The Imbalance GameStumbling from one crisis to the next

Are the long-term viability of the Euro, a perpetual Japanese quantitative easing program and sluggish U.S. growth all related? Are they independent issues or all manifestations of the same underlying problem?

While not trying to predict the next crisis, we outline a framework of imbalances that helps to better understand the structural challenges ahead of us. With this framework in mind, investors can be better positioned to navigate the current and future investing environment, with the ultimate goal of protecting capital and taking advantage of the opportunities when they do occur.

Looking beyond traditional theoryWhen analyzing the behavior of economies and markets, people often focus on cyclical booms and recessions. This is understandable, as this is what has mattered most in the past. However, we have to be aware that there is a lot more at play than just economic cycles, particularly in today’s environment.

At this juncture, there are many long term headwinds ahead of us, one of them being the peak of a debt super cycle. In the last 30 years, debt has been accumulating at a phenomenal pace in both developed and emerging economies. It has been the formula that created secular prosperity. But since the 2008/2009 global financial crisis, the world has felt debt fatigue and the real danger of secular stagnation. Even with extremely low interest rates and increasingly unconventional monetary policy, the world still struggles to find solid economic growth.

Within this paper, we will delve into the crux of today’s economic challenges and analyze how this debt super cycle has been created and what investors can expect going forward.

April 2016

Michael Craig, CFA Vice President & Director TD Asset Management Inc.

Amol Sodhi, CFAVice President TD Asset Management Inc.

Haining Zha, CFAVice PresidentTD Asset Management Inc.

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Policy Distortions — The global economy’s Achilles Heel The root cause of many of the issues that plague the global economy can be found in policy distortions. In our research, we categorize policy distortions into two types: Foreign exchange distortion and government and fiscal policy distortion.

Foreign exchange distortion refers to when a country’s currency is kept persistently below or above its fair value. Government and fiscal policy distortion refers to a variety of inappropriate policies chosen by governments, and can be very country specific. For example, in Greece, government and fiscal policy distortion could mean excessive government spending, inadequate tax collection measures and an overly generous pension benefit, however, for China, it could mean a weak social safety net that hinders consumer spending and the excessive leverage taken on by state owned enterprises.

These two types of distortions, in turn, cause two types of economic imbalances. On one hand, foreign exchange distortion causes an external imbalance which is reflected as persistent current account surplus or deficit and unusual capital flow patterns. On the other hand, government and fiscal policy distortion leads to an internal imbalance, which can take many different forms, but typically ends up as some form of debt within domestic sectors, e.g. dangerously high government debt in Japan or increasing income inequality and household debt in the U.S. pre financial crisis. These policy distortions allow the two types of economic imbalances to build without proper adjustment.

Over the next few sections, we will elaborate on each of the two policy distortions and the imbalances they cause. Then we will bring the two concepts together to show that they are two sides of the same coin, reinforcing each other to precipitate debt accumulation.

Foreign exchange distortion and external imbalancesBefore addressing foreign exchange distortion, it is helpful to first clarify why countries trade in the first place and what

role free floating exchange rates serve. There are two primary benefits to global trade:

1. Comparative advantage: leads to greater number of goods per available resources.

2. Specialization: leads to greater innovation and higher quality of goods.

Free-floating exchange rates help to ensure that trade and currency values remain balanced with one another and prevent material economic imbalances from building.

To illustrate the relationship between foreign exchange and trade, we use the chart below. Using foreign exchange as the horizontal axis and current account balance as the vertical axis, we can divide global economies into 4 quadrants. In the middle, is a stable trade zone, where the deviation from fair value exchange rates is relatively small and current account surplus/deficit relatively insignificant. Most countries tend to gravitate towards the stable trade zone over time.

The top right quadrant represents countries with higher productivity and are internationally competitive, e.g. Switzerland. Free floating exchange rates reward these countries with stronger currencies and greater purchasing power. This stronger currency, in turn, can make the nation’s goods more expensive for trading partners to purchase and can eventually reign in their exports growth, leading to a smaller current account surplus. If the country is not able to continue to innovate and generate large productivity gains, it will be pulled back to the stable trade zone.

The opposite case is the bottom left quadrant. This quadrant includes countries that have lower productivity and cannot produce at a competitive price on the international market, e.g. India. Households are punished with a cheaper currency and

External imbalance

Internal imbalance

Policy Distortions

Find moreaggregatedemand

Foreignexchange

Government and fiscal policy

Foreign exchange

Appreciation

Current account

Depreciation

Surplus

Deficit

Capital misallocation

Importing capital and investing

Productivity and innovation

Consumption binge

Stable tradeOptimal location for

most countries

China Switzerland

India Greece

For illustrative purposes only. Point in time examples.

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weaker purchasing power, which results in a lower standard of living. However, because of the cheaper currency, it becomes more attractive for investment. With enough investment in infrastructure and other key factors of production, the countries within this quadrant can have greater productivity and output growth, moving to the upper right towards the stable trade zone and have smaller current account deficits over time.

In normal circumstances, countries will move back and forth between the top right and bottom left quadrants and gravitate towards the center stable trade zone. That simply reflects the way foreign exchange rates function properly and regulate trade. However, foreign exchange distortion compromises the natural rebalancing mechanism and places some economies into the top left and bottom right quadrants.

The top left quadrant is for countries with persistent surpluses and undervalued currencies. China before 2008 is a good example. China had a hard currency peg to the U.S. dollar up until July 2005 and only gradually appreciated its currency thereafter with a soft peg. This led to massive exports and current account surpluses, which peaked at 10% of its GDP. Countries in this quadrant will keep accumulating capital which typically leads to capital misallocation.

The mirror image of that is the consumption binge case in the bottom right quadrant. This quadrant is for countries with persistent current account deficits but not any meaningful currency depreciation. Greece before the sovereign debt crisis is a good example. It had persistent trade deficits, however, its currency was not adjusting because the strength of the other European countries supported a stronger Euro. A stable currency enabled it to keep borrowing to consume.

Government and Fiscal Policy Distortion and Internal ImbalancesThe second policy distortion that can create internal imbalances and significantly suppress growth is government and fiscal policy distortion. Two common examples of such policies include:

1. Excessive government spending

2. Inappropriate tax and social policy

Excessive government spending leads to higher debt, which has a detrimental effect on future economic growth. In essence, taking on additional debt does not create new sustainable aggregate demand. It merely exhausts future demand. When the debt burden reaches unsustainable levels, the country becomes vulnerable to a debt spiral — particularly after an external shock. Furthermore, inefficiency in government spending tends to lead to much lower long term productivity growth.

Inappropriate tax and social policy is often less obvious. Income and wealth inequality issues are normally categorized as social rather than economic issues, falling off the market’s radar. But we believe it has deep ties to the macroeconomic phenomenon we observed. One of the most prominent phenomena in macroeconomics has been the decline of labor’s share of income globally over the past 20 years.

Why is this important? In most developed economies, growth is driven by consumption. Household consumption, in particular, depends on three factors: income, wealth and credit (borrowing). When income inequality increases and labor’s share of income drops, less money can be recycled into consumption for the average household, creating a lack of aggregate demand. For the wealth factor, wealth inequality is even more severe than income inequality.

According to academic research1, the share of wealth owned by the bottom 90% of the population has been steadily decreasing in the past two decades and currently only stands at 20% of the total wealth. Therefore, solid consumption growth requires more contribution from the wealthy group. However, that is not the case in today’s economy. Research shows that individuals in the wealthy group tend to save more and consume relatively less. The top 1% wealth bracket has a saving rate close to 40% compared to close to 0% for the bottom 90%.

Possible reactions to foreign exchange manipulationCountries not engaging in currency manipulation can counter the actions of their trading partners’ with three distinct responses: § Constructive measures.

Simply outcompete by raising their potential growth level. Investing in total factor productivity and reducing cost structures can accomplish this. This can also be accomplished through research and development which ultimately creates wealth. An example would be the post-World War II to the late 1960s period in the U.S.

§ Enact protectionist measures. Tariffs and duties are applied to goods produced by the offending country. This in turn prevents imbalances from growing larger but severely cripples global trade. An example would be the trade policies of the 1930s.

§ No measures taken. Here countries are accumulating persistent trade deficits and are faced with trading partners who have an unfair advantage in foreign exchange rate. This in essence is like perpetually consuming and paying for this consumption by simply issuing IOUs. The long-term implications are lower potential growth as it depletes future demand while consumption borrowing crowds out investment.

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Consequently, the burden of growth naturally falls on the third factor: credit/borrowing. But as we know, relying on credit is never sustainable and can eventually lead to a credit bubble and financial crisis.

Linking External and Internal DistortionsThe two types of economic imbalances created by policy distortions do not exist in isolation. They tend to feed and reinforce each other. The linkage between external and internal imbalance is through the Balance of Payment relationship. When a country suffers from an external imbalance and has a persistent current account deficit, it essentially borrows from international capital markets and has a capital account surplus. This borrowing is financing the internal imbalance, be it government, corporate or consumer debt. The availability of the funding also keeps interest rates low and spurs more borrowing, making the internal imbalance even worse.

On the other side, a more severe internal imbalance means more spending, higher trade deficits and a need to borrow more. This exacerbates the external imbalances.

This reinforcing cycle can continue because both exporting and importing countries have found more aggregate demand. From the exporting country’s perspective, it has extracted more demand from net exports. From the importing country’s perspective, it has found more demand through borrowing and consumption. Within a period of time, growth in both countries would look deceptively robust and both countries have motivation to keep the cycle going until it becomes unsustainable. The fundamental problem is that borrowing and capacity expansion cannot go on forever.

Is the future bleak?One of the most important conclusions from our research is that the two types of policy distortions create economic imbalances that can ultimately destroy growth potential. We believe they create unsustainable growth in the early stages and give the appearance that economies are strong and robust. However, when this process eventually ends, there is no V-shape recovery. They will start impeding growth in later years as the slow process of deleveraging takes hold. We are simply at the beginning of this latter stage.

So is the future bleak? Not necessarily, but significant reforms will be required to reverse this powerful dynamic. Without policy distortions being fundamentally corrected, investors should continue to expect a low growth world.

What are the investment implications to the various asset classes? Without significant policy changes, we expect equity markets to return low to mid-single digits, yields on fixed income assets will remain lower for longer and volatility will be increasingly difficult to rein in. In this environment, being able to identify structural breaks or signs of policy reforms can help investors protect their capital and take advantage of opportunities as they arise. n

A tale of two countriesLet’s take two countries Greece and U.S. to illustrate policy distortions and imbalances. These two economies could not be more different in terms of size, composition and competitiveness, yet they both ended up in a debt crisis that can be explained under the imbalance framework.

Currency distortions and external imbalancesDuring the 2000s, both the U.S. and Greece enjoyed far stronger currencies than what their fundamentals warranted. Greece enjoyed a strong currency and lower cost of funds due to its entry into the Eurozone. Although Greece was running persistent and sizable current account deficits that amounted to 6-8% of GDP, its currency did not adjust accordingly, as the Euro mainly reflected the strength of the northern European economies. The U.S. had a stronger currency, because its main trading partners (e.g. China and Japan) kept their currency value low against U.S. Dollar. Over the years, U.S. current account deficits rose steadily. Right before the financial crisis, U.S. current account deficits reached 6% of GDP. The massive current account deficits in both countries would be the equivalent of borrowing capital to fund the debt generated internally.

-20%

-10%

0%

10%

20%

30%

40%

50%

1910s 1920s 1930s 1940s 1950s 1960s 1970s 1980s 1990s 2000s 2010s

Top 1%

Top 10 - 1%

Bottom 90%

The wealthy are saving more and, relatively, consuming less

Saving rates by wealth class

Source: Wealth Inequality in the United States Since 1913: Evidence from Capitalized Income Tax data, Emmanuel Saez, Gabriel Zucman, National Bureau of Economic Research

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Different reasons for internal imbalancesLooking at the internal side, the two countries had very different stories for their internal imbalances. In the case of Greece, the internal imbalance was mainly caused by excessive government spending. The Greek government budget deficit rose from -4% in 2001 to almost -16% in 2009 while outstanding government debt nearly doubled. Unfortunately, while government debt was rising, investment as a percentage of GDP fell from 25% in the early 2000s to around 10% in 2014. Therefore, the debt servicing capacity of the country was falling while borrowing accelerated, making the Greek economy ever more fragile. In the U.S., government spending was also an issue, but the real consumption binge mainly occurred in the household sector before 2008. Because of the ineffective income and wealth redistribution embedded in U.S. tax policy, the income and wealth inequality gap was getting larger over the years. To support their daily spending, the average household had to increasingly rely on borrowing. Before the crisis, the U.S. government policy strongly encouraged home ownership, no matter whether people could afford it or not. This was reflected in the mortgage repackaging practice of Fannie Mae and Freddie Mac and the fast accumulation of subprime mortgage debt.

Fallout and AftermathIn both cases, the continued accumulation of debt for spending purposes was not sustainable. Eventually, the market realized that and both countries went through a severe deleveraging process. But the story is far from over. For Greece, because they remain in the Eurozone, they still do not have a free floating currency to devalue and a foreign exchange distortion still exists. The heavy debt burden and contracting fiscal policy only make the situation worse. In the U.S., the shale revolution helped reduce the current account deficit, but a much stronger U.S. Dollar against all major currencies impeded further improvement. Internally, as U.S. households continue to deleverage after the crisis, this leverage has been essentially transferred to the government and corporate sectors. The world is still trapped in an imbalance.

Internal imbalance

Policy Distortion §Adopted Euro as its currency

§Reckless fiscal policy

Low interest

rate

Unproductive allocation of debt

Accumulation of debt

Debt spiral

Trigger: financial crisis

Policy Distortion §Manipulation of trading partners

currency value §Tax and social policy

Low interest

rate

Allocation of debt

Accumulation of debt

Struggle to escape low growth

Trigger: financial crisis

Internal imbalance

Greece The United States

External imbalance

External imbalance

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1Source: Wealth Inequality in the United States Since 1913: Evidence from Capitalized Income Tax data, Emmanuel Saez, Gabriel Zucman, National Bureau of Economic Research The statements contained herein are based on material believed to be reliable. Where such statements are based in whole or in part on information provided by third parties, they are not guaranteed to be accurate or complete. The information does not provide individual financial, legal, tax or investment advice and is for information purposes only. Graphs and charts are used for illustrative purposes only and do not reflect future values or changes. Past performance is not indicative of future returns. Certain statements in this document may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “believes”, “estimates” and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS.TD Asset Management Inc. is a wholly-owned subsidiary of The Toronto-Dominion Bank.All trademarks are the property of their respective owners. ® The TD logo and other trade-marks are the property of The Toronto-Dominion Bank.