“You’re entitled to your own opinion, but not your own facts.” – Author Unknown
History shows that the pace of change is generally slow but accelerates due to either a technological breakthrough or a major crisis. The invention of the steam engine resulted in a major rise in productivity while the Second World War led to the Bretton Woods monetary system. What change has the recent financial crisis brought? A few months later we made our peace by blaming it all on sub-prime debt, greedy bankers and the decision to let Lehman Brothers fail. However, a lot of questions still remain unanswered.
At Auvest, we believe that asking the right questions is as important as finding the answers and this is what we have attempted to do in this report. The challenge we faced was to condense an internal research project that was much bigger in size and scope into something that would be concise and yet do justice to the subject. We hope that this report will raise a few questions while providing a perspective on the past drivers of global growth, an analysis of the current crisis and its implications and an overview of the opportunities and challenges in the coming years.
Financial Vandalism is a term we use to describe the current supremacy of finance over the real economy (the part of the economy that produces goods and services) as reflected in the era of excessive leverage, financial speculation and easy money. Finance, which is meant to facilitate the growth of the real economy by enabling the efficient allocation of capital has become disconnected from reality. This state of affairs is unsustainable, which is why we are making a call for the end of Financial Vandalism and a return to the real economy.
As presented in Section 1 of this report, global growth over the twenty five year period ending in 2007 was driven by five key engines: rise of fiat money and the ascent of the US Dollar as the world’s major reserve currency, demographic tailwind with the US baby boomers and young emerging market population, technology explosion enhancing productivity and impacting everything from communications to healthcare, globalization and world trade with the move in manufacturing and services from the developed world to emerging markets and financial innovation leading to increased leverage with a consequent rise in global money supply, lower interest rates and higher asset prices.
Apart from technology, which will remain a driver of growth going forward, the four other engines of the boom period are losing momentum. The status of the US Dollar as a reserve currency is under threat as the fiscal situation deteriorates and America’s imperial power wanes. Global demographics are turning negative with aging populations in the developed world and China, while income inequality and high unemployment threatens globalization and world trade. Increased regulation and higher capital requirements in the financial industry will suppress innovation, reduce leverage and lead to lower returns.
This structural transition exacerbates the current crisis. While the massive amount of government stimulus seems to have created a moment of calm, the global economy that emerges towards the middle of this decade will look very different from the one that entered the crisis in 2008. The illusion of prosperity created by the reflation of risk assets has resulted in the collapse being dismissed as an aberration, and now everyone is back to the party.
The level of debt in the developed world is unsustainable and significant debt destruction is needed. Deleveraging of the economy is critical for sustainable growth but it would involve a significant asset price correction and mass bankruptcies which the authorities are unwilling to allow. Despite the wishes of the financial magicians in charge, this problem of too much debt cannot be solved by taking on more debt.
Asset prices across the world have been buoyed by the huge increase in leverage during the last decade as well as the current high level of liquidity. In the absence of real organic demand, the only way to sustain growth and keep asset prices stable is to add more debt and keep interest rates low, a strategy being followed across the world. The futile attempts at reviving the global economy through more debt will only make the problem bigger and the eventual bust more painful and damaging to the real economy.
According to our assessment in Section 2 of this report, the current crisis will last until around the middle of this decade. The first act was the fall of the highly leveraged entities like Lehman, AIG and others which caused the credit crisis. In the second act, Sovereigns stepped in and took the bullet meant for the leveraged players through bailouts and fiscal stimulus thereby leading to deterioration of their balance sheets.
Act three is where we are at present, with liquidity induced inflation from the developed world’s loose monetary policies creating social instability in emerging markets which will force interest rate hikes and a consequent asset price correction. The developed world is importing this inflation from the emerging markets and central banks (especially the European Central Bank and the Bank of England) may be forced to raise interest rates.
Act four will see the crisis come back to the developed world as the bust in emerging markets raises concerns about global growth and the inability to service debt finally forces defaults and bankruptcies. This will be the most savage part of the crisis and may lead to the nationalization of many financial institutions. Act five will be the last act of this crisis, with every man for himself as governments realize that there is insufficient global demand to create employment at home and simultaneously engage in free trade, leading to a major trade war and eventually a new monetary system.
Once the crisis is over and a proper monetary system is in place along with a sustainable model of globalization, the world will be able to move forward to the real economy with a sense of optimism. Section 3 of this report presents a broad picture of the post crisis return to the real economy around the middle of this decade in the context of the significant demographic transition that the world is about to witness. The consumer of tomorrow will look very different from the one of today due to the retirement of the baby boomers in the US, rapid aging in Europe, a decline in the working age population in China and many more people in Africa and India. This new consumer will have different needs and current business models would have to adapt and new ones emerge to capture the opportunity.
Conclusions (Full Report)
• The financial crisis that started in 2008 is not yet over and still has some time to play out.
• The problem of too much debt cannot be solved by taking on more debt.
• The emerging markets will not save the world from the next phase of this crisis as they have weak domestic demand and are too dependent on investment and exports.
• Significant debt destruction has to happen before the global economy can get back on a path to sustainable growth. Many defaults and bankruptcies will occur as a result.
• This debt destruction will cause a large correction in asset prices globally.
• High and rising unemployment and income inequality globally will lead to protectionism and a trade war.
• A new monetary system will replace the current system around the middle of this decade.
• The world will recover from the crisis and the focus will return to the real economy.
• Major demographic changes are about to happen globally which will impact everyone.
• The world is positioned badly for these changes as regions with current installed manufacturing capacity will have labor shortages and regions with surplus labor have little installed capacity.
• Resource conservation and replacement, infrastructure and technology will be important sectors in the coming years and will see major investment.
• These changes will provide many opportunities and a large transfer of wealth will take place as many people will be caught on the wrong side of this transition.