Excessive Debt Will Continue to Constrain Economic Growth

| January 3, 2012

As we enter the twelfth year of the secular bear market in US stocks, it is instructive to review the structural environment that has produced a 0.2 percent annual compound return on the S&P 500 index since the secular peak in 2000.

Although consensus opinion remains optimistic about the prospects for renewed economic growth in the US, the underlying structural issues that have engendered a lost decade in the stock market remain in place. The primary problem is excessive debt, and we have yet to address it in any meaningful capacity, even the best debt consolidation plans are not enough. The following graph from Hoisington Management displays the long-term view of total US debt as a percentage of GDP.

The deleveraging cycle that began in 2009 will take many years to run its course and our economy will remain fragile and vulnerable to shocks until the process is complete. The last secular bear market to be accompanied by a deleveraging cycle occurred during the Great Depression and had a duration of 20 years. Thus far, the current secular bear market from 2000 has exhibited a similar character and it will likely continue until at least the end of the decade. The problem is not unique to the US as most of the countries in Europe face a similar dilemma as shown by the following graph from a recent report by David Rhodes and Daniel Stelter of The Boston Consulting Group.

Of course, the preferred solution to the debt problem is accelerated economic growth. However, as we first noted two years ago, research has clearly demonstrated that excessive debt makes that option untenable, as noted by Rhodes and Stelter.

Debt in itself makes it more difficult to grow out of debt. Studies by Carmen Reinhardt and Kenneth Rogoff and the Bank for International Settlements show that once government debt reaches 90 percent of GDP, the real rate of economic growth is reduced. This also applies to the debt of nonfinancial corporations and private households. Exhibit 2 shows the current debt level of key economies by sector. In all countries, the debt level of at least one sector is beyond the critical mark. Somewhat perversely, only in Greece are the two private sectors below the threshold. And only in Germany and Italy (in addition to Greece) do private households have a debt level below 70 percent of GDP.

Given that growth is not a viable solution, the only remaining options are repayment, restructuring or inflation, all of which require significant short-term economic pain, which is precisely why we continue to look to other temporary measures such as quantitative easing. When all of our available options are bad, human nature dictates that we will avoid their implementation as long as possible, as noted by Mohamed El-Erian of PIMCO in a recent article.

…It is no longer about economic cycles that involve temporary and reversible deviations from a familiar anchoring mean. It becomes a secular phenomenon that — in a fundamental manner — speaks to structural changes, institutional mishaps, and a whole series of the unthinkable becoming facts. In the process, policy measures lose effectiveness, consumer sentiment is disrupted, and healthy balance sheets retreat to the sidelines, thereby increasing volatility and accelerating deleveraging.

This is an unfamiliar world whose complexity increases exponentially as policymakers fall further behind the accelerating path-dependency dynamics. The engineering of a rescue becomes considerably more difficult and the politics even more intricate. That’s not even counting the implementation difficulties that inevitably accompany hard policy choices.

Structural challenges require structural solutions that, usually, involve a component of immediate sacrifice for the promise of welfare enhancements down the road. This tradeoff, between short-term costs and long-term benefits, is not one that comes easily to political systems heavily influenced by the election calendar.

The structural problems that have produced a lost decade with respect to stock market returns in the US remain in place. Until we recognize and accept the need for structural solutions that will require short-term pain, economic growth will remain constrained and the secular bear market will continue to engender a poor investment environment for stocks.

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Category: Commentary, Market Update

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