Market Views: Multi-Asset
Multi-Asset Insights: Deleveraging - its implications for the global economy and FX
In this month’s Multi-Asset Insights, we look at why the global economy is suffering from weak economic growth and consider the implications of deleveraging on growth, monetary policy and foreign exchange (FX) markets.
Why is global growth so weak?
Major economies around the world appear to be in a structural deleveraging cycle. We characterize this as credit growth falling short of nominal GDP growth due to shifts in demographic trends, increased financial regulation and a lack of credit multipliers.
In the 40 years prior to the global financial crisis, many developed markets became highly indebted. Using the US economy as an example, aggregate debt to GDP climbed from 150% in 1980 to 360% in 2008 (chart 1). Within this, household debt grew from 47% to 98% across the same period, financial sector debt to GDP increased from 20% to 123% and government debt grew from 43% to 70%.
The demographic trend of the outsized baby boomer populations moving through their life-cycle pushed household leverage higher. Financial deregulation and innovation led to significant expansions in bank balance sheets and social welfare services brought about higher government leverage.
Chart 1: US debt to GDP and short-term interest rates
Source: Federal Reserve Bank of St Louis, as of December 31, 2014
The onset of the financial crisis coincided with baby boomers, who previously supported the expansion of household debt, moving towards retirement and deleveraging as a result. At the same time, increased financial regulation put an end to the rapid expansion of leverage in the financial sector. However, much of the deleveraging seen in these sectors was countered by the expansion of government balance sheets with, for example, the US rising from 70% to 110% of GDP.
What are the implications for growth and how might policy makers respond?
If continued leveraging overstated growth potential in the decades before the financial crises, then a trend of deleveraging would imply that current growth potential is somewhat lower than that experienced prior to 2008. A deleveraging cycle also implies an environment characterized by deflationary pressures.
In our view, central banks will be required to maintain accommodative policy in order to support growth and allow deleveraging to occur at a modest pace. It is also likely that central banks will be required to continue to print money to counter deflationary pressures and to drive nominal growth expansion, as has been the case across many regions since 2008.
How will different economies respond?
We believe global growth is below potential due to a lack of credit multipliers during the present deleveraging phase. Central banks may seek to boost their economies to pre-crisis growth trajectories and combat deflationary pressures through QE. It is likely that this would lead to differing growth cycles. Countries where central banks engineer currency weakness will experience improved growth as their share of global growth increases, while those that have seen their currencies strengthen will experience deteriorating growth as they absorb weakness from other regions.
This has been seen recently between the eurozone and China. The collapse in EUR/CNY led to a meaningful pick-up in German exports while Chinese export volumes fell. The same can be seen in the US where the stronger US dollar is beginning to put downward pressure on the US trade balance and the “manufacturing renaissance”, as consumers substitute domestically produced goods for their cheaper imported equivalents.
How will this affect FX?
If central banks aim to counter the pressures of deleveraging through QE, we believe this could create cycles of currency weakness followed by currency strength, with regional variations through time. Such action will have profound effects on FX pairs depending on where each central bank is in its easing cycle. However, as certain regions are in better structural shape than others, we expect these cycles to oscillate around longer-term trends.