23.3.2016 Tommi Kemppainen

How much is a lot of debt?

Home in homeland – Real estate investments globally
Talk the talk – walk the walk

Interest rate cut as a market control mechanism doesn’t work anymore. The purpose of a lowered interest rate is to increase economic activity. This is when one can borrow more because the total expenses of old loans will fall, and the additional loan can then be spent or invested. At the moment, however, a rate cut doesn’t produce the desired economic recovery in accordance with this familiar mechanism. What is now different than before? Is it possible that there already is so much debt that even an interest rate cut isn’t a strong enough incentive to borrow more? If there already is too much debt with respect to financial capacity, it’s only logical that even a reduction in debt servicing costs won’t make us more eager borrowers (for example Irving Fisher has explicated this important dynamics; February 27, 1867 – April 29, 1947).

A low interest rate no longer helps

Is the debt excessive? Who can say what amount of debt is a lot, considering the world’s economic growth caused by productivity growth? After all, there was a lot of debt in October 2007, and still many stock markets are tens of percent higher than in that month (although there was the 50% drop to February 2009 lows).

The Market Oracle – Why Washington Cannot Prevent Economic Depression. Graph:Claus Vogt, Sicheres Geld. The above graph illustrates a time series of amount of debt. The graph doesn’t specify who has the debt but it depicts the total amount of debt in relation to gross domestic product. The statistics are from the U.S..

As the stock exchanges around the world survived the crash that began in 2007, why wouldn’t we be able to turn on the plus side now, in 2016? Has something changed? An economic slowdown, high amount of debt in national economies and higher-than-average stock valuations continue to be true in the world economy in 2016. The difference compared to 2007 is that we now lack the possibility to cut interest rates in order to revive the heart-attack economy. That remedy was used up to treat the collapse that started in 2007. The central bank of the world’s economic engine, the Fed, used its whole arsenal in the 2007-2009 stock market crash when it dropped interest rates from five percent to zero (as did the European Central Bank, but the FED did it more quickly and determinedly). This measure improved the debtors’ financial situation and encouraged them to borrow more. It also increased economic activity and compensated for the lack of productivity growth.

As regards shares and investment assets, the U.S. measures worked. The debt narrowed from 343.3% of gross domestic product (September 2007) to 334.6% (March 2015). Historically, however, the number is still very high (source: Y-Charts). In 2016, the world’s central banks no longer have the rate cut remedy available.

Trading Economics / Fed rate and Dow Jones Industrial Average The graph shows the Fed funds rate (in blue) which approached zero as the stock market index Dow Jones approached its 2009 low.


How did we come to this?

The year 2015 was a very good year for the HCP Black fund: a 9.59% return with a moderate level of risk (with 1-year volatility at 6.90% and annualized 3-year volatility at 5.80%). The most important remark of the first quarter of 2015 was that shares were no longer exceptionally cheap. The higher-than-average valuation level meant that the expected rate of return was no longer as high as a year or a few earlier. It also meant that the likelihood of share valuation levels to drop closer to average was increased.

The situation on February 18, 2015 HCP / Stretched Valuations and Zero Cash 2015. In this indicator, the market value of all stocks traded in the U.S. (Wilshire 5000 Total Market Index) is compared with the U.S. gross domestic product (GDP).

Situation on March 16, 2016 Gurufocus. In this indicator the market value of all stocks traded in the U.S. (Wilshire 5000 Total Market Index) is compared with the U.S. gross domestic product (GDP).

In 2015, HCP accumulated risk premiums increasingly from other investments than shares or bonds. The strategy worked well: the return of investments was in the same range as with shares on a typical year – over 9% – but the risk significantly lower than with share investments (which meant lower volatility).

The valuation level and economic situation

At the same time with the valuation level challenge in 2015, weak growth lead to expansionary policy that brought its own challenges. Nearly four years ago Europe witnessed a euro crisis, which caused banks to cut interest rates.

Now the interest rates are at zero (some of them even negative). Economic activity is weak and, in practice, for many of us, the interest rate levels aren’t getting any lower (even if some rate was cut even more below zero). Changing interest rate levels as an important remedy to increase economic activity has been used up. Borrowing and consumption with borrowed money can no longer be boosted by cutting interest rates. The euro crisis is still here, as is reflected by banks’ weak balance sheets, the high indebtedness of southern European countries, as well as the weak economic growth of many eurozone countries.

If preparing for recession is not enough

As shown by many indicators, there is a lot of debt. In addition, rate cut has undeniably been an important means of turning recession into economic growth, for lower interest rates have increased additional borrowing, thanks to reduction in debt servicing costs.

The Born again Debtor, November 2012; short-term U.S. interest rates Chart data FRED©. The chart above shows a collection of short-term interest rates from different historical periods to depict the level of interest rates determined by the Fed today.

What tools are there left in the arsenals of central banks when the rate cut remedy has been used up? When society wakes up to the fact there is too much debt, we are faced by austerity measures. In the Eurozone, we first saw a lot of headlines about Greece. Now we read about Finland’s reduced credit rating and our weak economic growth. In the indebted countries, austerity measures are planned and implemented already. Instead of interest rate cuts, the economic slowdown caused by austerity measures is now recovered by quantitative easing. Quantitative easing is no longer a matter of printing actual banknotes, but banks can increase money by permitting them to count in as assets capital that has previously not been accepted because of their poor quality. This allows banks to lend out more money. The central banks can also buy government bonds with the money they create electronically (Wikipedia – Quantitative easing). In addition, one means of reducing debt is debt cancellation. When it’s clear that the debtor is so over-indebted that it won’t be able to pay back the whole of its loan, form the creditor’s perspective it makes sense to agree to cut the debt to a size that the debtor can realistically pay back. So when rate cut is no longer a possibility, one can still seek economic recovery with austerity measures, quantitative easing, and debt cancellation. At best, the overall indebtedness will slow down through austerity measures, the economic slowdown caused by savings is compensated with quantitative easing and debt is reduced by canceling it. Thus the economy may recover over the years, and we are back in a situation where the amount of debt is no longer exceptionally high.

Over a hundred-year scale, we are naturally talking about productivity growth. However, it’s not realistic to try to achieve a very significant change in productivity in the short term (for example in 5 or 10 years). If the gross domestic product grew an additional percent or two annually by improving productivity, this would be the best that could happen over a hundred-year perspective. But in the short term, unwinding the debt tangle successfully is of greater importance ( for example Ray Dalio, founder, CEO and portfolio manager of Bridgewater Associates, has discussed this issue).

Whitehouse / Productivity Growth in the Advanced Economies, July 2015. In the two graphs above, the moving averages show how steady productivity growth is when short-term fluctuations are smoothed out.

It’s worth noting that the typical debt statistics don’t even show the hidden debt – unfunded liabilities. Population aging in Western countries weakens the dependency ratio, which translates as larger amount of unfunded liabilities of social security, for example. If the hidden debt in Finland is about five times the current government debt, it ought to be clear that managing it as well as possible is something that has the most impact on the next 5 to 10 years. (Who would calculate Finland’s unfunded liabilities as shown in the graph? The methodology is of the Nobel-prize winner Michael Spence’s.)

See also: HCP / Home in homeland, July 2015 Graph: Council on Foreign Relations – Michael Spence. The graph above illustrates official government debt as a percentage of gross domestic product and the estimated unfunded liabilities (for example those associated with social security that are not fully funded and are partly hidden debts).

The risks of reducing the amount of debt

If it turns out that the amount of debt in the economy has increased to the maximum and we indeed have to reduce it, investors will face risks that they haven’t needed to consider in the same way in over 80 years. The fact is that austerity measures and debt cancellation cause all kinds of turmoil in society. In addition, quantitative easing works as described above if successful, but if it fails, it can cause a complete distrust in money – in its capability of retaining its value and to serve as a medium of exchange.

HCP Black has been positioned with all of the above scenarios in mind. The focus of investments is on non-correlated alternative assets. As interest rates are mostly very low or at zero and the main cure is quantitative easing, it is expected that we see major fluctuations in currencies. The purpose of money is as a medium of exchange and a means by which to store value. With this risk in mind, HCP Black has been positioned to invest in strong currencies (list of important currencies, SDR). In addition, when writing this, HCP Black has invested 5 % of the portfolio in gold to serve as a medium of exchange and a means by which to store value.

When investing, one has to take into account unlikely risks which, if realized, have strong consequences. For example, the probability of a global depression may not yet be large, but if realized, its effect may be deepest in more than 80 years. Compared with October 2007, the risk of depression is higher today because the level of indebtedness is still historically high and the central banks have lost their rate cut remedy. I have positioned the HCP Black portfolio so that the fund holds only a small portion of assets which typically increase their value during a good economic trend. On the other hand, if there won’t be a global recession or depression and stock markets continue to rise, according to my estimates, it is still possible to gain annual portfolio returns. As a proof of this is HCP Black’s high return in 2015, which came mainly from investments other than shares (or bonds, which also require a favorable business cycle to cover the annual coupon payments and repayment of principal at maturity). In case the worldwide recession is realized, the majority of HCP Black’s portfolio is made up of investments independent of the economic situation. Therefore, gaining returns is possible also during a recession. With the global recession in mind, I’ve tried to take into account the historical mechanisms from over 80 years ago, so that the liquidity and purchasing power of the portfolio is retained as well as possible. Since the important active investors of that time have already died, I’ve relied on research data and significant investors’ understanding of the past in my portfolio management. No one has the first-hand experience with a truly global depression nowadays.

95% of the time, things are different

If we examine the economy as a system, we can say that the economy is a chaotic process where its numerous laws stay the same for long periods of time, even 100 years. Sometimes, however, the combined impact of these laws (the set of rules of the system) result in episodes where some of the rules become more significant than others (identifiable episodes are, for example, an economic boom, devaluation, and inflation cycle). In addition, the combined impact of these economic variables results in periods of time during which the system is more stable, as well as periods during which the system is particularly sensitive to change even due to a small wrong impulse. According to my estimate, the world economy at present is in such a delicate state (which it is about 5% of the time). I hope that my estimate is wrong – or if it’s correct, I hope that no shock will upset the delicate economic situation. In the best case, the coming years will be just ordinary years in the stock market, and I will be able to dismantle the investment protection of the HCP Black fund in the near future.

The one thing certain is that the impulse of zero interest rates has now been sent to the over-indebted world economy. (An impulse sent to the system, an identifiable cycle in the world economy, over-indebtedness):

The Born again Debtor, November 2012; short-term U.S. interest rates Chart data FRED©. The chart above shows a collection of short-term interest rates from different historical periods to depict the level of interest rates determined by the Fed today.

What is critical in the global trend of indebtedness is that the slow productivity growth can no longer be compensated by lowering interest rates. In the current situation, economic growth is unlikely to arise by increasing debt.

The Market Oracle – Why Washington Cannot Prevent Economic Depression. Graph: Claus Vogt, Sicheres Geld The above graph illustrates a time series of amount of debt. The graph doesn’t specify who has the debt but it depicts the total amount of debt in relation to gross domestic product. The statistics are from the U.S..
Summer of 1932, when the Dow closed at 41.22, 89 percent below its peak. Kuvaajassa yllä USA:n pörssi (Dow Jones Industrial Average) 1929-1932 suuren laman pörssiromahduksessa. Markkinalla osakkeet putosivat lopulta keskimäärin 89%. Tyypilliset taantumat sen jälkeen ovat pudottaneet pörssejä vain noin 50% tai vähemmän.

Below is my recent view of allocation that helps us survive the above-described possible global economic scenarios in the best possible way (as the situation develops, I will make changes to the allocation in the usual way):

HCP Black allocation history. The graph above shows how traditional correlated investments are now at their minimum and non-correlated alternative investments are at their maximum. Also, possible exceptional volatility is prepared for with cash and gold.

So much more

Our mandate is to invest money, manage risks and generate returns. The economy is not a machine separate from society. All of our everyday actions are intertwined with the machinery of the economy. Therefore, our mandate is also intertwined with the surrounding society.

We say that a healthy economy is like a glue that holds everything together. A healthy economy is about encounters and getting to know the new. In a society where the economy fails to glue things together, it’s even more important not to become isolated. The compartmentalization of society can be prevented. With our #HCPSPIRIT actions we enable new encounters and new kinds of activity which is valuable for all parties involved. We think it’s important that inside the economy and the stock market machine there is a community through which anyone can be influential. This also ensures that we won’t be alienated from reality. Together we’ll create activity that forms a healthy alternative to the financial world that is plagued by unhealthy incentives.

If the worst-case scenario happens in the global economy, all of such work is even a hundred times more important in the future than it is today. If my economic overview and our #HCPSPIRIT concept resonate with you, by investing in the HCP Black fund it’s possible to both manage your personal finances and take a stand in favor of a healthy financial sector.

Home in homeland – Real estate investments globally
Talk the talk – walk the walk
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