Leverage and Pain

http://www.forbes.com/finance/forbes/2008/1208/182.html

Leverage and PainA. Gary Shilling 12.08.08, 12:00 AM ET

Painful financial deleveraging has given us an excruciating global recession. It may cause even deeper pain ahead. The slashing of borrowing comes after spectacular buildups in the financial and consumer sectors. The combined debt and equity of U.S. financial institutions went from 10% of gross domestic product in 1973 to 118% at the end of 2007. Over the same period household debt, including mortgages, rose from 45% of GDP to 98%. Is it any surprise that this borrowing binge ended in a credit crisis?

The ending of a credit crisis entails deleveraging, which is to say, the liquidation, repayment or cancelation of debt. This process engenders pain.

Consumers dropped their saving rate from 12% in the early 1980s to zero 20 years later. They did this while persuading themselves that watching a rising stock portfolio or living in an appreciating house was a form of saving. The stock market crash at the turn of the century did not bring them to their senses, because by then the house price boom was under way. Now there's no asset left with which to play the savings fantasy game.

Stocks are not much higher than they were at the 2002 bottom. Houses are en route to what I forecast will be a 37% peak-to-trough falloff. Consumers are tapped out. Their credit cards are maxed out, and home equity lending is dead. Heavy borrowing pushed their equity in autos and other durables from 60% in the early 1990s to 40% today. Their $3 trillion in 401(k) plans at the end of 2007 has taken a beating as stocks have swooned.

So people are shrinking their discretionary outlays on everything from motorcycles to liquor. They're replacing a 25-year borrowing and spending binge with a saving spree. Over the last quarter-century consumer spending grew an average of one-half a percentage point per year faster than aftertax income, adding about a third of a percentage point to GDP growth. For the next decade spending is likely to rise a percentage point slower than income each year.

Consumer spending constitutes 70% of GDP, and the effect of that restraint is multiplied as it ripples through the economy. As a result real GDP growth will drop by a full percentage point from its earlier 3% rate to 2%.

The saving spree will be reinforced by the fact that baby boomers desperately need to save for retirement, while those in their 20s and 30s, typically big spenders as they form households, are much fewer in number. The threat of deflation also depresses consumer spending. People are waiting for lower prices before buying houses, and they'll wait to buy other things, too.

Capital spending will also be subdued, as slowing growth makes for excess capacity. Forget exports as a source of strength. American consumer restraint will slow imports, hurting foreign lands that depend on the U.S. for export growth and depressing their own demand for American products. Hence the clamor these days for government spending as a form of stimulus.

The BRIC quartet (Brazil, Russia, India and China) and other developing countries will sink like bricks as their exports drop and as commodity prices collapse, driven down by both enfeebled global demand and the end of the delusion that commodities are an asset class like stocks and bonds. China doesn't have a big enough middle class of free spenders to offset export weakness there (see my May 19 column, "Chinese Chance"), and the end of the oil boom will slash Middle East economic growth and hobble the petroleum-addled dictators of Venezuela and Russia.

Deleveraging threatens economic growth in many countries that have depended on Western bank generosity. Iceland is bust. Baltic nations, and eastern European ones like Hungary, are in for years of sluggish growth, with homeowners no longer able to borrow cheap money abroad. Argentina, already a pariah to international lenders, is setting an ugly precedent in grabbing its private pension funds to repay its debt.

The demise of securitization and other derivatives and the return to basic banking--lending prudently at profitable interest rates--will reduce credit availability for years and subdue economic growth. Big firms can't float commercial paper; little ones can't get bank loans to meet their payrolls. The accelerating consolidation of financial institutions will eliminate many risk-taking lenders, and entrepreneurs will be inhibited by the scarcity of venture capital money.
So even after the financial crisis and recession end, maybe by 2010, slow economic growth and poor profits are likely to drag on. Don't be in a rush to buy stocks.

A. Gary Shilling is president of A. Gary Shilling & Co., economic consultants and investment advisers.