Why Slow Growth is a Problem

IntRoDUCTION


There is no doubt that the current economic expansion has been weak. Since the turn of the century, Nominal GDP has only averaged 3.84% compared to 7.34% during the previous 50 years. Deflationary headwinds of technology, globalization, demographics and debt have been a key factor in slowing nominal growth. There are many economists who believe that a structural shift has occurred and slow growth will be the new normal. Even the Federal Reserve has adjusted their long-run growth projections. In 201 1 they projected long-run growth between 4.5%-4.8% and in the most recent projection in June forecasted 4.0%-4.3% (1). A slower growth period may not seem significant, but as a nation the United States bet on higher growth rates and then leveraged it. If growth remains at current anemic levels, pensions around the world and the Social Security system will go bankrupt. Tax revenue won’t be enough to fund “mandatory” government programs. People, businesses and governments will be unable to pay their debts as incomes remain stagnant. The economy is structured in a way that it is reliant upon higher growth rates and if those are not accomplished there are serious dangers of systemic risk.

 

Social Security/ Pensions


With all the negative publicity about Social Security, it may be a surprise to some that the program generated a $25 billion profit in 2014. At the end of 2014 the Social Security trust fund had a total value of $2.78 trillion (2). From these assets, $98 billion of interest income was generated. When excluding interest income, the Old Age and Survivors fund ran a deficit of $73 billion which is concerning since inflows from tax receipts were not sufficient to cover the annual payout. Since Social Security was established in 1935 demographics have change remarkably. According to the Census Bureau, in 2014 15% of the population was over 65 and that number is expected to be 21% by 2020. That’s compared with only 5.4% in the 1930’s. Although people are living much longer, the retirement age has only increased by 2 years (67 for those born after 1959). This amounts to beneficiaries being paid substantially more over their lifetime. The amount being paid to beneficiaries has increased by 108% since 2000 while taxes collected to fund the program have only grown by 55.6%. The Social Security Administration currently projects that total expenses will surpass total revenue by the year 2020 (3). This will be catastrophic as the fund decreases in size to make payments; interest income will decline widening the deficit. If the program doesn’t find a way to decrease expenses or increase revenues, the $2.78 trillion fund will be depleted by 2034. If Social Security payments in 2014 were limited to tax income received, they would have been $73 billion less, or 92% of the scheduled benefits.  According to the CBO, by 2034 beneficiaries will receive only 77% of scheduled benefits or $391 billion less than originally promised! Since these projections are so far into the future it’s difficult to predict accurately what will happen, but it is obvious that promises were made that cannot be fulfilled.


Pensions are another source of income that retirees are dependent upon. According to the S&P rating agency, the average funding ratio for state pensions was 70.9% in 2012 (the last year data is available) (4). This is concerning as 45% of pension revenues come from investments returns. State and local pension funds use a discount rate, which is their assumed investment returns, on their liabilities when calculating their funding ratio. The center for Retirement Research at Boston College found that for 2013 the average assumed investment return for 150 state and local plans was 7.7%. At this rate of return these pension funds were calculated to be 72% funded. If the investment returns were to average 5% that would mean pensions were only 50% funded (5). Since the 30-year U.S. treasury is yielding approximately 3%, substantial risk needs to be taken to obtain a 7.7% return. In the fiscal years of 2008 and 2009 combined, state pension funds lost $583 billion. With pension funds holding nearly 70% equities another market correction would make some of these funds insolvent.


 As mentioned in the previous newsletter, equity valuations are near all-time highs. Not to mention the average economic expansion since WWII has been 58.4 months and we are 73 months into the current growth cycle. However, a correction isn’t needed to render these plans insolvent. We have shown in previous economic updates that overtime market returns and the growth of the economy are closely correlated. The economy has slowed since these pension funds were established and it’s becoming obvious they aren’t sustainable. In Detroit pension checks were cut by 6.7% for 12,000 retirees AND they had to repay $212 million in interest they accrued in a city-run savings plan (6). As Mike Shedlock has pointed out, Illinois pensions are only 39% funded or burdened with $105 billion in unfunded liabilities. Politicians and fund managers did not enact the structural changes needed for these funds to remain solvent as the economy has structurally slowed. In many places people who assumed they would receive a pension throughout retirement may be in for a rude awakening.

Debt


It has been said that since WWII, the world has been in a debt supercyle. Debt has soared higher at an exponential rate around the world. Even the financial crisis in 2008 couldn’t stop the debt supercycle. From Q4 2007 to Q2 2014 global debt has grown by $57 trillion or 40.14%. The problem with ever increasing debt is that it inherently pulls demand forward. Things that may have been purchased tomorrow are purchased today using debt. This leaves us paying for future demand today, using up tomorrow’s funds. In a healthy economy, debt is used productively to increase income and is either paid down or rolled upon maturity. This is not a problem in a world where GDP is growing at a similar pace of debt because the payments do not become a burden. Wages are rising, demand is strong and creditors are willing to roll debt at prevailing rates. However, it seems this game is coming dangerously close to an end. Despite massive efforts by central banks around the world, global demand is slumping. World trade grew by less than 3 percent in 2012, 2013 and 2014, compared to the pre-crisis average of 7.1 percent (1987-2007). Interest rates are at historically low levels and average loan durations continue to increase in an attempt to keep the game going. So it seems the world economy is not healthy and growth is stagnating. 


A perfect example of debt being rampant in the global economy is the current situation iron-ore producers are in. “When Australia’s richest person, Gina Rinehart, needed cash last year to build a massive iron-ore mine called Roy Hill in northwest Australia, five export-credit agencies and 19 banks teamed up to provide the US $7.2 billion required, sealing the largest project-financing deal in industry history.” (7) China appeared to be a growth machine (also financed by debt growing from $1 Trillion at turn of century to $25 trillion today) causing demand for commodities to skyrocket. As the price for commodities rose due to greater consumption, companies took on debt to increase their capacity to produce.  Since firms projected prices would continue to rise, they believed that additional revenues from increasing production would be much greater than the cost of debt required to add capacity. “The world’s largest mining companies by market value had accumulated nearly $200 billion in net debt by 2014, six times higher than a decade ago, according to consultancy EY, while their earnings only increased roughly two-and-a-half times.” With the Chinese economy slowing, the demand for iron-ore has fallen drastically below projections. At the same time, the capacity for Iron Ore production is extremely high because of all the debt financing that has gone into the mines. The result has been iron ore falling by over 67% since its peak in February 2011. This means that revenue generated by the increased production is much less than originally anticipated when the mining companies decided to take on the debt. These businesses are now struggling to make debt payments as revenues have collapsed. If commodity prices remain low it could potentially lead to large defaults putting stress on the financial system.

In the United States the housing bubble was a time period where households took on an exurbanite amount of debt. In 2000 the leverage ratio, household debt divided by wages and salary income, was 140% and by 2009 soared to 218%. The ratio has since come down to 180% as mortgage debt has fallen, but there is still a serious problem. Wages have remained nearly stagnant and there is still debt being used to fuel consumption which takes away from future demand. There are still 5.1 million or 10.8% of homeowners who are underwater on their mortgages (8). This means that they owe more in debt on their house than it is worth!  The same is happening with automobiles loans that are greater than the value of the vehicle. According to Office of the Comptroller of the Currency, “In the fourth quarter of 2014, the average LTV for used vehicle auto loans were 137 percent." All of the interest that must be paid over the duration of the loan is money that could have been put towards discretionary spending later. The problem is reduced when incomes grow at a faster rate than interest on the loan, but that hasn’t been the case. As a nation we continue to attempt to increase consumption through debt with ridiculous financing but it is beginning to do the opposite. True growth can only come in the form of increased incomes. Debt is like a medicine that provides only short-term relief. We have continuously used that medicine and now it looks like we’ve made the economy sicker!

Conclusion

 Nominal growth in the first half of 2015 was only 2.5%. These levels are too slow to produce meaningful jobs and higher wages. The Federal Reserve has used unconventional policy and kept short-term interest rates at the lower bound for over six and a half years to encourage growth. Since the financial crisis, government debt has grown nearly three times faster than GDP. The solution to an economy oversaturated with debt has been to try to encourage more lending! However, the marginal benefit of debt has continued to decline. The economy has structurally changed and policy makers have refused to accept this because it means difficult decisions. Rather than being forward looking and preparing for the consequences of slower growth, everything that can be done to preserve the status quo has been. Unfortunately, changes aren’t made until it is too late. Retirement programs and debt that is unsustainable in this current growth environment will not be restructured until the moment the bills cannot be paid. What cannot be paid will not be. It is better to recognize the reality of an evolving global economy and prepare, rather than hope that everything will revert to the way it used to be. 

 

Corey J. Gallahan – CFP®, MBA Canisius College
C. Clayton Sauberan – BS Economics Bentley University
Brian C. Rogers- BS Economics & Finance Bentley University

   

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