Recovery hopes and de-leveraging cycles
Markets sense a turning point in global activity. Equities have rallied and sovereign bond yields have ticked up. Within equity markets the emerging markets are leading the way, an indication that growth expectations are improving given the link with global trade. Hopes of a trade deal between the US and China have helped, but there is little evidence of recovery in the survey data with the global purchasing managers index (PMI) falling further in August as the service sector weakened.
However, whilst these indicators do not bode well for global growth, there are signs that the worst may be behind us in the US where data is now surprising on the upside. Home sales, manufacturing output and retail sales have beaten expectations. The survey weakness is concentrated outside the US, particularly in Europe where the latest PMI's have been feeble. China has also seen soft data, although our activity indicator which adjusts for inflation ticked up in August.
The longer run issue for the world economy remains the same though: a deficiency in demand with no obvious global locomotive.
Consumer and government spending account for the slowdown
In terms of the components of GDP the weakness can be largely attributed to the consumer. There was also a negligible contribution from government spending compared with positive contributions in all of the previous cycles bar two. This would largely reflect cuts in public investment, but also layoffs at the state and local level.
On the more positive side, trade has been less of a drag than before the crisis. Meanwhile, fixed investment has actually held up in the current cycle and whilst not as strong as in earlier periods such as the 1990s expansion, has made more of a contribution than in the last cycle. This though may change as geopolitical uncertainty (trade tensions, etc.) takes its toll on business confidence and spending.
Coming back to the cycle as a whole, the pattern of consumer and corporate spending is reflected in the debt markets. Households in the US have been deleveraging since the global financial crisis, whilst after a brief period of debt consolidation corporate gearing has been rising. Admittedly much of the latter has gone into share buy backs rather than capital spending, but nonetheless there is a contrast with the personal sector where debt to GDP has declined from 98% in Q1 2008 to 74% in Q2 this year.
A decade of de-leveraging for US households
Overall the level of debt in the economy has risen as a share of GDP from 227% to 247% largely as a consequence of the increase in government debt to nearly 100%. For the household sector though the past decade marks a sea change in behaviour as we have never seen such a sustained period of debt reduction. There have been phases where household leverage has stabilised, or fallen slightly. However, with the exception of these periods the household debt to GDP ratio rose steadily from 1960 to the global financial crisis with an acceleration after 1983. Much of this was encouraged by successive governments which de-regulated banks and promoted home ownership to the widest groups of the population with ultimately disastrous effect.
A period of balance sheet repair followed the crash as households worked to restore their finances. What is interesting though is how long the current period of household deleveraging has gone on with little sign that it might be ending. Today the debt to GDP ratio is below levels seen at the start of the last expansion and still falling.
Signs of scarring?
There were many excesses during the run-up to the crisis as the banking system forgot the concept of prudent lending, but it is hard to argue that the whole period was an aberration. Other measures such as buoyant household wealth and interest cover suggest the US consumer's financial position has now been restored. Perhaps we are seeing the “scarring” effects of the financial crisis; this can affect the willingness of households to borrow for a generation as occurred after the Great Depression.
If households have decided to eschew debt then the ability of the US Federal Reserve (Fed) to generate recovery through cutting interest rates is clearly limited. We have argued previously that the Fed will struggle to overcome the headwind from the trade tensions and this only adds to its difficulties by blocking one of the main monetary transmission mechanisms.
Measures to roll back some of the regulation on banks may help in this respect, but the most likely outcome is another bout of fiscal policy. This has become the policy prescription of the day.
However, it faces two challenges in the US. The first is that the government's debt to GDP ratio is already high at close to 100%. In the past this might have been an issue as investors worried about government spending "crowding out" private sector activity, but the bond markets do not seem concerned at present. The second is the political cycle. There is little extra government spending in the pipeline for the rest of this year or next; we are probably looking at 2021 at the earliest after the presidential election. No doubt there will be promises of fiscal largesse from both sides in the election race, but 2020 looks like it will also lack growth unless households rediscover the joys of debt.
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