By David Rosenberg, originally published by the Financial Post on July 19, 2019
No wonder interest rates are so low, pricing power is so anemic and central banks are so freaked out.
What’s driving the recent dovish actions of central banks around the world? The answer is deflation, still the No. 1 threat to global economic stability.
After a decade of expansion, growth in aggregate demand has been so insufficient in eating into aggregate supply, that we are left with a global output gap (the gap between actual global GDP and the level that would be consistent with an economy operating at full capacity) that is equivalent to 0.5 per cent of GDP.
The recovery in the wake of the Great Recession is known for its duration, but its magnitude has been so pathetic that we still have excess supply across the world.
This is why we have continuous deflation pressure — there is too much spare, or idle, capacity. That this has happened with all the policy stimulus thrown at the situation is truly remarkable and disconcerting since central banks are pretty well out of bullets, or close to being in that untenable situation.
It is one thing to say, “Hey, deflation is good, it boosts my real wage and increases my purchasing power,” but that ignores the overwhelming, detonating impact of delinquencies, defaults and then cancelled order books, rising unemployment and declining consumer confidence as deflation causes the real cost of debt to rise inexorably.
This is in the context of the most overleveraged global economy of all time.
This is in the context of the most overleveraged global economy of all time, and by whatever measure you want to use. Plus, the Fed and other monetary authorities lose control of their ability to impact the economy when there is deflation since it slows down the process of lowering real interest rates, which is the name of the game when it comes to central bank stimulation.
And for those that think that government debt-financed “fiscal stimulus” is going to help matters, look at Canada as a template — repeated rounds of stimulus over the expansion, not to mention Robin-Hood-like tax policy shifts, and the output gap is estimated to be in a -0.25 per cent to -1.25 per cent range.
Extra debt is only going to make this worse — it’s akin to throwing fuel on the flames. In addition to aging demographics, overextended balance sheets at every level of society are the pervasive constraints on the world aggregate demand curve.
The hallmark of this expansion is that global debt has surged from US$116 trillion at the 2007 credit bubble high to US$244 trillion currently, an increase of US$128 trillion. That truly is an epic change, seeing as global nominal GDP has only risen from US$58 trillion to US$85 trillion (for a US$27 trillion increase).
So let’s get this straight: The increase in debt from cycle peak to cycle peak occurred with debt outstripping the income required to support that debt by a factor of five!
And we have people out there wondering why interest rates are so low, pricing power is so anemic and central banks are so freaked out?
The solution is debt default, a debt jubilee, debt forgiveness or debt retirement — call it whatever you want. But not before this extraordinary 290 per cent world debt-to-GDP ratio is resolved will policy stimulus be effective in creating the conditions for aggregate demand to play catch-up and surpass aggregate supply growth, thereby closing the deflationary output once and for all.
Perhaps a turnaround in birth and fertility rates in much of the industrialized world will help out as well, but demographics exert their impact glacially. There is no sign of any revival here anyway, at least in the U.S. where the share of adult males living with their parents is at a level we haven’t seen since the Great Depression.
For some perspective, we know that the mortgage boom in the U.S., and China’s discovery of leverage in the last cycle, helped propel outstanding global debt at all levels of society — household, business, and government — to US$116 trillion at the 2007 bubble peak from US$86 trillion at the peak of the 2000-01 cycle. Over that six-year time frame, nominal world GDP expanded to US$58 trillion from US$33 trillion.
So let’s do the math on that — in that bubble era, debt growth outstripped the rise in global GDP by 20 per cent. In this cycle, the one we are currently living in, debt has outstripped by 370 per cent. This grotesque amount of leverage helped provide the illusion of growth and prosperity, but only a vulnerable and fake environment that would make the likes of Grigory Potemkin very proud (look him up from Russia in the 18th century — one of Catherine the Great’s favorites) — truly nothing more than a house of straw.
There has been, and will continue to be, a lot of money to be made in the fixed-income market.
So in a nutshell, we have been with a deflationary output gap now for over a decade, which is unprecedented in data back to 1985. And the ammunition for central banks is completely depleted for a late-cycle backdrop. But we know that when we have a deflationary output, inflation does tend to average 130 basis points below the levels that coincide with ‘excess demand’ periods when the output gap closes (or moves positive). We also know that the yield on the 10-year T-note is typically 140 basis points lower; for those questioning the longevity or veracity of this year’s bond market rally — my advice is to stop banging your head into the wall. Bond yields and inflation at some point will embark on a durable uptrend, but not before the output gap closes, and that does not look likely to happen for a very long time.
Not only is the output gap historically wide for such a late stage of the business expansion, but a 17-month string of declines in the OECD leading indicator to its lowest reading in a decade strongly suggests a widening of said output gap.
This is going to mean even lower inflation, in some cases a mild case of deflation ahead, and with that even lower bond yields. There has been, and will continue to be, a lot of money to be made in the fixed-income market.
A more in-depth version of this article was published in the Financial Post.