A Global Savings Glut? Or Just Deflationary Forces?

Wednesday, June 3rd 2015, 9:31AM

by Andrew Hunt

One of the reasons that we tend to eschew “black box” forecasting models of any economy (aside from the fact that our econometrics courses now seem to have been a long time ago) is that we suspect that there are simply too many variables and discontinuities for even mathematicians with the skill of the late John Nash to ever really encompass effectively.

In this context, one of the least understood or modelling-friendly “variables” within a macroeconomic system is the household savings rate. For example, overall demographics within a country will play an important role in determining aggregate savings behaviour by the population as a whole, while interest rates and interest rate expectations will also exert an important, but probably non-linear, influence on people’s savings behaviour. We suspect that the relationship is essentially “U-shaped” in that people will save more either at very low yields or very high yields – the “bottom” of the savings rate will likely be somewhere around the 3-8% yield range (in the US and elsewhere).

The absolute level of incomes will also impact the savings rate but so too will the distribution of incomes. If the income data is too skewed with a lot of less well-off people and a lot of very high earners, many people may simply not be able to afford to save. Asset prices and “wealth effects” will also play some potential role in determining the amount of current income that is devoted to savings, although the coefficient on this particular factor will likely vary according to whether the higher asset prices can or cannot be used as collateral within a fully functioning (or not) credit system. In particular, the availability or otherwise of credit will play a large role in determining the savings rates, as will any legacy effects of previous credit excesses. Similarly, household expectations over the outlook for inflation or deflation will also play some role in determining the savings rate, although we doubt that this term is quite as important as many analysts suspect.

Finally, we would also note that people’s expectations over the economy’s – and more particularly their own – future income trends will play a large role in determining just how much money people will wish to save in the current period.

If we were to take a quick “global economic tour” with these various and often contradictory factors in mind, we would find that while the US may have enjoyed plenty of asset price inflation, the lingering difficulties with regard to the availability of credit have probably blunted any wealth effects and therefore higher asset prices not created the type of fall in the savings rate for which many were a few years ago – for some reason – hoping. Moreover, we also find that household expectations for the future seem to be modest and interest rates are particularly low by historical standards.

Along with the household sector’s still-high debt burden and the low level of home equity ratios, these factors probably do argue for a higher rather than lower savings rate but we suspect that the crucial factor in the increase in the savings rate within the US over recent months has been occasioned by the fall in commodity and fuel costs that have simply made it possible for more people to save. Hence, the US savings rate has increased significantly of late and we suspect that this is not merely a temporary or transitory factor.

In Japan, a country in which the population is rapidly ageing and which is facing deep-seated problems in the funding of its pension systems, the savings rate has also increased of late even as real income growth has improved. Despite Abe’s promise to create inflation in the future, households evidently remain cautious over the outlook for their real long-term wealth and, as a result, their level of cash saving has increased despite the recent increase in equity and property prices.

In Germany, which also faces some very challenging demographic headwinds, we find that the recent collapse in household expectations for real interest rates over the next 5-10 years has helped lead the savings rate to rise appreciably – Europe may have “gone too far” with its yield compression and this may be one reason why the ECB seems to be flailing around once again. The same effect may also be present in France and to a lesser extent in Italy. In the UK, the data is more mixed – there have been some asset price gains and the credit system is functioning while the demographic situation seems less encouraging of higher savings.

Within Latin America the recent fall in commodity prices and the resulting decline in the countries’ terms of trade indices seem to have shaken people’s perceptions of their long-term permanent income prospects. Moreover, interest rates – particularly in real terms – have increased in parts of Latin America to relatively high levels and we suspect that both of these factors will soon result in higher savings rates. In Australia, we suspect that the still-high cost of living may simply be preventing people from saving even as their perceptions of their real longer term wealth decline but we also suspect that were land prices to fall this might change appreciably. New Zealand’s savings rate is being buffeted by the ‘quake rebuild effort, the rise in house prices with some credit growth and the country’s rapid population growth, factors which may keep it relatively low over the next few years.

Finally, in China we have strong equity market gains at present (albeit gains that have been built on what has, by any standards, been a fantastic surge in household leverage) but the ongoing house price deflation, the emergence of a credit system that now only seems to want to lend to investors running on margin financing, a downturn in labour market conditions and perhaps rather less optimism than there once was in the economy all argue for a higher rather than lower savings rate. Finally, China’s ageing society may also simply need to save more for the future. In India, weak sentiment and slower credit growth may finally lead to a much-needed increase within the savings rate.

Overall, it seems to us that one of the “biggest themes” of 2015 – albeit a largely unexpected and perhaps still unrecognised one for many – has been an increase in global savings rates, a trend that we suspect has been accentuated by the redistribution of incomes from spenders (such as Australasia and Brazil) to savers (in China, Japan and Germany) that has been implicit in the recent falls in commodity prices.

The question then arises as to just where will these savings flow? Perhaps in a perfect world, these new savings would be used to finance the acquisition of productive capital in the world’s economies but in reality we find that investment rates are either low or falling as a result of weak confidence, over-regulation and weak corporate cashflows that are themselves the product of rising household savings. Despite some slightly better US durable goods orders figures over the last two months, the trend in US capital spending is probably still flat at best, while in Europe it is clear that the ECB’s latest policy measures have failed to encourage more investment by the private sector. Meanwhile, in China, it is clear that both investment and investment intentions are declining at a relatively rapid pace – China’s post-2008 credit-fuelled capital spending boom is over.

In practice, we can find very few countries (at most a handful) in which capital expenditure rates are rising and therefore we can suggest that the old Keynesian problem of too much saving/too little investment (that so occupied Keynes in the 1930s) may well be reappearing. Certainly, Keynes has much to tell us at this point.

In any individual economy, it is a mathematical identity that the level of savings minus the level of private investment must be equal to exports minus imports plus government spending minus tax receipts. If savings minus investment are, though, higher than the sum of the other factors, then the level of aggregate demand (that is, total spending) will tend to fall short of what is required to support the level of incomes, usually with deflationary consequences for the economy until something else changes in the system (for example, more exports, fewer imports, more government spending, lower taxes or a fall in the savings rate). It is, though, true that for the world economy as a whole, exports must equal imports (unless there really is trade with Mars!), which implies that the difference between savings and investment globally must be equal to the global public sector budget deficit.

Many governments around the world remain enslaved or at least beholden to the notion of fiscal austerity and hence they currently seem committed to the notion of reducing their budget deficits. Admittedly, in a “perfect Ricardian Equivalence Theorem world”, a lower budget deficit should, over the medium term, encourage people to save less to “compensate” for the increased public sector saving but, in reality, the RET model did not make much sense even when it was popular… We therefore have a situation in which global savings are rising relative to investment but government spending is falling relative to taxation. It is difficult to imagine a more inherently deflationary scenario.

As to whether the current deflationary scenario will persist over the medium term will depend upon what happens to the excess savings that are being generated. If the savings that are being created – and in particular we are thinking here of the emerging markets and the periphery of Europe – are simply used to discharge existing debts and not used by the recipient banks and institutions to fund new credit growth, then the deflationary shock will likely persist. Worryingly, there is considerable evidence that this is happening, particularly with regard to the current flows back into the US from its former EM debtors.

We are somewhat concerned to find that many of the increased savings emanating from the EM and even parts of Europe at present are being made via an increased level of debt retirement and the proceeds of these repayments are frequently finding themselves “piling up” in the US banking system that, for now, remains hide-bound and constrained by the regulatory environment and therefore unable or unwilling to extend new credit.

Within this process, we find an unfortunate echo of the situation in the late 1920s and 1930s when the US received large debt repayments and other capital inflows but was unable to recycle them with the result that the process became highly deflationary for earnings and activity rates within the global economy. As a consequence, we do welcome the recent political initiatives to reverse some of the recent banking system regulation but this process may take some time to run its course.

We do suspect that some proportion of the increased savings flows – including many of those from China – will continue to flow into the asset markets, be they equity markets in the US or China, or property markets elsewhere, but it is not clear whether these flows will have a positive, neutral or even negative impact on global growth. If some of these flows simply succeed in making property even more prohibitively expensive for domestic residents, then it is quite possible that they will force more people into even higher levels of saving. We suspect that there are many residents in Sydney or parts of the Bay Area in the US that are finding rising property prices are a problem rather than a benefit.

Nevertheless, these flows of savings are likely to continue in the near term at least and in such an environment, there will be an increased incidence of bubbles in some markets. Moreover, we also suspect that savers or their advisors will attempt to find “new sectors” for their funds and as such we suspect that infrastructure project finance may well prove to be the next bubble.

In some ways, we do hope that the infrastructure sector does start to attract proportionately more savings – but only if the increase in capital leads to more useful and productive activity rather than simply higher prices and lower yields. Clearly, the solution to the savings-investment balance that we noted earlier is ultimately more investment and as such a rise in infrastructure spending might be useful, providing of course that these projects do not simply become “roads to nowhere” as they did in Japan in the 1990s and 2000s. A better form of higher investment spending would be that which occurred in response to either technological change or appropriate deregulation by the authorities but unfortunately neither of these seem to be on the investment horizon at this time.

Therefore, we suspect that if a new global deflationary scare later this year or next year is to be avoided, we will need to see a significant increase in government budget deficits to counter the current ongoing rise in savings. This very Keynesian solution would represent something of a (politically) expensive U-turn by governments and therefore we could argue that even this seems unlikely this year.

Consequently, it seems to us that the asset-market investment landscape over the next few quarters is therefore likely to be typified by sector-specific bubbles in the near term that occur against a background of a growing global deflationary threat that will, one day, likely undermine corporate earnings and, we suspect, equity markets despite their bubble tendencies.

In summary, the surplus of savings within the global economy may well succeed in supporting asset markets for a while longer but we suspect that the financial markets will not be able to remain divorced from the deflationary global economy indefinitely; one day savers will have to recognise the lack of income growth that is inherent in the deflationary environment and we suspect that this “period or reckoning” could well occur later this year, particularly if the situation in China continues to deteriorate and the RMB were to join the list of weak currencies (in this context, this week’s softer Yen is clearly most unwelcome since it will increase pressure on China to follow Japan’s lead).

There are, we suspect, still bubbles left to form within financial markets in the near term but clearly the “clock is ticking” with regard to the arrival of the next deflation scare that could well undermine not just markets directly but also the world’s faith in its policymakers.

Andrew Hunt International Economist London

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