• Global growth is picking up and no major economy is over heating
  • China has a debt issue, but is well equipped to orchestrate a soft landing
  • Expanding inflationary gaps are bullish equities
  • Watch for the GDP gap to close and monetary policy for signals of when to change strategy

The US economy has de-levered and GDP growth is picking up. After years of crisis, the European economy is also hitting its stride. And despite high debt levels and the regulatory storm, even worries about China’s debt have eased for the time being. So, despite high valuations, risky assets continue to provide gracious returns. When will the good times end? How will we know they are ending? And how to take advantage? In this post I give my view.

United States - the Goldilocks economy

Consumers and businesses in the world’s largest economy have de-levered to pre-great recession levels. Meanwhile, the US government has levered up to post World War 2 levels. Households, businesses, and government are all increasing debt and income at the same rate (Figure 1). No imminent debt bubbles are forming.

Figure 1: US debt to income for consumers, business, and government

Figure 1 -US_income_to_GDP.png

Source: FRED, Vital Data Science

As US government debt has offset consumer and business deleveraging, total debt to GDP levels remain at historical highs (Figure 2). The US governments has more options for dealing with debt than business or consumers, therefore, while not inconsequential, the chances of US government debt creating an imminent crisis are low. Meanwhile, consumers and business are free to use their cleaner balance sheets to spend and invest which should grow the economy. Interest rates are likely to remain below those considered normal for the foreseeable future given government debt loads. Combine all of this and you have an economy that is finally performing above its potential (Figure 3), but is not over heating - the Goldilocks economy.

Figure 2: US total debt to GDP and Fed Fund Rate

Figure 2 - debt_to_income_and_fed_funds.png

Source: FRED, Vital Data Science

Figure 3: US inflationary and deflationary gaps

Figure 3 - GDP_gaps_and_recession.png

Source: FRED, Vital Data Science

U6 unemployment rate is nearing 2007 levels, leading indicators and consumer sentiment are high, capacity utilization has stabilized (Figure 4). Increasing inflation is coming. The last time debt/income levels of consumers and business were at these levels interest rates were near 5%, so all things being equal, the Fed has room to play with.

However, all things are not equal. The economy is more fragile than debt to income values indicate. Low labour force participation rate and a lagging real median US income are signs the recovery mainly benefited wealthier citizens at the expense of middle America. Wealthier citizens do not consume their wage gains - they invest them. With no meaningful wage gains, large consumer spending will drive debt creation and be sensitive to interest rates.

Figure 4: US Leading indicators, capacity utilization, consumer sentiment, U6 unemployment, and inflation

Figure 4 - US_LI_U6_etc.png

Source: FRED, Vital Data Science

Another headwind in the American economy is demographics. The US population is increasing at the lowest level since WWII. Population growth will be a lower contributor to GDP than in previous generations and US business will need to look outwards to grow. Expanding abroad will be challenging in today’s global political climate. With growth being challenged domestically and offshore, the waves of consolidation in many industries will continue as companies use scale to squash competition, lower costs, and control pricing.

European Union - growth finally

Europe has followed a similar trajectory to the US, but is a couple of years behind. The time delay is the result of: a) American Fed’s robust response compared with the ECB’s initial tepid response to the financial crisis, and b) the challenge of coordinating the actions of different governments and cultures post crisis. Outside of the time delay, the debt to income dynamics are similar: consumers and business have de-leveraged, governments have increased debt burdens (Figure 5). European GDP is rising, helped by loose monetary policies which decreased the value to the Euro and resulted in a stronger trade balance (Figure 6).

Figure 5: EU GDP

Figure 5 - EURO_GDP.png

Source: FRED, Vital Data Science Inc.

In the near term, Europe’s headwinds are mainly geopolitical: the rise of populism, nationalism, and Euro skepticism; Brexit; Russian meddling in Europes Eastern borders and politics; US unwillingness to commit to supporting NATO allies; and recently, Merkel’s inability to form coalition in Germany. For the time being, and excluding Russian meddling, I see these headwinds mainly as noise in region which is otherwise hitting its stride after the 2008 financial crisis.

Figure 6: European currency

Figure 6 - EURO_FX.png

Source: FRED, Vital Data Science Inc.

Tailwinds for Europe include the election of a more business minded president on France, Francois Macron; generally good management of the refugee crisis which over the long term may serve as a springboard for growth by improving demographics; and prolonged accommodative monetary policy combined with a rebound in the global economy which will help drive export led growth.

I believe that Europe is likely to continue to expand, albeit at a moderate pace. However, when the next financial crisis hits, the Euro zone is no better prepared than it was for the last one. Unless the structural flaws which the great recession exposed are addressed, the next recession may well cause the disintegration of the Euro Zone.

China - orchestrating a soft landing

From a debt and income perspective, China is like US and Europe in 2003 in the sense that debts are increasing at a higher rate than income (Figure 7). Unlike Europe and US during that period Chinese GDP growth is slowing, albeit from a very robust pace. The ‘regulatory storm’, as it is being referred to, is slowing debt growth and lowering other stimulative forces in the economy. It is a risky time for the Chinese economy, but there are three factors which improve China’s prospects.

  1. Party control of the state, economy, and population allows for coordinated (monetary, fiscal, and regulatory) policy creation and effective implementation;
  2. strict control over currency prevents sharp swings, financial outflows, and enables coordination with monetary, fiscal, and regulatory policies; and
  3. movement of the economy towards a consumer model which is less dependent on external demand for growth.

China has picked the best parts of open economies and combined them with the best parts of controlled economies, then employed a strategy to aggressively modernize and grow its economy by directing capital and other resources where needed.

Figure 7: Chinese debt to GDP

Figure 7 - CH_debt_to_GDP.png

Source: FRED, Vital Data Science Inc.

 

 

While growth may be slowing and debts may be increasing, the three factors listed above as well as economic gains China made in the last several decades will help China de-leverage smoothly. China does have a debt problem which it needs to address, but they are well equipped to provide a soft landing. Doing so in the midst of a expanding global economy only increases the chances of success, or put differently, reduces risk of imminent crisis.

 

Outlook

In a turn of events which surprised many (myself included), the global economy has hit its stride.

I believe the global expansion has legs for another 1-2 years. No major economy is currently over heating, and there are currently no imminent economic crisis. The US economy is furthest along the expansion phase and is now operating above its potential; it is therefore most at risk of over heating. Slack has all but disappeared in the labour market and inflation should begin to increase in the coming months above the Fed’s target of 2%. The Fed will further normalize monetary policy.

With interest rates at historical lows, debts at historical highs, and increasing inequality, the economy is more fragile than some of the headline numbers show. Because of this, there is increased risk of tightening too quickly and triggering a recession sooner than would otherwise happen - this happened in 1937. The Fed appears aware of this risk and is taking a very gradual approach to tightening.

In the US, inflationary gaps on average last over 2 years, for the aforementioned reasons this one will likely be shorter and the next recession is likely to be deeper. In the next recession, the Fed will not have the luxury of high interest rates to lower and will embark on a asset buying program to stimulate the economy, which will have limited impact in a low yield environment. The government will then be forced to step in and give money to families and business to invest, in the form debt write-offs, interest free loans, and tax breaks.

China will continue to attempt to orchestrate a soft landing de-leveraging. The key will be if the party can find the right formula. The odds are against them, but given their aforementioned advantages, China is uniquely capable of orchestrating a soft land. We remain cautious on China as we believe a crisis in the region would have strong spillover effects in the global economy.

Europe will grow until it is derailed by either internal turmoil (see risks to forecast below) or until a decrease in global demand. I believe this will happen in the next 2 years as a result of the US economy over heating (or being cooled too quickly) and/or the China’s deleveraging. In the meantime we do not believe Europe poses a major risk to equity bull market.

Economic Trend: increasing inflationary gap with rising interest rates.

Duration: 1 to 2 years. While history tells us economies do not stay in equilibrium, currently no major economy is over heating. US economy is furthest along in the cycle and will likely be the first major economy to over heat and cause the next global recession.

Risks to forecast: 

  1. China is in a sensitive debt position, there is risk a “soft-landing” deleverging is not orchestrated.
  2. US political instability/grid-lock creates an environment which is anti-growth/investment.
  3. Geopolitical instability in eastern Europe, or the Korean Peninsula, or in the Middle East causes a major war.

Strategy

It will continue to be a good time to be long equities. Figures 8 and 9 show results of my GDP gap model. The model employees is a Bayesian Network algorithm, trained on US economic data. The US is in a increasing interest rate, inflationary gap, and likely increasing inflationary gap environment. Based on historical evidence, our model indicates very high likelihood of a continued bull market in equities (green circle in Figure 9).

Figure 8: Bayesian network model results, pg. 1

Figure 8 - bayes results pg 1.png

Source: Vital Data Science Inc.

When will I be worried? The first indicator for me will be closing of the inflationary gap. This will be a sign the economy is cooling, and increases the probability of an end of the equity bull market. The most important variable is monetary policy. If the economy cools per above and the Fed responds by lowering interest rates, that will be a very strong indicator that the bull market is over (purple circle in Figure 8). Until either of these indicators presents, or I believe one of the three risk I mention above has a strong chance of occurring, I will remain long equities.

Figure 9: Bayesian network model results, pg. 2

Figure 9 - bayes results pg 2.jpg

Source: Vital Data Science Inc.

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