When Will We See Deleveraging?

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

Deleveraging has been in discussion ever since the financial crisis of 2008-09. I have read numerous commentaries on the painful and long process of deleveraging, which is assumed to be underway. In this article, I will discuss the reasons for believing that the real deleveraging is yet to start.

To put things into perspective, the chart below gives the total credit market debt owed in the US. The total credit market debt has surged from $47 trillion at the beginning of 2007 to $56 trillion in the fourth quarter of 2012. On a consolidated basis, there has been significant leveraging instead of deleveraging. Also, if excessive debt was one of the primary reasons for the current crisis, we are headed for a bigger crisis in the future.

A break-up of the total debt outstanding in the US might give a better picture of the sectors that have been leveraging and the sectors that are deleveraging. Starting with the household sector, the chart below gives the total debt outstanding as of 4Q12.

The household sector debt peaked out in April 2008 at $13.8 trillion. Since then, households have been deleveraging and the total debt has declined by $1 trillion to $12.8 trillion as of 4Q12. This is very understandable and can be related to in an economic downturn associated with relatively high level of unemployment. I must mention here that students loan, which are over $1 trillion, can be a potential problem for banks over the next few years. The most important point that I want to highlight here is that the household sector has acted rationally and deleveraged in the downturn.

I switch my focus to the domestic financial sector, which has been at the epicenter of the current crisis. The chart below gives the total debt owed by the financial sector as of 4Q12.

The total debt owed has declined from a peak of $17 trillion to $13.8 trillion as of 4Q12. There is no doubt that domestic financial institutions were excessively leveraged before the crisis. This has reversed to some extent and I expect the deleveraging process for financial institutions to continue for the long-term. The problem of non-performing assets will stay for long-term and financial institutions will be forced to deleverage and sell non-core assets over the next few years. Artificially low interest rates continue to act as an extended bailout for banks. Overall, the banking sector is also trying to work its way out of the crisis.

Coming to the non-financial corporate sector, the sector has been leveraging after a brief period of deleveraging. I must point out here that the US corporate sector has been the dynamic sector of the economy and the primary GDP driver after the crisis. In that sense, the leveraging is understandable as the leverage does bring in an incremental positive impact on the GDP.

The chart below gives the US corporate profit after tax. As of fourth quarter of 2012, the US corporate PAT was at a record high of $1.7 trillion.

Finally, total government debt is shown in the chart below. Total Federal debt has surged from $8.8 trillion at the beginning of 2007 to $16.4 trillion as of 4Q12.

In other words, the government sector has been the biggest contributor to the leveraging process after the crisis. The benefit of the leveraging has been minimal on the real economy and I discussed this aspect in detail in my earlier article. The deleveraging of the private and household sector after the crisis has been offset by the leveraging in the government sector.

I come back to the primary question - When would the real deleveraging start?

I am of the opinion that the government sector will continue to leverage and the CBO data does indicate that the expected deficits over the next 10 years will be in the tune of $10 trillion. The government is in an inescapable debt trap and the effort of the government sector would be to inflate its way out of debt. I had discussed the topic of financial repression in one of my earlier articles.

What is more important here is to understand the implications of such an event. In all probability, there will be a bout of high to very high inflation followed by deflation. Investors therefore can consider playing the inflation trade over the next 3-5 years. However, volatility will remain a key characteristic of the current investment environment. Investors therefore need to remain invested for a relatively longer period than venturing into trading. For the medium-term, the following investments look attractive -

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. Also, with excess money flowing into risky asset classes, the S&P should trend higher over the next 3-5 years. Therefore, the expected correction can be used to consider fresh exposure to the ETF. The ETF provides investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index.

Besides physical gold, gold ETFs are a good option for long term and investors can consider exposure to the SPDR Gold Shares (NYSEARCA:GLD) ETF. The investment seeks to replicate the performance, net of expenses, of the price of gold bullion.

iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) - The iShares ETF corresponds generally to the price and yield performance, before fees and expenses, of publicly traded securities in emerging markets, as represented by the MSCI Emerging Markets Index. It is important to diversity the portfolio to emerging markets as the EM's have the potential to significantly outperform developed markets in the long term.

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 considering incremental demand from Asia and continued expansionary monetary policies.

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.