When does a recession become a depression?

When does a recession become a depression?

Macro Letter – No 131 – 21-08-2020

When does a recession become a depression?

  • Defining a depression as opposed to a recession is open to wide interpretation
  • Recessions are a natural part of the credit cycle
  • Depressions are destroyers of a nation’s wealth
  • Fiscal policy can help ease the pain of ‘creative destruction’ but long-term planning is key

There is a tide in the affairs of men

Which, taken at the flood, leads on to fortune.

William Shakespeare (Julius Caesar)

When your neighbour loses their job, it’s a recession.

When you lose your job, that’s a depression!

Harry S. Truman (33rd President of the Unites States)

The common knowledge definition above is grim and highly specific, but its banality serves to highlight the fact that the recession/depression question is not that simple to answer. Back in 2007 The Federal Reserve Bank of San Francisco – What is the difference between a recession and a depression? – attempted to reach a conclusion. They embraced the NBER definition of a recession: –

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.

And turned to Gregory Mankiw to distinguish between the two states of economic contraction: –

There are repeated periods during which real GDP falls, the most dramatic instance being the early 1930s. Such periods are called recessions if they are mild and depressions if they are more severe.

Despite the Federal Reserve’s valiant efforts, the simpler and more commonly accepted definition of a recession is a consecutive two quarters of decline in GDP. When it comes to depressions, however, there is little consensus; the two most common descriptions are: –

  • A decline in GDP of more than 20%
  • A period of more than two years of declining GDP

Whilst the two definitions are not mutually exclusive, they are broadly different. I believe the difference between a recession and a depression is more nuanced. A recession is a natural part of the business (or perhaps we should say credit) cycle, a depression, by contrast, involves the physical destruction of the economy – businesses are irreparably broken, employment opportunities terminally destroyed, investment has to be totally written off.

An alternative approach is to examine previous great depressions. Alas, this method proves equally inconsistent, for example the Great Depression of the 1930’s is generally considered to have lasted from 1929 to 1941 and yet, as the chart below reveals, there were only two distinct periods of declining GDP growth between 1930 and 1933 and again between 1937 and 1938: –

Source: Federal Reserve Bank of St Louis

Notwithstanding my more prosaic definition above, I favour the two year plus definition over that of a sharp decline in GDP. A recession hurts some parts of an economy, a depression is more widespread.

Another factor often associated with recessions and depressions is a rise in the rate of unemployment. Historically, rising unemployment has preceded the onset of recessions and only once recessions have become protracted have they been dubbed depressions.

A further differentiator relates to the absolute level of inflation. In general, as inflation rises, central banks respond by raising short-term interest rates. This helps to cool overheating economies, however, if they tighten too aggressively they may prompt a recession as the credit cycle is forced into a sharp contraction. By contrast a depression is often accompanied by an absolute fall in the price level, caused by an excessive overhang of domestic or corporate debt.

As an investor, why does a depression definition matter? Because financial markets are forward looking. If investors believe the recovery from the Covid-19 pandemic will be ‘V’ Shaped, then, even a 20% decline in GDP, together with zero interest rates, price support for government bonds and a fiscal expansion on a scale not witnessed since the ‘New Deal’ of FDR, will rapidly translate inot a sharply rising stock market. If, by contrast, it becomes clear that a tsunami of creative destruction is sweeping away entire industries, then even the most lavish of New New Deals may be insufficient to hold back the tide of stock liquidation as market participates rush to the safety of cash.

So far the official policy response has been sufficient to convince investors that a depression will be avoided. Scratch the surface of the S&P 500, however, and a rather different picture appears. The chart below shows market performance up to the end of May. The same five technology stocks have continued to drive S&P 500 index performance since then: –

Source: FactSet, Goldman Sachs

Technology has been the top performing sector. One argument for such elevated valuations rests on the premise that the pandemic has accelerated a wide range of technology trends bringing with it the potential for much swifter profits. In finance parlance, the net present value of future technology cash-flows has been brought forward by, some analysts suggest, several years. No wonder, they argue, that these stocks have broken to new all-time highs: and will continue, higher.

Since May, the broader stock market has hung of tech coattails (at the time of writing – 19-8-2020 -the MSCI World Index is up 1.73% YTD). For the present, hope triumphs over fear, yet vaccines remain many months from being widely available, meanwhile, for the Northern hemisphere, autumn – and fears of a second wave of infections – draws imminently near.

For emerging markets the situation is worse still. As Carmen and Vincent Reinhart, writing in Foreign Affairs – The Pandemic Depression– put it: –

Although dubbed a “global financial crisis,” the downturn that began in 2008 was largely a banking crisis in 11 advanced economies. Supported by double-digit growth in China, high commodity prices, and lean balance sheets, emerging markets proved quite resilient to the turmoil of the last global crisis. The current economic slowdown is different. The shared nature of this shock—the novel coronavirus does not respect national borders—has put a larger proportion of the global community in recession than at any other time since the Great Depression. As a result, the recovery will not be as robust or rapid as the downturn. And ultimately, the fiscal and monetary policies used to combat the contraction will mitigate, rather than eliminate, the economic losses, leaving an extended stretch of time before the global economy claws back to where it was at the start of 2020.

The World Bank estimates globally more than 60mln people will be pushed into severe poverty. Meanwhile, in developed countries, bankruptcies, which have been postponed by government intervention, may meet their personal epiphanies as fiscal largesse is suddenly withdrawn. Unless the lockdown restrictions are lifted and people feel safe, both medically and financially, to venture out and spend, the destruction of large swathes of developed market economies has simply been deferred.

By next month we will have experienced two quarters of diminished growth – this is a deep recession already. Swathes of the economy have been permanently altered, making a depression highly likely. Millions of workers have been displaced, it will take more than a handful of months for them to be retrained. Without the consumption demand from these erstwhile workers, it will be difficult for new and existing companies to create the growth they need to hire new employees.

Fiscal spending will need to be undertaken on a much larger scale, and for much longer, than has been envisaged so far. In all the major financial crises since 1850, the average time for per capita GDP to recover to the pre-crisis level was eight years. To date it is estimated that the G20 response to the pandemic has amounted to $11trln. Most of these measures have been ‘temporary’ or ‘short-term.’ It is quickly becoming clear, the disruption to employment, business and sectors of the economy will be protracted and, in many cases, permanent, The IMF estimate that for advanced economies the deficit-to-GDP ratio will rise from 3.3% in 2019 to 16.6% this year. For emerging economies, where the capacity for fiscal expansion is more limited, the ratio is expected to swell from 4.9% last year to 10.6% in 2020. Whilst for advanced economies the cost of borrowing has remained low in emerging markets financing costs have risen. The burden of fiscal stimulus will inevitably fall most heavily upon the treasuries of the advanced economies.

Conclusion

As Sir Winston Churchill once said: –

Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.

In the aging societies of the West (and elsewhere) the individual need for income remains key. Developed nation governments are fortunate in their ability to borrow more cheaply than at any time in economic history. Whilst it is at odds with my Austrian, free-market instincts, I am forced to admit that fiscal policy is the least panful weapon available to combat the economic catharsis created by the pandemic. Economically, there will be a heavy price to pay, but the alternative is a dangerous cocktail of political fragmentation and polarisation.

For investors the task of securing steady real income remains challenging. Private debt and asset backed lending, which offers high yield, comes with both default and liquidity risk. The chart below looks at some of the public market options, financial repression is rife across the credit spectrum: –

Source: Federal Reserve Bank of St Louis

High income stocks might be an alternative but they offer no guarantee, no matter how ‘blue-chip’ the name. An addition to the acceleration in technology trends, growth stocks in general are benefitting from the exceptionally low interest environment, but there will be a greater number of failures because the cost of speculative finance is also at an historical low. Active management has been unfashionable for at least a decade but looking ahead preservation of capital is going to be more important than capturing out-sized gains.

I wrote about value investing back in June in – A Brave New World for Value Investing – concluding that:

Stock and corporate bond markets have regained much of their composure since late March. Central banks and governments have acted to ameliorate the effects of the global economic slowdown. As the dust begins to settle, the financial markets will adjust to a new environment, one in which value-based stock and bond market analysis will provide an essential aid to navigation.

The geopolitics of trade policy, already a source of tension before the pandemic struck, has been turbo-charged by the simultaneous supply and demand shocks and their impact on global supply chains. Supply chains will shorten and diversify. Robustness rather than efficiency will be the watch-word in the months and years ahead. This sea-change in the functioning of the world economy will not be without cost. It will appear in increased prices or reduced corporate profits. Value-based investment analysis will be the best guide in this brave new world.

I would add an additional strategy to the investment armoury, a momentum overlay. With fiscal and monetary policy continuing to support economies as they transition to the new world order, capital flows will be a powerful arbiter of investment return. Technology stocks may look expensive by most normal metrics but the trend is patently clear. Do not emulate Cnut The Great, but do as Brutus advises in the opening quote, after all, financial market liquidity flows like tide.

Protectionism: which countries have room for fiscal expansion?

Protectionism: which countries have room for fiscal expansion?

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Macro Letter – No 66 – 25-11-2016

Protectionism: which countries have room for fiscal expansion?

  • As globalisation goes into reverse, fiscal policy will take the strain
  • Countries with government debt to GDP ratios <70% represent >45% of global GDP
  • Fiscal expansion by less indebted countries could increase total debt by at least $3.48trln

…But now I only hear

Its melancholy, long, withdrawing roar…

Matthew Arnold – Dover Beach

Over the course of 2016 the world’s leading central banks have subtly changed their approach to monetary policy. Although they have not stated that QE has failed to stimulate global growth they have begun to pass the baton for stimulating the world economy back to their respective governments.

The US election has brought protectionism and fiscal stimulus back to the centre of economic debate: but many countries are already saddled with uncomfortably high debt to GDP ratios. Which countries have room for manoeuvre and which governments will be forced to contemplate fiscal expansion to offset the headwinds of protectionism?

Anti-globalisation – the melancholy, long, withdrawing roar

The “Elephant” chart below explains, in economic terms, the growing political upheaval which has been evident in many developed countries:-

world-bank-economist-real-income-growth-1988-2008

Source: The Economist, World Bank, Lakner and Milanovic

This chart – or at least the dark blue line – began life in a World Bank working paper in 2012. It shows the global change in real-income, by income percentile, between 1988 and 2008. The Economist – Shooting an elephant provides more information.

What this chart reveals is that people earning between the 70th and 90th percentile have seen considerably less increase in income relative to their poor (and richer) peers. I imagine a similar chart up-dated to 2016 will show an even more pronounced decline in the fortunes of the lower paid workers of G7.

The unforeseen consequence to this incredible achievement – bringing so many of the world’s poor out of absolute poverty – has been to alienate many of the developed world’s poorer paid citizens. They have borne the brunt of globalisation without participating in much, if any, of the benefit.

An additional cause for concern to the lower paid of the developed world is their real-inflation rate. The chart below shows US inflation for specific items between 1996 and 2016:-

pricesnew

Source: American Enterprise Institute

At least the “huddled masses yearning to breathe free” can afford a cheaper television, but this is little comfort when they cannot afford the house to put it in.

Anti-globalisation takes many forms, from simple regulatory protectionism to aspects of the climate-change lobby. These issues, however, are not the subject of this letter.

Which countries will lose out from protectionism?

It is too early to predict whether all the election promises of President-elect Trump will come to pass. He has indicated that he wants to impose a 35% tariff on Mexican and, 45% tariff on Chinese imports, renegotiate NAFTA (which the Peterson Institute estimate to be worth $127bln/annum to the US economy) halt negotiations of the TPP and TTIP and, potentially, withdraw from the WTO.

Looking at the “Elephant” chart above it is clear that, in absolute per capita terms, the world’s poorest individuals have benefitted most from globalisation, but the largest emerging economies have benefitted most in monetary terms.

The table below ranks countries with a GDP in excess of $170bln/annum by their debt to GDP ratios. These countries represent roughly 95% of global GDP. The 10yr bond yields were taken, where I could find them, on 21st November:-

Country GDP Base Rate Inflation Debt to GDP 10yr yield Notes
Japan 4,123 -0.10% -0.50% 229% 0.03
Greece 195 0.00% -0.50% 177% 6.95
Italy 1,815 0.00% -0.20% 133% 2.06
Portugal 199 0.00% 0.90% 129% 3.70
Belgium 454 0.00% 1.81% 106% 0.65
Singapore 293 0.07% -0.20% 105% 2.36
United States 17,947 0.50% 1.60% 104% 2.32
Spain 1,199 0.00% 0.70% 99% 1.60
France 2,422 0.00% 0.40% 96% 0.74
Ireland 238 0.00% -0.30% 94% 0.98
Canada 1,551 0.50% 1.50% 92% 1.57
UK 2,849 0.25% 0.90% 89% 1.41
Austria 374 0.00% 1.30% 86% 0.54
Egypt 331 14.75% 13.60% 85% 16.95
Germany 3,356 0.00% 0.80% 71% 0.27
India 2,074 6.25% 4.20% 67% 6.30
Brazil 1,775 14.00% 7.87% 66% 11.98
Netherlands 753 0.00% 0.40% 65% 0.43
Israel 296 0.10% -0.30% 65% 2.14
Pakistan 270 5.75% 4.21% 65% 8.03
Finland 230 0.00% 0.50% 63% 0.46
Malaysia 296 3.00% 1.50% 54% 4.39
Poland 475 1.50% -0.20% 51% 3.58
Vietnam 194 6.50% 4.09% 51% 6.10
South Africa 313 7.00% 6.10% 50% 8.98
Venezuela 510 21.73% 180.90% 50% 10.57
Argentina 548 25.75% 40.50% 48% 2.99
Philippines 292 3.00% 2.30% 45% 4.40
Thailand 395 1.50% 0.34% 44% 2.68
China 10,866 4.35% 2.10% 44% 2.91
Sweden 493 -0.50% 1.20% 43% 0.52
Mexico 1,144 5.25% 3.06% 43% 7.39
Czech Republic 182 0.05% 0.80% 41% 0.59
Denmark 295 -0.65% 0.30% 40% 0.40
Romania 178 1.75% -0.40% 38% 3.55
Colombia 292 7.75% 6.48% 38% 7.75
Australia 1,340 1.50% 1.30% 37% 2.67
South Korea 1,378 1.25% 1.30% 35% 2.12
Switzerland 665 -0.75% -0.20% 34% -0.15
Turkey 718 7.50% 7.16% 33% 10.77
Hong Kong 310 0.75% 2.70% 32% 1.37
Taiwan 524 1.38% 1.70% 32% 1.41
Norway 388 0.50% 3.70% 32% 1.65
Bangladesh 195 6.75% 5.57% 27% 6.89
Indonesia 862 4.75% 3.31% 27% 7.85
New Zealand 174 1.75% 0.40% 25% 3.11
Kazakhstan 184 12.00% 11.50% 23% 3.82 ***
Peru 192 4.25% 3.41% 23% 6.43
Russia 1,326 10.00% 6.10% 18% 8.71
Chile 240 3.50% 2.80% 18% 4.60
Iran 425 20.00% 9.50% 16% 20.00 **
UAE 370 1.25% 0.60% 16% 3.57 *
Nigeria 481 14.00% 18.30% 12% 15.97
Saudi Arabia 646 2.00% 2.60% 6% 3.97 *

 Notes

*Estimate from recent sovereign issues

**Estimated 1yr bond yield

***Estimated from recent US$ issue

Source: Trading economics, Investing.com, Bangledesh Treasury

Last month in their semi-annual fiscal monitor – Debt: Use It Wisely – the IMF warned that global non-financial debt is now running at $152trln or 225% of global GDP, with the private sector responsible for 66% – a potential source of systemic instability . The table above, however, shows that many governments have room to increase their debt to GDP ratios substantially – which might be of luke-warm comfort should the private sector encounter difficulty. Interest rates, in general, are at historic lows; now is as good a time as any for governments to borrow cheaply.

If countries with government debt/GDP of less than 70% increased their debt by just 20% of GDP, ceteris paribus, this would add $6.65trln to total global debt (4.4%).

Most Favoured Borrowers

Looking more closely at the data – and taking into account budget and current account deficits -there are several governments which are unlikely to be able to increase their levels of debt substantially. Nonetheless, a sizable number of developed and developing nations are in a position to increase debt to offset the headwinds of US protectionism should it arrive.

The table below lists those countries which could reasonably be expected to implement a fiscal response to slower growth:-

Country GDP Debt to GDP 10yr yield Gov. Debt 70% Ratio 90% Ratio 12m fwd PE CAPE Div Yld.
Saudi Arabia 646 6% 3.97 38 452 581 ? ? ?
Chile 240 18% 4.60 42 168 216 15.6 ? ?
New Zealand 174 25% 3.11 43 122 157 19.3 22 4.1%
Peru 192 23% 6.43 44 134 173 12.1 ? ?
Bangladesh 195 27% 6.89 53 137 176 ? ? ?
UAE 370 16% 3.57 58 259 333 ? ? ?
Colombia 292 38% 7.75 111 204 263 ? ? ?
Norway 388 32% 1.65 123 272 349 14.2 11.5 4.3%
Philippines 292 45% 4.40 132 204 263 16.4 22.6 1.6%
Malaysia 296 54% 4.39 160 207 266 15.6 16 3.1%
Taiwan 524 32% 1.41 166 367 472 12.8 19 3.9%
Thailand 395 44% 2.68 175 277 356 13.8 17.7 3.1%
Israel 296 65% 2.14 192 207 266 9.4 14.6 2.8%
Sweden 493 43% 0.52 214 345 444 16.1 19.8 3.6%
Indonesia 862 27% 7.85 233 603 776 14.7 19.6 1.9%
South Korea 1,378 35% 2.12 484 965 1,240 9.6 13.1 1.7%
Australia 1,340 37% 2.67 493 938 1,206 15.6 16.1 4.3%
Mexico 1,144 43% 7.39 494 801 1,030 16.6 22.4 1.9%
India 2,074 67% 6.30 1,394 1,452 1,867 15.9 18.6 1.5%
4,649 8,114 10,432

 Source: Trading economics, Investing.com, Bangledesh Treasury, Star Capital, Yardeni Research

The countries in the table above – which have been ranked, in ascending order, by outstanding government debt – have total debt of $4.65trln. If they each increased their ratios to 70% they could raise an additional $3.47trln to lean against an economic downturn. A 90% ratio would see $5.78trln of new government debt created. This is the level above which economies cease to benefit from additional debt according to  Reinhart and Rogoff in their paper Growth in a Time of Debt.

Whilst this analysis is overly simplistic, the quantum of new issuance is not beyond the realms of possibility – India’s ratio reached 84% in 2003, Indonesia’s, hit 87% in 2000 and Saudi Arabia’s, 103% in 1999. Nonetheless, the level of indebtedness is higher than many countries have needed to entertain in recent years – ratios in Australia, Mexico and South Korea, though relatively low, are all at millennium highs.

Apart from the domestic imperative to maintain economic growth, there will be pressure on these governments to pull their weight from their more corpulent brethren. Looking at the table above, if the top seven countries, by absolute increased issuance, raised their debt/GDP ratios to 90%, this would add $3.87trln to global debt.

Despite US debt to GDP being above 100%, the new US President-elect has promised $5.3trln of fiscal spending during his first term. Whether this is a good idea or not is debated this week by the Peterson Institute – What Size Fiscal Deficits for the United States?

Other large developed nations, including Japan, are likely to resort to further fiscal stimulus in the absence of leeway on monetary policy. For developing and smaller developed nations, the stigma of an excessively high debt to GDP ratio will be assuaged by the company keep.

Conclusions and investment opportunities

Despite recent warnings from the IMF and plentiful academic analysis of the dangers of excessive debt – of which Deleveraging? What Deleveraging? is perhaps the best known – given the way democracy operates, it is most likely that fiscal stimulus will assume the vanguard. Monetary policy will play a supporting role in these endeavours. As I wrote in – Yield Curve Control – the road to infinite QE – I believe the Bank of Japan has already passed the baton.

Infrastructure spending will be at the heart of many of these fiscal programmes. There will be plenty of trophy projects and “pork barrel” largesse, but companies which are active in these sectors of the economy will benefit.

Regional and bilateral trade deals will also become more important. In theory the EU has the scale to negotiate with the US, albeit the progress of the TTIP has stalled. Asean and Mercosur have an opportunity to flex their flaccid muscles. China’s One Belt One Road policy will also gain additional traction if the US embark on policies akin to the isolationism of the Ming Dynasty after the death of Emperor Zheng He in 1433. The trade-vacuum will be filled: and China, despite its malinvestments, remains in the ascendant.

According to FocusEconomics – Economic Snapshot for East & South Asia – East and South Asian growth accelerated for the first time in over two years during Q3, to 6.2%. Despite the economic headwinds of tightening monetary and protectionist trade policy in the US, combined with the very real risk of a slowdown in the Chinese property market, they forecast only a moderate reduction to 6% in Q4. They see that growth rate continuing through the first half of 2017.

Indian bond yields actually fell in the wake of the US election – from 6.83% on 8th to 6.30% by 21st. This is a country with significant internal demand and capital controls which afford it some protection. Its textile industry may even benefit in the near-term from non-ratification of the TPP. Indian stocks, however are not particularly cheap. With a PE 24.3, CAPE 18.6, 12 month forward PE 15.9 the Sensex index is up more than 70% from its December 2011 lows.

Stocks in Israel, Taiwan and Thailand may offer better value. They are the only emerging countries which offer a dividend yield greater than their bond yield. Taiwanese stocks appear inexpensive on a number of other measures too. With East and South Asian growth set to continue, emerging Asia looks most promising.

A US tax cut will stimulate demand more rapidly than the boost from US fiscal spending. Protectionist tariffs may hit Mexico and China rapidly but other measures are likely to be implemented more gradually. As long as the US continues to run a trade deficit it makes sense to remain optimistic about several of the emerging Asian markets listed in the table above.