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

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.