Debt implosion looms large
As the Corona reality virus bites deep
A question many are asking after the Corona virus played havoc with the markets these past few weeks, is whether we are witnessing the end of excessive financialisation of economic activity. Ever since we went off the gold standard, the world used record levels of debt creation and money supply to stimulate economic growth. And it went much further than countering natural and essential economic cycles: including political and electioneering pressures and particularly the growing power of the financial elite putting pressure on the monetary authorities to issue more debt and reduce interest rates.
From a real economic growth point of view, it hasn’t really worked, a point emphasised recently by South Affrican Reserve Bank Governor Lesetja Kganyago. While some economic growth may have been a spinoff of increased money supply and increased debt, the bulk of extra money creation did not find itself in the hands of the public or even production capacity where real value is created; but rather with the rentier financial elite where it was deployed in reinvesting in assets and causing some big bubbles in stock markets, upmarket property and bonds. That broadly left us with two economic systems: financial and real, where the former has increasingly become disconnected from the latter. It took a small bug to trigger a clash of horns between the real economy and the financial economy. For a while there seemed to be resistance to the real economy stamping it's authority on financial markets and finally triggering a blow-off of the speculative froth that has been driving global economics for decades. What Wall Street first saw as a long awaited correction of an 11 year old bull market from years of prices being pumped by cheap money, share-buy-backs and private equity purchases and mergers, then formally became a bear market. But as one commentator noted: Wall street could fall as much as 40% and then still be in a bull market. Over the last 10 years since the 2008 financial crisis, shares on average are still nearly 250% up; and 150% higher than five years ago.
Stock markets are the strongest connection between the real economy and the financial because while prices may be propped up by cheap debt, the effects of developments in the real economy are immediately felt in listed companies’ earnings and performance. These can only be ignored for so long and offer a platform for speculators to take positions for and against various equities. The confusion between the two was blatantly clear in the performance of Wall Street. For weeks after the virus hit the headlines in early February, Wall Street simply ignored it and the Dow continued to show daily gains.
Wall Street’s reponses to the corona virus were bizarre to say the least and showed the difficulty in balancing capital investment growth based on cheap debt with performance and earnings based on market factors. When Wall Street realised that the latter could be severely affected by the COVID-19 outbreak, the Dow dropped like a stone. Then it quickly recovered some losses on an anticipated “unexpected” stimulus from the Federal Reserve Board. Then it fell again, because some saw the 50-point rate cut as a reflection that things were really bad. It then recovered some when the positive effects of the cut were taken into account. At time of writing, this market was expecting a further 75 point rate cut this month, in addition to a $1 trillion fiscal stimulus package. All of this shows that stock market investors especially in the U.S. have been obsessed with shareholder value and capital growth and are more likely to take their lead from the monetary authorities than from earnings potential.
In truth, rate cuts seem senseless. It may help some capital gains in shares, but it certainly won’t do anything for company earnings. What on earth are sick and quarantined supply chain operators going to do with cheap debt – if it reaches them in the first place? Real earnings and wages are going to be affected more by supply constraints than demand and it’s on the cards, albeit not fully calculated yet, that COVID-19, as exaggerated as it may be, is going to have significant impact on global economic growth on many fronts.
Perhaps the stock market bubble has burst. But the real debt bubble has been in the bond market where for a short while it was inflated further by flight to “safe haven” arenas. There prices rose and yields tumbled further to the point the U.S.10 year bond was very close to negative yields for the first time – adding to the more than $15 trillion bonds where interest rates are negative. This is rewriting economic text books, and the only way for that froth to be blown off is for interest rates to increase. In turn that could plunge the world into a depression.
But is that not a price that has to be paid for decades of money mismanagement and affluence? The point is that for some time now, the global malaise has largely been a financial one and while we have seen different markets heavily shaken by COVID-19, the real trigger for a global breakdown will most likely be financial and a bursting of the debt bubble: such as a major corporate or institutional insolvency; monetary stimulus not working and running out of monetary options such as creating more debt and pushing interests to much below zero.
That could be on the cards already. As realisation grows that many bonds are no longer “safe” and that there could be some major defaults, these are beginning to be sold off setting off a fall in price, and a rise in yields. So by sheer market force, long term interest rates have begun to rise in defiance of Central bank counter measures. That is sending heavy signals of a potential debt implosion mentioned earlier.
As far as South Africa is concerned, I have argued for some while now that while we desperately need corrective measures on a number of fronts, these are all going to be overtaken by global events. None more so than Tito Mboweni’s budget. It is closely dependent on what happens elsewhere, but more disturbing is that it is a budget of intentions rather than action. Intentions need solid commitments from all of those affected.
He never had that and the cracks are becoming clearer.