Investing – A lost decade?

Posted By Darren Winters on Aug 12, 2017


Investing – A lost decade?

Is a lost decade approaching?
The economy works in a simple mechanical way, it is made up of a few parts and a lot of simple transactions repeated over and over again many times. There are three main forces driving the economy; productivity growth, short term debt cycle and the long term debt cycle. If we chart these three forces, then superimpose them in one chart we create a template for tracking economic movements and forecasting economic performance.

The total amount of spending drives the economy. Moreover, one person’s spending is another person’s income. As spending increases so too do income which makes people more credit worthy.

Credit is an important factor in the spending equation because when a person receives credit he is able to increase his spending. More spending boost incomes which facilities more borrowing and that increases income further. So this positive self-reinforcing pattern repeats itself and it is why economic cycles exist.

How The Economic Machine Works by Ray Dalio provides investors with a practical economic template to anticipate and sidestep a future global economic crisis. Are we entering a lost decade?

Why?
Any time households, businesses, governments borrow they create a cycle – ”it sets into motion mechanical predictable series of events that will happen in the future”. Borrowing increases investment and consumption in the short term but in the long term the burden of servicing debt will have a negative impact of spending and investing, hence borrowing creates a cycle.”

Moreover, if the cycle goes up it eventually needs to come down this is known as the short term debt cycle which typically lasts 5-8 years. At some point, debt burdens become too burdensome (this typically occurs when debt levels rise faster than income) and the long term debt peaks.

The last time long term debt peaked was in 2008 and 1929 in the US. At this point in the cycle, the economy starts deleveraging, households cut spending, income falls, credit disappears, asset prices drop and banks cut lending (credit squeeze), stock prices collapse and the vicious cycle feeds on itself. The increase in borrowing costs can also spin the cycle in reverse.

As the value of asset prices fall that reduces the value of collateral borrowers can raise, making them even less credit-worthy. So in a deleveraged economy spending, income, borrowing, and credit all go into a tailspin. It becomes a self-perpetuating vicious cycle.

Lenders stop lending, borrowers stop borrowing the economy no longer becomes credit worthy. But lower interest rates won’t tackle the problem, bearing in mind that interest rates are already low. So debt burdens can’t be relieved by lower interest rates.

A Lost Decade - Investing

What options are then available to tackle deleveraging? There is no easy solution because of the side effects. If the debt is too high simple logic would say cut spending (austerity), however, the side effect is that such a policy is deflationary leading to further economic contraction.

Why not then reduce the debt through defaults and restructuring? But that would cause asset prices to fall making debt burden even worse.

Then why not redistributed wealth from the have to the have not’s through progressive taxation? That could cause social tensions and resentment among the classes. Moreover, it could increase tension between debtor and creditor countries which might lead to extreme political change similar to what occurred in the 1930s in Europe.

Finally, the central bank to the rescue? Interest rates are already low so what else is left- print more money. Central bank’s purchase of government bonds, quantitative easing (QE) enables the government to carry out fiscal expansionary spending, which aims to boost income, thereby crank starting the growth cycle again.

However, QE also increases the government’s debt burden, widens wealth divide through asset price rises and also risks runaway type of inflation.

So there needs to be a balance between deflation and inflation. If money creation offsets falling credit then there will be no inflation. Furthermore, income needs to grow faster than debt growth. The key is not to print too much money that will lead to rising inflation. An ideal deleveraging (beautiful deleveraging) occurs when growth is slow and the debt burden is reduced. But that is a lost decade.

So let’s apply Dalio’s economic template to the current economic situation.
The growth in the supply of USD fell again 5.4% to a 105 month low. The last time money supply grew at such a slow rate was during 2008. M2 (the measure of all money supply that includes all measures of cash and deposits) growth fell to 5.6%, a 20 month low in February. https://mises.org/library/money-supply-growth-falls-again-dropping-105-month-low.

Loan growth has not been so weak since April of 2011. Consumer loans, real estate loans are all contracting. In short, M2 has fallen to 2010 levels.

During a boom, the money supply grows very quickly as banks make more loans. Conversely, in a recession or when the economy turns downwards, we see a decline in the money supply.

There is currently a contraction in the money supply playing out. Moreover, economic growth remains anemic, productivity and wages are stagnating in most advanced economies. The current economic data indicates (using Dalio’s economic template) that the world’s largest economy is deleveraging.

If you are the type that likes to see the glass half full then the best case scenario (a beautiful deleveraging) would mean a lost decade could be dead ahead. If we are about to enter a lost decade make sure you are in the know and can play your investments to your advantage with Forex and Stock Market Training.

But what if it all goes pear shaped?
Equally the largest credit expansion in the history of finance deployed by the central banks to prevent a financial economic meltdown in 2008 could still play out.

The economic “recovery” post-2008 was a credit driven recovery. Put another way, the economy didn’t recover due to higher productivity and wages instead it was propped up on credit. But credit creates cycles. So the greater the credit expansion potentially the steeper the fall sometime in the future. These are uncertain times.

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