How many among economists, and businessmen, expect negative economic growth (contraction in economic output) for the next decade or two, not just in the US, but in the whole developed world? The easiest and most accurate answer would be almost none. Is it possible that this turns out to be the most devastating 'black swan' that will appear?
With all the chances of being proven wrong over time, I do believe that the future holds grim prospects for the world economy. Current economic theory, based on pure fiat currency, simply discounts the huge impact of debt on economic activity. I have amply discussed my theory regarding the implications of debt in a previous article.
Recently, by the occasion of the publication of Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) investor letter, Warren Buffett said the following "the babies being born in America today are the luckiest crop in history." Mr. Buffett has tens of billions of reasons backing every statement he makes, but I beg to differ on this one, and I don't have that much obvious 'reasoning' strength to back my disagreement other than the rationale behind my argument. Let's take a look at the chart below, showing how private debt to GDP has grown in the US (and the rest of the world for that matter). The chart shows US non-financial debt (business and household) since the 1920s until a couple of years ago.
The two lines (above) combined clearly show that levels of private debt in the US (and also in the rest of the world) have never been so high. Although it seems like US private debt levels have somewhat fallen since the financial crisis, it may only be marginally, which could have since evaporated because of massive non-financial corporate borrowing for Mergers and Acquisitions (M&A) and share buybacks within the past few years (not necessarily seen in this chart). However, private debt levels for the whole world, calculated in US dollar terms, have risen markedly since the financial crisis, thanks to Emerging market borrowings, especially in China.
I am not hearing economists or important business people, let alone politicians, ever mentioning what is going to happen to economic activity if we remove further private debt accumulation. As things stand now, not only in developed economies, but also in China and many other Emerging economies, there isn't much appetite, let alone room, for further debt accumulation. The whole world seems to have run out of possibilities to add to private debt. Even negative interest rates have failed to encourage further borrowing. This is quite a new situation, as corporate borrowing seemed to be very profitable up until 2013 or so in China, and up until last year in the US, though for very different reasons. Chinese companies were using the funds for investments while US companies were using the funds for buying shares, whether their own shares in buybacks, or other companies' shares in M&A. Both of these activities seem to be quite a stretch at this moment. Chinese companies, on aggregate, are not delivering results to justify any further lucrative borrowing, while the S&P 500 has almost doubled since the lows of 2011 when most corporate share purchases started. Corporate share purchase in America has been losing its punch in recent quarters as EPS (Earnings Per Share) have been falling despite continued corporate squeezing of share counts (buybacks or M&A). These two, Chinese and US corporate borrowings, were the engines of private debt accumulation for the last few years. Both of them have pretty much lost their economic/financial rationale, and impact.
What next? Chinese companies need serious restructuring, while US companies will have to drastically reduce their share purchases. None of these two have yet happened in earnest, but I believe they will, soon. It doesn't exactly take a genius to see that a great number of Chinese companies are selling their products at a loss, whether at home or abroad. And it doesn't take a genius to see that profits have been falling in corporate America for more than 4 quarters by now. Even adjusted earnings have been falling, and 'adjusted' usually means adjusted to the upside, ignoring many accounting costs which corporate bosses consider to be one-off or non-core. But the fact is that these types of costs are always there, and they are always one-off or non-core, but they tend to appear in different shapes or forms.
Of course all these 'issues' (or negatives) can be temporary as economic activity picks up if you are patient enough, right? I could even call this the 'Warren Buffett hypothesis'. The contemporary great investor is the living proof that all you need to do is to be patient and everything will work themselves out, and the economy will eventually continue to grow, almost like magic!
But what if he is simply wrong? What if he was only lucky enough to have been born exactly at the right time, and he happened to have the luckiest idea out there to invest using a great deal of leverage at the exact dawn of what has so far proved to be the nirvana epoch of leveraged investing? Mr. Buffett tends to say that borrowing is dangerous in investing, but let's just be serious here; he takes premiums for insurance and uses the funds to buy shares! That could arguably be, at least, one of the few mothers (if not the fattest one) of leveraged investing ideas. It would have also been considered utterly insane, irresponsible and risky, at any other period of time in history, EXCEPT for the period that followed World War Two until today.
I have drawn the following two charts showing what a debt-fueled growth cycle, and a non debt-fueled growth cycle, can look like.
We have been on a mega credit cycle (leveraged growth) since the end of the Second World War, which has pretty much reached saturation by now. The credit cycle has been so lengthy that we have had many traditional growth cycles within it, like the one which started in 2001 and ended in 2007. And I believe, no matter what central bankers or politicians do, there won't be any growth for Developed economies (and some Emerging economies) ahead, but plenty of recession, until all the excess capacity has been cleaned up. There is plenty of excess capacity out there, particularly manufacturing in China, but also a huge amount of excess service capacity in Developed economies.
Almost nobody is thinking, let alone talking, about possible consequences of so much debt having been accumulated in decades. All this private debt has continuously created additional economic activity. When the process of debt accumulation stops it will not mean slow growth, or zero growth, because private debt has always carried interest, and all private debt in the world at this moment carry interest. There are bankers, private lenders, and a huge number of various market participants, who live off the proceeds of private debt. They are an essential, though hugely bloated, component of today's economy. In an environment in which debt no longer grows, the economy will not stagnate. The process will inadvertently reverse, and economies will have to shrink in real terms. Inflation (in case governments can kick-start it) can indeed give the impression that some metrics remain constant, but real economic output will have to start reversing (shrinking) when debt no longer accumulates. And this will fundamentally happen because of the fact that private debt, invariably, carries interest (and various other costs), and in an environment of zero economic growth (as debt levels no longer grow), excess debt of the prosperous past cannot continue being serviced (famous recent example can be Greece).
Government debt is a completely different matter, as it can be (as it has always been) serviced through inflation (printing additional money). In the worst case scenario government debt can also be taken over by the central bank (as it has already been done many times in Quantitative Easing) and rolled on forever, or at some point even written off (given new extraordinary laws for extraordinary times). Nevertheless governments are not currently employing huge numbers of employees, or creating job opportunities for others. Governments are not, and will not, be able to compensate for all the decline in the private sector.
Here is what I envisage a very probable financial scenario ahead. The unraveling of what I described above will have very bad repercussions for risk assets; private debt (especially corporate bonds), stocks and real estate. Since we have ALWAYS had recovering markets ever since the Second World War, an initial crash of perhaps 30% or so (S&P 500 going to 1,500), most likely this year, will attract new investors, and new money, in to risk assets, who will expect a rather quick recovery in 2017 or 2018 latest. Governments will also take unprecedented measures, this time more fiscal than monetary (because monetary policy is out of ammo in pretty much all Developed economies). These measures will also encourage a lot of new risk taking and private financial investments. Therefore there will be a period of renewed enthusiasm in risk-taking which will lead to a short-lived stability in risk asset valuations. However, the fundamental problem is, as I have explained, that there is simply too much private debt out there which has created, for decades, continuously rising economic activity. As this private debt naturally tends to become ever more unprofitable, there is simply no way around a natural contraction until the market finds a flooring where economic activity becomes sustainable again. And this is quite far away, with private debt around the world at record highs. I expect these government fiscal measures to have some effects, particularly inflationary, but the initial crash of 30% that I mentioned can also pop two huge dormant financial bubbles - another euro crisis, and a debt crisis in corporate China. These two will create real drag on economic activity. A worsening financial situation in Developed markets will make a crash in the Chinese yuan, and a renewed euro crisis both unavoidable. Almost any major economist and business person would agree on this with me. However almost all of them would expect all these horrible situations to work themselves out in a few quarters. But I believe that there will be another, larger decline in risk assets later on, a decline which will take US indices toward the lows of 2008-2009. And there will be no quick coming back to record highs this time around. Private deleveraging will inevitably take place, businesses will suffer greatly and unemployment will rise.
All this sounds too bad even to imagine, but I believe it to be a natural consequence of decades of simply wrong fiat currency economic policy which has encouraged uncontrolled private borrowing for decades. One cannot leverage up forever and enjoy improved material prosperity (economic growth) based on borrowing from the future unless being prepared to understand that one day things will, inevitably, reverse. One day you will simply run out of people willing to risk their funds lending to you. They (the lenders) cannot be replaced by the government in today's sophisticated financial system, as they, the creditors themselves, are a major component of economic activity and their loss would in itself be a massive blow to the economy, let alone the consequences of their inaction (not lending). Investors are hoping that the party can go on for longer. I don't. The only time a major private deleveraging happened was after the crash of 1929, and it took the world to a decade of deep economic depression. The difference today is that the private debt pile has been going up for much longer and it has become much larger.
Disclosure: I/we 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.
Additional disclosure: I am short Nasdaq 100.