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The Great Deleveraging: How to Advise Clients in a Period of Weak Growth

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The second quarter of 2009 was memorable for delivering a few worldwide shocks: Chrysler’s government-forced bankruptcy, the horrid death of singer Michael Jackson and a globally denounced rocket launch by North Korea.

But the end of that quarter also marked, without headlines, the period when leverage (borrowing money) relative to GDP reached a peak in the United States and the process of deleveraging (reducing that huge accumulated debt) began.

Nevertheless, the U.S. economy today supports its highest level of debt in history. How we got here and what is needed to shake those shackles are explored in a new book, The Great Deleveraging: Economic Growth and Investing Strategies for the Future (FT Press) by Chip Dickson, co-founder of equity research firm Discern and former Lehman Bros. chief equity strategist, and Oded Shenkar, Ford Motor Company Chair in global business management at Ohio State University’s Fisher College of Business.

The Great Leveraging began in the late 1990s but has roots in the 1960s thanks, in part, to the Vietnam War. Still, the chief force driving the economy “beyond its natural evolutionary path,” as the cerebral Dickson, 57, a Chartered Financial Analyst, puts it, was housing and the government policies encouraging home ownership.

The current deleveraging is only the second such in the last 100 years; the first began in the 1930s and lasted until 1953.

As debt contracts, today’s deleveraging should, as before, bring several years of weak economic growth, forecasts Dickson, Discern’s research director and strategist.
A meaty section of his and Shenkar’s book is devoted to how investors can try to successfully navigate through this challenging time. In particular, the authors focus on three emerging markets poised for substantial growth: China, India and Israel.

Research caught up, by phone, with the Detroit-born Dickson — previously a bank analyst at Salomon Bros. and Smith Barney who left Lehman in 2006 (“I was very fortunate!”) — after his return to New York City from a strategy meeting in Changsha, China.
You write that the next decade will be brutal for many investors. That’s pretty downbeat!

The brutal part has partially been experienced. But a lot of challenges and structural shifts are taking place. One is deleveraging.

Please define deleveraging in 50 words or less.

Well, leverage is the act of borrowing and increasing the debt level relative to your equity and/or asset base. With deleveraging, you’re reducing the level of debt in an absolute fashion; but you’re also reducing the ratio of debt as a percentage of equity and assets.
What goes into the deleveraging process?

Growing the economy faster than debt grows, strengthening balance sheets, writing off debt, improving margins and increasing the level of wealth, as reflected by rising equity markets.

But what’s the best path to deleveraging?

Growing the economy faster than growing debt. That’s what started to happen in the 1930s. The economy almost got cut in half from 1929 to 1933. Even though government debt went up, the private sector paid down debt; and the economy started to grow again.

After previous deleveraging, what has been the state of the economy?

Those years were disappointing at best; and many were disruptive. Because people paid down debt and didn’t borrow, growth slowed. Typically, to deal with periods of deleveraging, people get more austere in their spending. Individuals and companies pull in their horns; there’s less pricing power.
You write that in developed economies, the point where additional debt will become economically destructive is close. Is the U.S. there yet?

It feels like we are; but, actually, you don’t know till you’re past it. You could say that Greece, Spain, Ireland and Portugal are past that point.
You contend that the technology and housing bubbles were fake growth. Please explain.

The Nasdaq bubble was based in large part only on valuations going up in…


the extreme. That created an illusion of wealth; it wasn’t sustainable. With the housing bubble, there were goals to get more and more people in houses; and we were using standards that were increasingly lenient. That caused valuations to go up a lot further than they should have.

We created structures to support the leverage…but there was a lot of hidden debt out there that people weren’t paying attention to — both in the public and private sectors.

In what parts of the economy are the pressures to deleverage greatest?

The public and financial sectors. Financial services has already started the deleveraging process and gone through a pretty hefty restructuring. Debt levels in the industry have come down a fair amount.

You write that deleveraging in the financial sector should involve “reintermediation, recapitalization and rationalization.” What’s, um, “reintermediation”?

Asset-backed securities started the practice of “disintermediation” — taking assets off banks’ and other financial companies’ balance sheets — where debt was used to support the asset-backed securities. That process has stopped and begun to reverse itself. For instance, lots of credit cards that were backing asset-backed securities have moved back on banks’ balance sheets. That is, they’re being “reintermediated.” The amount of debt supporting asset-backed securities has declined by almost a third.

What about other parts of the economy?

The non-financial private sector hasn’t gone through much deleveraging. But the household sector is close to starting it.

What sector will come after that?

The government. And that’s going to be the big one. Based on what happened in the 1930s, the government is the last to go; but eventually it has to deleverage.

Is President Obama on the right track with his proposed spending cuts and tax increases?

If the Federal government reduced the rate of spending by 1 percent — from


5 percent to 4 percent — we would be spending about $1.5 trillion less today. That would mean a lot less pressure on the private sector to pay taxes.

What’s a smart way for investors to make it through this volatile period?

Reduce exposure to U.S. equity markets and increase exposure to global markets. More and more, many of the largest firms will come from countries other than the U.S. — especially, emerging and developing economies such as China, India, South Korea and Brazil.

The shift to emerging markets is significant. Talk more about it.

Well, the U.S., the largest economy, is expected to have OK growth this year. Japan isn’t anticipated to grow very much; it looks like in 2011, it will be firmly entrenched as the No. 3 economy in terms of size instead of No. 2. And the European economy isn’t growing quickly.

On the other hand, China looks like it will grow more than 9 percent in 2011. It went from the seventh-largest economy in 2000 to the third largest in 2008 and is well on its way to becoming No. 2. Starting in 2011 through 2015, it’s expected to create at least 20 percent of global GDP growth. And between 2025 and 2050, China is anticipated to catch up with the U.S. as the world’s largest economy.

India is forecast to grow about 8-plus percent this year, and Brazil should have good growth too.

But what about political risk in emerging and developing markets? That can’t be ignored.

You’ve got to be sensitive to it: Investors should examine the level of political risk and try to lessen or avoid it. When investing in Chinese companies or funds, for instance, it’s important to understand where the political risk might be — if there are any constraints that the government might apply to those companies.

Investors need to do lots of research and due diligence because in emerging markets, opportunities are in unfamiliar environments not necessarily known for transparency.

What does China’s five-year plan call for?

To maintain 7-plus percent growth in order to maintain social harmony. That means their economy is going to double twice over the next 20 years. They clearly want to create their own brands. They don’t want to just build iPhones — they want their own Apple phone-maker. And they’re going to start making airplanes too.

Wait — what’s “social harmony”?

Narrowing the income gap. They’re focusing on that. It’s one reason they’re moving industry to the interior: they want to reduce the number of people on farms and bring them into the cities.

Back to China’s wanting to be an innovator. That’s new!

They’re actually pushing very hard for it and are putting a lot of that structure in place.

What about its famed quality-control problems, i.e. turning out defective products?

They’re working pretty hard at correcting that too. They try to learn from their mistakes. They address them; but they don’t dwell on them. You know, they can put up fairly significant buildings from start to finish in less than a year!

And they remain standing?

Yes — though a few tilt (laughs)! The country’s priorities are to keep the economy growing in order to maintain social harmony. That’s a very big part of what China is.

What about its banking sector? That’s well known for being opaque.

They need to transform it — make it more transparent and viewed as less of an arm of the government and having pretty weak standards.

Many industries can benefit from China’s rise, you write, including eventually the brokerage industry. How so?

In time, they’ll have a much bigger middle class; they [already] have a pretty big wealthy class. There’ll be lots of IPOs coming out of China. So you’ll have a build-up of wealth and transactions.

Let’s turn to India. Why is that a good bet?

India’s growth is estimated to average more than 6 percent between 2006 and 2020. That’s higher than that of any other emerging market, including China. India is projected to add almost half-a-billion people between now and 2050 — absolutely breathtaking.

There will be many companies coming out of India. Financial services are beginning to happen there.

The service sector, including call centers and software development, are expected to thrive. But they’re also trying to build out a manufacturing base. Also, India has growing alliances with other economies, such as China and Israel.

But India has a poor infrastructure.

That’s an opportunity! They need to build it out, and the companies that facilitate that will probably have some attractive growth.

What is Israel’s appeal to investors?

It has a high level of innovation and R&D. The number of its firms on the Nasdaq is second only to the U.S. Israel has lots of tech start-up companies — which they encourage. It has low government and public debt. It has many venture capital firms and is the recipient of one of the world’s highest levels of per capita foreign investment.

What sectors in emerging economies are particularly good investment plays?

Energy-related, infrastructure-related companies are going to have lots of opportunities for the foreseeable future — and in developed countries too.

But you say that the very best opportunities are outside the U.S., especially in emerging markets. Why?

China’s per capita GDP in 1950 was less than it was in the year 1500! That speaks volumes. They’re going to go from a very meager living standard to a middle class of about a billion-plus people in the next 10 or 20 years. They’ll start to have money to spend in a way they never did before and will want stuff like cars and clothes and gadgets and services.
What other specific sectors present outstanding opportunities in emerging markets?

Two are consumer staples and consumer discretionary. These countries will need and want the basics — soap, shaving instruments — but also soda pop and cereal and milk. Wal-Mart wants to be in a lot of these places. This is the stuff that Procter & Gamble provides. And of course the tobacco companies will try to maintain a less restrictive environment in those markets.

Any final thoughts on deleveraging and how the government can aid the process?

One of the things it hasn’t been good at, and is still not good at, is having any kind of spending discipline. It’s not just President Obama: Government spending has gone up almost every year for the last 46 years. Congress shares a lot of the blame.


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