In his book A Short History of Financial Euphoria, the economist John Galbraith shows that about every twenty years we conveniently and collectively forget just about everything that happened in the previous twenty years. As a result we lurch relentlessly from boom to bust, something which he attributes to “the breathtaking brevity of the collective financial memory”.
Today, just five and a half years after the world came to brink the of financial collapse, it seems we are already putting the memory of the Great Recession behind us. With stock markets testing their all-time highs, the feeling among investors is that a new financial crisis is becoming less and less likely. This is a dangerous view.
In a recent article Mark Mahaffey, Co-Founder and CFO of Hinde Capital, examines the financial stability of the world economy to see whether it is increasing or decreasing.
To answer this question he looks at the following variables:
- Total income (current and future)
- Total debt (current and future)
- Savings/ “firepower” (crisis protection)
First let’s look at income. The chart below shows nominal GDP growth projections for five major economies. Aside from China which continues to grow, and the US, which is likely to experience modest growth, nominal growth, i.e. these nation’s income, looks set to be poor, and real growth will struggle to be positive.
Nominal GDP projections based on recent trends (in $ bns)
Chart courtesy of hindecapital.com
While income is struggling to keep pace with inflation, total debt, in many of the world’s major economies continues to rise. In fact, as mentioned previously, only three of the ten largest developed economies have begun the process of debt repayment, while the rest have actually increased their debt burden, three of them quite significantly.
Total debt is made up of private (household), public and financial sector debt, and while private debt and financial sector debt has for the most part been declining, public sector debt has been ramping up to compensate.
The bottom line
We are getting further and further into debt while at the same time we are producing less and less growth/ income with which to service it. It is clear then that we’re moving closer to a financial crisis not further away, and as Mark Mahaffey points out, “In 2007, the world had emergency firepower of 5% central bank rates that could be cut, and trillions of dollars of bonds yet to be purchased to back stop the system. What do we have today? Far, far less options.”
While it is likely that over time ultra-loose monetary policy will push the value of stocks and commodities higher, it is important that investors be mindful of these growing structural problems and design their portfolios accordingly.