Ruh Roh: ICAP Says Deleveraging Process Still In "Early Stages... [and] It Will All End In Tears"

Nicolas Lenoir of ICAP Futures LLC offers a sobering take on our current (global) economic situation.

Private vs. Public: Two Different Stories

• Subtracting government spending from GDP, we find that the private sector GDP is barely flat [year-over-year]
• Around the world governments have taken over for the private sector, China’s stimulus package for 2008 was 14% of GDP
• The US Federal Reserve’s balance sheet expanded by $1.4Tr to compensate for credit contraction
• But consumer credit outstanding is still shrinking and the deleveraging process is in its early stages
• The Federal Reserve’s balance sheet is expected to shrink slowly as asset purchase programs have expired

Restart Private Credit?

• A strong February reading was canceled out by March, April will be crucial to tell if the consumer is back spending money she/he does not have
• Small businesses are still reporting difficulty accessing credit
• Lending standards have been tightened and it is preferable to stay away from what caused our downfall in the first place, GSEs now represent 90% of the MBS market [Ed: and are not addressed in the so-called 'comprehensive financial reform' bill introduced by lame duck and crisis instigator Chris Dodd]
• Total US debt as a percentage of GDP is skyrocketing
• The last 30 years of growth have been fueled by an expansion from 160% to 380% of the debt to GDP ratio: we simply cannot keep carrying on
• The savings rate after briefly flirting with 7% is now back to 3% and headed lower; it is dramatic

Expand Public Spending?

• Since 1970 federal spending has increased 7X as much as the median income
• Since 1980 the 5thpercentile for household income has grown at 3 times the annual pace of the average household income
• Total Public Debt Outstanding grew by $4Tr since the end of 2006
• Many worry that excessive issuance will lead to failed auctions resulting in a dangerous bear market for US Treasuries
• Japan went down the path before us; 20 years later all they have is a 200% public debt to GDP ratio to show for it along with a soon-to-be negative savings rate

Between a Rock and a Hard Place

• Consumer credit has not restarted meaningfully yet, and public debt is reaching worrying levels so the government cannot keep acting as the engine of growth much longer
• Q2 numbers will impress because of inventory rebuilding but once that momentum abates the scrutiny on federal spending as the only engine of growth will intensify
• Two possible scenarios:
-- Private sector lending rises again holding growth between 2.5% and 3.5% until the inventory cycle peaks, then closer to 2% once the government progressively pulls out stimulus and the cycle peaks
-- The federal government is forced to step up again as private sector growth falters again
• Two scenarios for the economy yet three scenarios for the bond market:
-- The economy grows enough for the federal government to pull back spending and the Federal Reserve to normalize rates in 2011 avoiding a financing crisis: 10% probability
-- The economy slows and government spending keeps expanding to maintain growth in a slump that carries on for several years: 70% probability
-- The US faces a refinancing crisis after other countries default due to the same problem: 20% probability

The Deflationary Case

• Demographics are going to play a fundamental role in the next 20 years and it starts now
• Using a distribution of the average salary as a function of age, the aging of the baby boom generation has been a major boost to GDP since the 70s contributing as much as 2% and 1.5% on average
• For the next 30 years demographics will only contribute 0.65% on average
• The 65-year old or older population is going to grow between 1.7% and 2.5% over the next 30 years against 1.15% on average over the last 20 years

We Are Not Alone

• Aging in China will be exponentially worse due to the one child policy
• Also add in the fact that there are 58% men when the “natural” observed population split is 48% men and 52% women
• Currently the percentage of the Chinese population which is outside of the workforce is 43%. Starting in 2012 this number is going to move up to reach 60% in 2060
• It will reach 50% before 2020
• In the US this number is currently 35% according to the official BLS releases; it has moved up from 33% in the last 10 years

Lenoir concludes with this cheery missive:

"It will all end in tears with skyrocketing interest rates but until then we are stuck in a low yield environment that can last for some time if we believe modern Japanese history."

Vote accordingly in November.