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Introduction to the Great Deleveraging: Economic Growth and Investing Strategies for the Future

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This chapter is from the book
In this introduction to their book, Chip Dickson and Oded Shenkar address why the United States took on so much debt, how the debt will be reduced, and the costs of that deleveraging.

This book addresses why the United States took on so much debt and, eventually, how the debt will be reduced—delevered—and the costs of that deleveraging. In between, it differentiates sources of real economic and financial market growth from those that hinder and undermine them. It also provides some perspective on asset class returns over the last nine decades and some insight into the foundation of past secular bear and bull markets. That perspective is meant to better frame some basic rules of the investment road and hopefully make for more effective future navigation in an increasingly shifting global economy and more diverse market environment. First, the book starts with a reminder of a time when the outlook seemed pretty bleak.

1980 was a difficult year around the world, and it was evident in the somber public mood. The governments of the United States and much of Europe were trying to reverse a decade-long tide of rising interest rates, high inflation, and poor economic growth. In the United States, the core inflation rate rose above 12.5%, the U.S. government paid about 17.5% for short-term money funded with 3-month T-Bills, the rate paid for a conventional 30-year mortgage reached 16%, and good corporate credits saw the prime rate rise above 20%. It was very expensive to take risks and few dared or could afford to borrow. All this happened at a time when the last of the baby boom generation was entering the workforce.

The rest of the world did not fare much better. Sub-Saharan Africa suffered from overwhelming poverty and growing political instability. The largely centrally planned economies of China and the Soviet Union remained unable to lift much of their population from abject poverty and the rest of Asia was not doing much better. Over half of the world's population lived under totalitarian rule while many democratically elected governments pursued a course enhancing the role of government relative to the private sector. The major exceptions were Japan, which was continuing its remarkable post-World War II rise, and the oil-rich countries, which remained the beneficiaries of a seemingly endless and vital resource in great demand—oil.

For the typical 1980 investor, the prospect of better economic times and surging financial markets seemed far-fetched. Any time the economy and the market rebounded, negative economic news would darken the horizon again. Virtually no one realized that this dismal year actually marked a dramatic inflection point. The leadership and structure of governments the world over was beginning to change, real economic growth was set to accelerate, a wave of technological innovation was about to take hold, and financial markets were ready to take off.

What had happened was that the same destructive forces of inflation and historically high interest rates that had wreaked economic havoc triggered a political backlash against the existing order of the time. The backlash started in the United Kingdom, where Margaret Thatcher and the Conservative Party came to power in 1979 and implemented reforms that eventually lowered the rate of inflation, reduced regulatory barriers, and set in motion an economic surge. The United States followed suit in 1980, electing Ronald Reagan. With Reagan and with Paul Volcker as the head of the Federal Reserve, trends started to reverse. After years of dealing with double-digit inflation and interest rates well over 10%, the stage was being set for the beginning of the Great Equity bull market that lasted in the United States until 2000.

Reducing inflation and lowering interest rates also meant that the cost of capital was reduced, which made investing more attractive. The risk-free rate fell as did the risk premium, which is another way of saying that growth expectations increased as investors' confidence grew. Lowering the cost of capital meant that the value of a dollar of profit rose. For the equity markets, it meant valuations rose. Concurrent with these changes were regulatory and technology developments, making investing more accessible and less costly to the individual investor. Investment products proliferated as did the number of financial markets around the world that were open to investors from other nations.

Five Major Events Driving Globalization

At about the same time, on the other side of the world, big changes were also brewing. In China, late 1978 saw the beginning of economic reforms that would eventually catapult China to its current position as the world's second-largest economy. After cautiously reopening the country for foreign investment, its paramount leader, Deng Xiaoping, declared that it was "glorious to get rich" and encouraged the Chinese to go into business and become entrepreneurs, first in small businesses and then on a grander scale. Since then, China's economy more than quintupled in size by sustaining an annual compound growth rate of over 12%. A $500 billion economy representing a mere 2% of the global economy in 1992 became an almost $3 trillion economy representing close to 6% of the world's economy in 2008. That growth greatly reduced the number of Chinese living in poverty: Between 1993 and 2005, the number of poor in China fell by about 70% (see Exhibit 1).

Exhibit 1

Exhibit 1 The Number of Very Poor in China Fell More Than 75% Between 1981 and 2005.

(Source: Carpe Diem Blog)

The Great Openings

The Chinese reforms would be one of five major events creating the foundation for a major wave of globalization and, with it, the creation of financial wealth. The other four were the move toward free markets through the elections of Margaret Thatcher and Ronald Reagan, the fall of the Berlin Wall in 1989, the start of the World Wide Web in 1991, and the Free Trade initiative started under the first Bush administration and put into effect by the Clinton administration. Taken together, these events provided the foundation for a more open global economy, triggering a surge of innovation and productivity, a decline in geopolitical tensions, more open communication, and a surge in education. We call these "The Great Openings."

Over the next 25 years, that wave of technological and political change would alter many assumptions and some of the structures of daily life. Taken for granted today in most developed countries are the Internet, e-mail, cell phones, smartphones, PDAs, increased computer processing power, smaller devices, digital television, speech recognition, DVD players, music and video downloads, automated teller machines, 24/7 news, endless entertainment choices, blogs, GPS (Global Positioning System), and immediacy. Many of these technologies were introduced into developing markets much faster than previously was the case. As they grew, the economy and financial markets grew with them.

Between 1980 and 2007, the global economy grew more than 3.5 times. Global gross domestic product (GDP) reached almost $55 trillion; on a real basis, it grew more than 2.5 times (Exhibit 2). Per capita, GDP went from $2,771 in 1980 to $8,443 in 2007. The value of the world's stock markets increased from close to $675 per person to just under $9,500—up more than 14 times. The value of all financial assets increased from near $2,700 per person to an estimated $28,500. It was a period of significant global economic expansion and wealth creation.

Exhibit 2

Exhibit 2 The Global Economy Index—Actual and Expected

(Source: IMF)

Strong economic growth and attractive financial market performance coincided with population growth. It also coincided with other positive trends like lower poverty levels, rising life expectancy, and declining illiteracy. In 1981, almost 52% of the world's population lived on no more than $1.25 per day and almost 75% lived on less than $2.50 per day, as shown in Exhibit 3. By 2005, the number of people living on $1.25 per day fell to 25.2%, while the number of those living on $2.50 per day fell to 56.6%—a remarkable improvement. The global illiteracy rate fell from 30.3% in 1980 to 18.3% in 2005 according to UNESCO. In the United States, life expectancy rose from 73.7 years in 1980 to 77.8 years in 2005.

Exhibit 3. World Poverty Figures by Region, 1981–2005; Percent Living Below the Poverty Line (Source: Chen, Shaohua and Martin Ravallion, "The Developing World Is Poorer than We Thought, but no Less Successful in the Fight Against Poverty," Quarterly Journal of Economics, in press Fall 2010)

Region

$1.25/day

$2.50/day

1981

1990

1999

2005

1981

1990

1999

2005

East Asia & Pacific

77.7

54.7

35.5

16.8

95.4

87.3

71.7

50.7

Of which China

84.0

60.2

35.6

15.9

99.4

91.6

71.7

49.5

Eastern Europe & Central Asia

1.7

2.0

5.1

3.7

15.2

12.0

21.4

12.9

Latin America & Caribbean

11.5

9.8

10.8

8.4

29.2

26.0

28.0

22.1

Middle East & North Africa

7.9

4.3

4.2

3.6

39.0

31.2

30.8

28.4

South Asia

59.4

51.7

44.1

40.3

92.6

90.3

86.7

84.4

India

59.8

51.3

44.8

41.6

92.5

90.2

87.6

85.7

Sub-Saharan Africa

53.7

57.9

58.2

51.2

81.0

82.5

83.8

80.5

Total

51.8

41.6

33.7

25.2

74.6

70.4

65.9

56.6

Improvements in the quality of life occurred while the world's population expanded from 4.43 billion people in 1980 to more than 6.7 billion people in 2008. In 2005, in a global population of 6.5 billion, 1.2 billion people resided in developed countries and 5.3 billion lived in developing nations. The combination of population and economic growth brought with it a surge in the number of new businesses created. Those new businesses often came from new industries and product lines, such as personal computers, cell phones, semiconductors, the Internet, credit cards, mortgage banking, and health-care companies that made artificial joints—to name a few. New players also emerged: S&P companies like WalMart, Best Buy, Intel, Microsoft, Apple, Dell, Cisco, Amgen, Stryker, Visa, Master-Card, Yahoo!, and Google were not part of the S&P 500 Index in 1980.

The post-1980 period also saw an unprecedented wave of globalization, which was reflected first in the economic mix and only more recently in the investment mix. In 1992, the developed world's share of the global economy exceeded 75%. As recently as 2000, it remained close to that level, as shown in Exhibit 4. Since 2000, the developed world's share declined to 68% in 2007. Since 2001, the United States share of the global economy declined from about 32% to 23%, according to statistics from the World Bank. Since 1980, its peak level was almost a 34% share of global GDP in 1985. Japan's 2008 share of 8% global GDP represents a significant reduction in its share of global GDP since 2001 when it was 12.9% and from its peak of 18% in 1994.

Exhibit 4

Exhibit 4 The Developed World's Shrinking Share of the Global Economy

(Source: United Nations)

The developing world continued to gain share since 2001. For instance, based on the World Bank statistics, China saw its share of global GDP rise from 4.2% to 7.1% in 2008. The Russian Federation's share increased from 1.7% to 2.7% and reflects the tremendous increase in global demand for energy. Brazil's share of global GDP rose from 1.9% to 2.6%, and India's share rose from 0.5% to 2.0%. This was a period when low- and middle-income countries experienced faster economic growth and garnered a greater share of the global economy.

In line with the economic mix, the developed world controlled the dominant share of financial assets. As recently as 2001, the U.S. equity market represented over 50% of global equity market capitalization. By the end of 2007, however, the U.S. equity market represented about 30% of global equity with a market capitalization of over $60 trillion. Between 2002 and 2007, the size of the equity market almost tripled, and it increased more than six times between 1992 and 2007. An investor in the global equity market in 1980 saw their investment increase more than 20 times through 2007. With the global economy, the character and structure of the global financial markets also changed dramatically. The forces stimulating the growth of the financial markets started in the late 1970s as inflation and interest rates began to peak in much of the developed world. Also, the technologies driving the digitalization or the economy became more accessible, affordable, and impactful. This started the initial stage of financial asset growth relative to GDP in some of the world's developed countries.

The economic and financial success of the 1980–2007 era was constructed on some very durable foundations, but also on some false ones. There were weaknesses and structural decay only a few recognized. As is often the case, perception did not match reality. Since the end of 2007, the global equity markets lost more than 50% of their value from peak to trough, and much of the world's economy fell into recession. Future economic and financial prospects seem much less attractive two years ago even though the economic cycle turned and a modest recovery began.

Through it all, the world's population continued to grow. That growth is expected to continue through 2050, but at a slower rate. By 2050, the world's population is expected to exceed 9 billion, as shown in Exhibit 5.

Exhibit 5

Exhibit 5 Global Population Expected to Exceed 9 Billion Before 2050

(Source: U.S. Census Bureau, International Data Base, June 2009 update)

The global population reached 6.76 billion in 2009, and by 2050, it is expected to reach 9.32 billion, an increase of 2.56 billion people or 38%. That increase is equal to the world's population in 1950. India is expected to pass China and become the most populous country. Its expected increase of 500 million people will be greater than the population of every country in the world except China. Combined, those countries are expected to house 33% of the world's population compared with 36% in 2009. The largest absolute growth from 2009 to 2050 is expected to come from the countries shown in Exhibit 6.

Exhibit 6. Top 25 Countries: Expected Population Increase Between 2009 and 2050 (Source: U.S. Census Bureau)

Country

2050 Estimated Population

Expected Change

Expected Percentage Change

India

1,656,553,632

499,655,866

43.2%

Ethiopia

278,283,137

193,045,799

226.5%

United States

439,010,253

131,798,130

42.9%

Congo (Kinshasa)

189,310,849

120,618,307

175.6%

Nigeria

264,262,405

115,033,315

77.1%

Pakistan

276,428,758

101,850,200

58.3%

Uganda

128,007,514

95,637,956

295.5%

China

1,424,161,948

85,548,980

6.4%

Bangladesh

233,587,279

77,536,396

49.7%

Philippines

171,964,187

73,987,584

75.5%

Indonesia

313,020,847

72,749,325

30.3%

Brazil

260,692,493

61,953,224

31.2%

Egypt

137,872,522

59,005,887

74.8%

Sudan

88,227,761

47,139,936

114.7%

Niger

55,304,449

39,998,197

261.3%

Mexico

147,907,650

36,695,861

33.0%

Madagascar

56,513,827

35,860,271

173.6%

Burkina Faso

47,429,509

31,683,277

201.2%

Iraq

56,316,329

27,370,760

94.6%

Kenya

65,175,864

26,173,092

67.1%

Tanzania

66,843,312

25,794,780

62.8%

Afghanistan

53,354,109

24,958,393

87.9%

Turkey

100,955,188

24,149,664

31.4%

Yemen

45,780,651

22,922,413

100.3%

Vietnam

111,173,583

22,596,825

25.5%

The United States is expected to remain the third most populous country in the world with a population exceeding 400 million. Its population growth is expected to be greater than the global population growth in large part because of more open immigration. Growth is not expected everywhere and 15 countries are expected to experience a population contraction of more than 1 million, as shown in Exhibit 7.

Exhibit 7. Fifteen Countries Expected to Experience the Largest Population Decline by 2050 (Source: United Nations Population Fund)

Country

2050 Estimated Population

Expected Change

Expected Percentage Change

Japan

93,673,826

-33,404,853

-26.3%

Russia

109,187,353

-30,853,894

-22.0%

Ukraine

33,573,842

-12,126,553

-26.5%

Germany

73,607,121

-8,722,637

-10.6%

Italy

50,389,841

-7,736,371

-13.3%

Poland

32,084,570

-6,398,349

-16.6%

Korea, South

43,368,983

-5,139,989

-10.6%

Spain

35,564,293

-4,960,709

-12.2%

Romania

18,678,226

-3,537,195

-15.9%

Taiwan

20,161,286

-2,813,061

-12.2%

Bulgaria

4,651,477

-2,553,210

-35.4%

Belarus

7,738,613

-1,909,920

-19.8%

Czech Republic

8,540,221

-1,671,683

-16.4%

Hungary

8,374,619

-1,530,977

-15.5%

Serbia

5,869,146

-1,510,193

-20.5%

The global economy and financial markets should continue to be volatile and evolve, while the world's population continues to grow. There will be many challenges and there will be many opportunities.

To provide a better perspective, the book begins with a discussion of the "great leveraging," a flashback into the debt and risk accumulated in the United States, and is followed by a quick history of bull and bear markets, global economic growth, and the economic returns generated by different asset classes over time. We then detail the destruction of euphoria, including the telling story of Japan, and the way out of euphoria. Finally, we turn to market scenarios, signals, and the great deleveraging we are undergoing today, accompanied by the global economic outlook and its investment implications.

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