Weak Global Credit Growth Keeps Rates Low, Risk Assets' Risk-On Period Longer

by: Robert P. Balan


The issue that inhibits growth in many developed economies is that desired savings are rising while desired investment is falling - credit growth is not growing fast enough.

Lack of a global "borrower/spender of last resort" prolongs the global slowdown. Fortunately, there is some progress: Brexit may finally force politicians to get serious with infrastructure spending.

With central banks unable to tighten monetary policy much more, this effectively means the conventional concepts and implications of the business cycle may not apply during the current period.

Concepts of valuation being applied at this time, which have origins in the conventional business cycle theme, are being trumped by the liquidity being proffered by the global central banks.

The risk-on period may therefore extend further as global central banks gear up for another wave of generosity; this time undervalued commodities (and oil, gold) will be the primary beneficiaries.

The issue that inhibits growth in much of the developed economies is that desired savings are rising while desired investment is falling. The US example is useful in illustrating this fact. Credit growth in the US is not strong enough to kick-start growth higher: US households and corporations have become increasingly averse to taking on new debt, causing desired savings to rise and desired investment to fall. The cause: credit growth is not growing fast enough to sustain desirable rate of economic growth. And that loops back into a higher savings rate by households and corporations fearful of the consequences of yet another growth recession.

As we see from the chart above, credit growth matters to GDP growth. And the lack of progress on that aspect loops back into a higher savings rate by households and corporations fearful of the consequences of yet another growth recession - which, in turn, negatively impacts on aggregate demand. The main challenge facing the world economy today, in fact, is a shortfall in aggregate demand, as a consequence of this pullback in consumption and corporate capex (see chart below).

This has shown up as a surfeit of savings over investment, or equivalently, an excess of output over desired spending. The Great Financial Crisis (GFC) was responsible for altering consumer preferences in fundamental ways. For example, less than half of Americans told Gallup that they wanted to save more money before the financial crisis; today, that number has risen to two-thirds, according to the survey. Among households that want to spend more, they say that stricter lending standards are preventing them from doing so. This is why up to this time, deflation, rather than inflation, has been the primary risk to the global economy, which shows up in disinflation, and in the sharp drop in US and global bond yields to once unfathomable levels (negative in many parts of Europe, in fact); see chart above.

The lack of a global "borrower and spender of last resort" - prolongs the slowdown

The situation is exacerbated by the refusal of the governments of many developed economies to engage in fiscal stimulus, or to put it starkly, in deficit spending. The lack of a global "borrower and spender of last resort" - is prolonging the global growth slowdown. This was true in the US as well; after initial fiscal stimulus during 2008-2009 FY sparking growth which was higher than those of other countries, US budget outlays were cut and growth was held up only by additional stimulus coming from the Federal Reserve (see chart below).

Fortunately, there is some progress along this front - fiscal austerity is giving way to talks of infrastructure spending by politicians (the new Canadian prime minister actually partly ran on a platform of infrastructure spending, and won), and the obsession with fighting inflation is starting to be replaced with talk of helicopter money (which is basically a Treasury function and in the purview of fiscal policy), and other radical solutions. But those solutions will not come soon enough to prevent further growth stagnation. However, this means that interest rates will remain low, and the risk-on environment will continue for longer. Our practical assessment: it will take another growth recession scare to spur a transition from "talking fiscal stimulus" to "actual fiscal stimulus". Since we do not expect a recession over the next 6 to 12 months, then fiscal stimulus is unlikely to feature into financial market expectations until probably the end of 2017, by our reckoning.

The Brexit vote was pivotal in the transition to more fiscal spending, in our opinion. After the June 23 Brexit results, all politicians have been given a warning shot. Politicians now have no choice but to react. They have to placate the irate masses. Therefore, ideology is out, realism is in. Populism is in - any other polity is out. And there is only one way to do it. The meme of austerity, which is keeping global growth in doldrums, is out - fiscal spending to generate growth is in. It may take a while, but the seeds of widespread global spending have been, or are being, sowed. With fiscal (deficit) spending, growth and inflation should follow. We again illustrate this with an example from the US experience, post-GFC (see chart below).

The global central banks' hands are tied

Insufficient credit growth takes away what is, by far, the most powerful transmission channel of central bank monetary policy - modulating credit - which had been utilized very effectively by central banks until the Great Financial Crisis of 2007-2009. This had forced central banks to rely increasingly on manipulating asset prices, interest rates and exchange rates to stimulate activity and growth with the use of their balance sheets. The central banks have had plenty of success with the former approach in the years after the GFC (see chart below). The Federal Reserve's QE programs have become a dominant determinant of asset prices after the GFC (see chart below).

The other tool of the central banks in promoting growth - manipulating the local currency lower - has had spotty results so far; not all central banks can successfully push their exchange rate down at the same time. At least one central bank has to be willing to take the other side of the FX transaction. The Fed had previously been willing to take that role, but has of late demurred when the strength of the US dollar started to negatively impact domestic and EM (e.g., China) economic activity. The Fed had historically used the relative levels of the US dollar to tighten or loosen fiscal conditions, when altering official policy rates was neither feasible nor desirable.

With rates at default low - even negative - levels, the business cycle stays dormant for a while

Therefore, many, if not all, central banks (e.g., the Federal Reserve) do not have the wherewithal to tighten policy rates, or tighten them aggressively. As a consequence, over the near term (6 to 12 months), bond yields will likely stay low and depressed by default. With central banks unable to tighten policy by much, this effectively means that the conventional concept of Business Cycle ("BC") may not apply during the current period. The Business Cycle - it should actually be called the "Credit Cycle" - happens when in a world of vigorous credit growth, there would be periods of upward pressure on interest rates and subsequent decline in rates, so as to bring the demand and supply for capital into balance, and this happens in a more or less regular cadence. But with rates at default low, even negative, levels, the Business Cycle stays dormant, and so the usual implications BCs have on asset prices do not necessarily apply during this period.

The conventional view is that it is becoming increasingly difficult to sustain the advance in the equity and bond markets because valuations in those markets have become stretched. But we argue that the concepts of valuation being applied at this time have origins in the conventional Business Cycle concept, which we believe do not apply, given the macro conditions prevailing in the current regime. Therefore, we believe that with interest rates at a default setting of low (even negative), and unlikely to change much during the period, risk assets should continue to perform well in the near term. The risk-on period will likely go longer than what can be normally expected, compared to periods when the financial markets are subject to the normal vagaries of the Business cycle - the liquidity being proffered by the global central banks' expanding asset balances trumps the vagaries of the BC at this time. The bank reserves parked at the Fed, for instance, have become the dominant factor in US interest rate and asset price determination, even today (see chart below).

We believe that global equities (the US stock markets at least) and other risk assets will trade sideways over the course of summer, then resume the uptrend during the later part of the year, as we expect the central banks of the major developed economies to undertake a new wave of stimulus or further policy easing by then.

Investors are migrating to undervalued financial assets

Nonetheless, equity and bond valuations are indeed deemed stretched by many investors, and that is causing a re-evaluation of other alternative assets that have been left behind, valuation-wise. With central banks still being generous, and will likely become even more generous if the global growth doldrums carry on for longer, investors are starting to have a closer look at commodities and other hard assets. The new interest was raised to a new level with precious metals (GOLD) at the start of the year, when US and global growth dropped precipitously, sparking a massive precious metals rally that is still ongoing. Then HY took off, triggering a base metals sector rally in February, when it became apparent that China is not going to implode (see chart below). High yield rates are still falling sharply and should maintain its momentum in the short term at least. Then the Agriculture sector followed suit in April when the El Nino started to make a transition to La Nina, an even worse nemesis of the sector. It also helped that some prices in the Base Metals and Agriculture sectors have gone below cost of production, and that has helped curtail further supply.

Citigroup said in a report this week that supply cuts are showing in petroleum and North American natural gas, some base metals and farm products, even as global raw material demand still continues to grow, helped by the US and China. The improving global demand outlook was one of the reasons why returns from commodities trounced those from other assets in the first half of 2016, underpinned by the oil market's showing signs of rebalancing, spurring a rally in energy prices. Clearly, investors are looking to shift focus and have gone to undervalued assets in the commodities and hard assets sectors, including precious metals.

Meanwhile, the US dollar will remain range-bound and benign

With the Fed unable to change monetary policy setting much, and the risk remaining to the upside, the US dollar will tend to trade according to factors other than those related to interest rate differentials and monetary policy divergences. We submit the proposition that a forthcoming sharp rise in oil prices will lead to, or help, in weakening the US dollar going into the late part of H2 2016 and even further (see charts below). A sharp rise in crude oil prices, and attendant weakening of the US dollar, should help spark renewed interest on the commodities asset class, as well as provide underlying upside pressure on inflation and inflation expectations. The recent sharp rise in oil prices will be factored-in in inflation measures by late Q3 2016. Development in inflation prospects along those lines will loop back, and should further provide boost to commodity prices (e.g. crude oil) and add to the downward pressure on the US dollar.

There is significant amount of academic work which investigated the long-run relationship between US dollar rates and the price of oil. The academic work generally finds that US dollar exchange rates and the price of oil are cointegrated and exhibit a positive long-run equilibrium relationship: that is, higher oil prices are associated with the decline of the US dollar, and lower oil prices can be associated with the rise in the value of the US currency. Furthermore, the literature generally finds that oil prices Granger-cause exchange rates, but not vice-versa, meaning that causality flows from oil price to the USD exchange rate. That kind of relationship is not difficult to show with normal regression analysis. In the charts provided below, we show that, indeed, the causality flows from oil prices to the USD exchange rate.

Brent Crude Oil price as the reference variable (x axis); USD TWI in the y-axis. The regression work shows that the R^2 deteriorates when you put the USD price ahead of the Brent price by one quarter.

Brent Crude Oil price as the reference variable (x axis); USD TWI in the y-axis. The regression work shows that the R^2 improves when you put the USD price behind the Brent price by one quarter.

All the regression work presented above provide support to the thesis that crude oil impacts the US dollar much more than the other way around. The proposition that the rising price of crude oil will help weaken the US dollar over the course of the year owes it origin in a series of charts, which includes those shown below:

The charts shown above and below analyze the correlation between the oil price and the CapEx and oil output variables. The relationship between CapEx and production has been generally constant in recent history - the amount of CapEx spent 16 months ago continues to the the primary determinant of oil production today (see chart above). The lead of output over oil price has widened from 2 months to 1 month periodically. Then we add the US dollar into the mix, shown in its inverse. If indeed crude oil is a lead variable for the US dollar, with a negative co-movement, the expected sharp rise in crude prices over the next two years (at least) as consequence of collapsed capital expenditures (see chart below) should correspondingly weaken the USD TWI.

The outlook for commodities and other hard assets is improving significantly

The improved outlook for oil and other hard assets has not gone unnoticed by investors and major investment banks. Bloomberg reports that returns from commodities trounced those from other assets in the first half as the oil market showed signs of rebalancing, spurring a rally, despite the UK's vote to quit the EU, for a while boosting concern about the outlook for growth. Global raw material demand still continues to grow, helped by the US and China, while supply cuts are showing in petroleum and North American natural gas, some base metals and farm products, Citigroup said.

"Unlike last year, when commodity markets rallied through the second quarter only to fall sharply come the third as oversupply persisted, this rally looks more sustainable as physical markets have tightened considerably," Citi analysts wrote. "Global demand continues to grow at a moderate rate while the pullback in capital spending is reducing not just supply growth but total supplies across nearly all extractive industries."

"Crude oil prices are expected to resume their ascent as the market rebalances further and this should be bolstered by deepening cuts in non-OPEC oil production. In oil, the pendulum is clearly swinging from the bears to the bulls, " Citi also said.

In this environment of rebalancing supply and demand, we foresee that the current price rise has much further to go into 2017. The decline in global crude oil output will likely accelerate over the next few quarters based on the historic relationship between global CapEx and global oil production (refer to the chart above). Based on the chart above, and our other supply-demand based models, one of those is shown below, there should be a sharp uptake in crude oil prices as from late Q3 until year-end. The rise in crude oil prices could be sustained by the failure of the expected backstop measures to provide the oil supply when needed - we could be looking at an oil price reaching $90 per barrel by 2018 (see chart below).

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. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The company the author represents may have outstanding long or short positions in the commodities discussed in the article. The company may also initiate new positions, long or short, in any of those commodities mentioned, within 72 hours of publication of this article.