GOLDMAN SACHS: The developed world is exiting the GFC debt deflation cycle

Picture: Amory Ross Team Alvimedica, Getty Images

This is no small thing for traders, or markets.

The Goldman Sachs Australian economics team, lead by chief economist Tim Toohey, says that after eight years, the global economy is finally following the United States out of the pernicious debt deflation cycle that has so gripped and characterised growth and markets over that time.

It also means notions of enduring secular stagnation, proposed by former US Treasury Secretary Larry Summers and Robert Goron, are misplaced.

That can have profound implications for markets, Toohey and his team say:

“It is one thing to believe that structural forces indicate that potential economic growth will be somewhat slower in the future, as we have advocated on numerous times over the past 5 years. It is an entirely different thing to suggest that a stagnation of global growth into perpetuity is the most likely outcome. Indeed, even post a downward reassessment of potential economic growth there is still ample room for an industrial upswing to emerge and ultimately prove costly for those positioned for secular stagnation.”


Escape velocity

Toohey says that “any reasonable assessment on the state of the US economy can no longer conclude that the US remains locked in the spiral” of debt deflation. “Core inflation is now 2.2% yoy, financial wealth has risen 59% since the financial crisis trough and 34% since the prior peak, non-financial corporate profits have risen 72% since the financial crisis trough and 17% since the prior peak, the unemployment stands at 4.9% – close to full employment, consumer confidence is 101.1pts (the highest since September 2015) and the PMI stands at 52.1.”

“Encouragingly, other major economies are beginning to show similar signs,” he adds.

But he’s still worried about the “main missing ingredient”, which is the still slowing velocity of money in the economy. That means financial sector balance sheets are important for hitting escape velocity to completely free the economy from the debt deflation cycle.

Yet because banks tend to be pro-cyclical when it comes to financial leverage – and as a result, their lending activities – and with much of the regulatory changes behind them in Australia, Goldman argues that financial institutions will soon work to accelerate leverage and thus the velocity of money here in Australia and abroad.

In the Australian context, many bank watchers will find this a remarkable call.


The return of the old-fashioned Industrial Cycle

Toohey and his team say that “if the global economy is breaking free of the destructive [debt deflation] cycle…and the financial sector deleveraging is also drawing to a close, given the length of the recent debt-deflation cycle it is worth revisiting what a typical industrial cycle looks like”.

That’s important, he says, because many “financial market participants would have yet to experience the ebb and flow of an industrial cycle in their careers”.


“While the distance between each step may differ from cycle to cycle, there remains a predictable rhythm to steps in each cycle,” Toohey says. “The detection of each step on the path is instructive of how much further the cycle has to run until demand peaks and growth slows again.”

He has Australia, Canada, New Zealand, the euro zone, and South Korea also following the United States and United Kingdom out and moving up from the demand growth trough stage of this cycle.

China, Japan, India and “most of EM” are approaching the trough.

Crucially for those long bonds and looking at zero rates as far as the eye can see, Toohey has an ominous warning:

“Economic cycles have a tendency of creeping up on financial market participants.”

He highlights that:

  • The global industrial cycle appears to be awakening from its long slumber.
  • Excess money, the money supply less nominal GDP growth and a leading indicator of of the industrial cycle, is “consistent with global industrial production accelerating towards a 4-5%yoy range over the next 12 months”.
  • Industrial metals appear to have bottomed in late 2015 and risen significantly since.
  • That industrial cycles are influenced by consumer demand is a given. But the pessimism exhibited by consumers in the post-GFC world has given way and shown a “consistent improvement and since 2015”. Likewise, business sentiment has picked up in 2016.
  • A recovery is needed in east-Asian manufacturing to confirm the upswing. Only Taiwan has so far moved into year on year positive growth. But other nations are improving.

That’s bad for bonds but good for commodity prices, the Australian and New Zealand dollars.

“Given some of the trends are already detectable in the economic data it is unusual that global bond markets are yet to reflect these developments,” Toohey says.

Yield curves have not picked up on this trend and Toohey says the expected pick-up in industrial production worldwide “would be consistent with a 100-150bps steepening in the G7 yield curve”.

Naturally that will impact on stocks via the bond/stock valuation equation.

That means “a better pulse for the global industrial production cycle is not necessarily a positive for equity markets such as Australia that have enjoyed the ‘search for yield’ by increasingly transforming the structure of their equity markets into bond-like proxies”.

Further complicating things for Australin investors, the RBA, and the economy is that the trend of increases for commodity prices is set to continue which see “the risks to commodity-linked currencies like the A$ and NZ$ … skew to the upside”.