduce debt: restructuring, inflation and growth. Whether we like it or not, debt restructuring may happen. If it is to be done, it is best done quickly. Policy-makers need to be careful about delaying the inevitable and merely funding the private exit. Historically, as an option to restructuring, financial repression has been used to achieve negative interest rates.

Getting growth restarted

Americans’s net worth has fallen from 6 ½ times income pre crisis to about 5 at present. These losses can only be recovered through a combination of increased savings and, eventually, rising prices for houses and financial assets. Each will clearly take time.
The most palatable strategy to reduce debt is to increase growth. In today’s reality, the hurdles are significant. Once leverage is high in one sector or region, it is very hard to reduce it without at least temporarily increasing it elsewhere.
In recent years, large fiscal expansions in the crisis economies have helped to sustain aggregate demand in the face of private deleveraging. However, the window for such Augustinian policy is rapidly closing. Few except the United States, by dint of its reserve currency status, can maintain it for much longer.
With deleveraging economies under pressure, global growth will require global rebalancing. Creditor nations, mainly emerging markets that have benefited from the debt-fuelled demand boom in advanced economies, must now pick up the baton.
This will be hard to accomplish without co-operation. Major advanced economies with deficient demand cannot consolidate their fiscal positions and boost household savings without support from increased foreign demand. Meanwhile, emerging markets, seeing their growth decelerate because of sagging demand in advanced countries, are reluctant to abandon a strategy that has served them so well in the past, and are refusing to let their exchange rates materially adjust.
(Both advanced economies and emerging markets) are doubling down on losing strategies. As the Bank has outlined before, relative to a co-operative solution embodied in the G-20’s Action Plan, the foregone output could be enormous: lower world GDP by more than US$7 trillion within five years. Canada has a big stake in avoiding this outcome.

Implications for Canada

Canada has distinguished itself through the debt super cycle, though there are some recent trends that bear watching. Over the past twenty years, our non-financial debt increased less than any other G-7 country. In particular, government indebtedness fell sharply, and corporate leverage is currently at a record low.
Over the same period, Canadian households increased their borrowing significantly. Canadians have now collectively run a net financial deficit for more than a decade, in effect, demanding funds from the rest of the economy, rather than providing them, as had been the case since the Leafs last won the Cup.
Developments since 2008 have reduced our margin of manoeuvre. In an environment of low interest rates and a well-functioning financial system, household debt has risen by another 13 percentage points, relative to income. Canadians are now more indebted than the Americans or the British. Our current account has also returned to deficit, meaning that foreign debt has begun to creep back up.

Canadian firms should recognize four realities: they are not as productive as they could be; they are underexposed to fast-growing emerging markets; those in the commodity sector can expect relatively elevated prices for some time; and they can all benefit from one of the most resilient financial systems in the world. In a world where deleveraging holds back demand in our traditional foreign markets, the imperative is for Canadian companies to invest in improving their productivity and to access fast growing emerging markets.

Putting today’s challenges in context

In reading this talk and in sharing Mark Carney’s perspectives, sobering as they are, there are three considerations to bear in mind:

First, the most positive news is that Europe’s leaders appear to be coming to terms with reality. It does seem that not just Carney, but politicians and central bankers across Europe do grasp the gravity of the challenges; and are starting to implement strong measures in response.

Second, strategists universally agree that the market has priced in a recession in Europe. Unless things get much worse, virtually all of the challenges Carney outlines are reflected in current stock prices.

And finally; a reminder of the continuing divide between the bad news when it comes to debt and economic growth on the one hand and companies that are continuing to find ways to deliver strong earnings on the other. Just remember that at some point company earnings have to re-establish a connection with overall economic growth.

If you’re interested in reading more, here’s a link to the Globe and Mail column:
http://m.theglobeandmail.com/news/opinions/jeffrey-simpson/mark-carney-the-man-who-speaks-the-truth/article2270030/?service=mobile

And here’s the full text of Mark Carney’s speech:
http://www.bankofcanada.ca/wp-content/uploads/2011/12/speech-121211.pdf