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Banking and Credit

My writings typically focus on stocks and bonds, however with recent cracks in the banking system in March and extending into May, I want to give you my thoughts on the future landscape. I will keep my concentration on the big picture and just to a couple of pages as this issue of banking and credit can have many nuances creating a long-winded response. The idea is that these banking and credit problems are a part of a long-term debt cycle and there is a high chance of slow growth over the next decade as it relates to investments and GDP.

Banking has played a big part in increasing asset valuations. The near zero-interest rate (credit) environment stemming from the financial crisis has lent itself to this issue by distributing massive amounts of cheap money (debt) from banks and institutions to the consumer/public over the past 15 years. I think the graph below depicting the total debt as a percentage of GDP gives a good idea of where we are and where we are going. Currently, we are at the top of this cycle and deleveraging will have to occur at some point.

Before anyone gets scared by the word “deleveraging”, there are two types we commonly think about. The first one, the bad one, is complete default on major assets and drastic government spending cuts which can lead to deflation and cause a major depression. The other deleveraging, which I believe is the more likely case, is slower growth through a balance of the Feds’ levers. Let me explain.

First, I don’t know when the start of the deleveraging will occur because debt can continue to pile on through monetary and fiscal policy for decades. We are currently seeing the same debt/GDP ratio that occurred in the 1940s. The ten years following the peak of the debt/GDP ratio in the mid-1940s there was real GDP growth of 1.7%. Average real GDP growth is 3.3% over the past 94 years. Depending on how proactive and reactive the Fed is to this situation, it is likely we will see a deeper than normal recession. Why? The current amount of debt in the system looks to be too large for a normal recessionary environment to occur. The government and the Fed will use the normal system of inflationary and deflationary levers through liquidity injection, debt restructurings, defaults, government spending cuts, and taxes increases but at a much larger scale that avoids a depression but prompts a deep recession.

The big picture here is that the next decade will be difficult for investments and the growth of the U.S. Slow economic growth seems likely based on current debt levels. The fallout from this, points toward a drastic deleveraging and deep recession which impacts assets held in portfolios. The good news is that slow growth is better than no growth and Chasefield has risk management strategies that can add potential returns to contend with a slow growth cycle.