The Real Deleveraging Is Impending

Includes: EEM, GLD, SLV, SPY, VDE
by: Disruptive Investor

Economic history tells us that free markets tend to behave irrationally at times. The same economic history also tells us that markets always return to realistic levels in the long term. The critical factor is to allow the financial or economic system to clean out the excesses.

One of the biggest factors behind the biggest financial crisis after the Great Depression of 1929 has been excess leverage in the financial sector. Leveraging by households and the government (especially after the year 2000) also deserves a mention.

The crisis, which took an ugly shape since October 2007, did lead to the natural process of deleveraging in some sectors. However, on a consolidated basis, the problem of excessive debt remains and can be a potentially bigger threat to the global economy in the long term. This article discusses the reasons for believing that the real deleveraging is still to come. Also, the investment ideas for near to medium-term are discussed.

The point I am trying to make in this article is evident from the chart below, which gives the debt to GDP for advanced economies from 1989 to 2012.

The overall debt to GDP levels peaked out at 195.2% in 2009 and declined to 184.0% by 2011. However, the debt to GDP increased to 188.4% in 2012. The increase in leverage has primarily been due to higher government debt, which has been partially offset by a decline in debt in the financial sector. Very clearly, the total leverage in the system remains close to the levels witnessed during the peak of the financial crisis.

Therefore, if excess leverage was one of the main contributing factors to the crisis, the core issue still needs to be resolved. More importantly, the problem threatens to get bigger as governments around the world peruse expansionary monetary policies. I am emphasizing on the government sector because a government sector deleveraging can lead to an impending collapse of the financial system. Also, the timing seems right as the chart below shows the government debt scaling new highs in advanced economies. In all previous instances of abnormally high government debt (above 90%), the result has been default, financial repression and high inflation.

All these scenarios have the potential to bring about the real deleveraging in the global economy. More importantly, it can lead to massive wealth destruction and widespread social unrest. My objective is not to scare investors. However, one needs to exercise caution and be more informed of the dire consequences of leveraging and excessive government debt. This is especially true when government debt is having a diminishing impact on economic growth.

Specific to the U.S., my concern is even higher as government debt surges to uncharted territories and is already over 100% of GDP. Further, the CBO has projected USD10 trillion in deficits over the next 10 years. Huge unfunded liabilities will add to the gigantic debt. Therefore, there is no case for government debt deleveraging in the foreseeable future.

The private sector, which is the dynamic sector of the economy, has acted more rationally by deleveraging. The same holds true for the household sector, which has been deleveraging, even with interest rates remaining at record low levels. However, if the government continues to pile debt and tax increases are implemented in order to control deficits, crowding out of the private sector investment can do worse than good to the economy.

Considering these factors, investors can expect the real and massive deleveraging cycle to begin sometime in the next 5-10 years. Before that, the governments in the Western world will continue with their expansionary monetary policies, which benefit banks and financial institutions more than consumers. I explained this in detail in my earlier article.

From an investment perspective, all risky asset classes will continue to trend higher over the next few years as ultra-easy monetary policies lead to the flow of money to asset classes such as equities, industrial commodities, agricultural commodities, energy and precious metals. It is also very important to be diversified globally in the current economic and financial scenario. With this broad rationale, I would consider the following ETFs in my portfolio.

SPDR S&P 500 ETF (NYSEARCA:SPY) - It has been proven that beating the index is not an easy task. Therefore, the strategy should be simple -- beat the index or invest in the index. From this perspective, SPY looks interesting. The ETF provides investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index. I expect the S&P to trend higher over the next 3-5 years.

iShares MSCI Emerging Markets Index Fund (NYSEARCA:EEM) - is a good option to invest in emerging markets. I can say with conviction that emerging markets will outperform the advanced market equities over the long term. The ETF, with a low expense ratio of 0.67% seeks to provide investment results that correspond generally to the price and yield performance, before fees and expenses, of securities in emerging markets, as represented by the MSCI Emerging Markets Index.

Vanguard Energy ETF (NYSEARCA:VDE) - The ETF seeks to track the performance of a benchmark index that measures the investment return of stocks in the energy sector. With a low expense ratio of 0.19%, the ETF is a good investment option in a sector, which has good upside potential in the long term.

SPDR Gold Shares ETF (NYSEARCA:GLD) - I maintain that view and investors can consider exposure to the hard asset for the long term. In the near term, some more correction in the precious metal is entirely likely. However, expansionary monetary policies, artificially low interest rates and demand from Asian central banks will trigger long-term upside in the precious metal. The GLD ETF seeks to replicate the performance, net of expenses, of the price of gold bullion.

iShares Silver Trust ETF (NYSEARCA:SLV) - Very similar to the argument for gold, I am also bullish on silver for the long term. Investors can consider exposure to silver through the purchase of physical metal or the ETF, which seeks to reflect the price of silver owned by the trust, less the trust's expenses and liabilities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.