Debt is, at its simplest, a promise to repay a sum of money borrowed later. It may involve interest and other debt service charges. Payment of interest usually means an extra portion of the amount borrowed that is payable over a period of time. The creditor wants the interest rate to be higher than the cost of borrowing and the rate of inflation. It wants the value of the money to be depreciated in excess of the total amount of money repaid and interest over the loan period. In other words, real returns must be positive. A sensible debtor wants a used debt to bring a positive real return. Sometimes it makes sense to take on debt with a negative real return to avoid complete economic collapse. In other words, the debtor buys time to get his finances in order.
The debtor becomes insolvent if he is unable to pay the debt. To
do this, he has to provide collateral. The creditor must make a
probability assessment of how well the debtor can pay his money back,
either directly from the debtor or by redeeming the collateral. The
more uncertain the repayment and the lower the security, the higher
the interest the debtor will have to pay. This happens when the
creditor understands the situation of the debtor. At the peak of debt
cycles, creditors’ lack of understanding of debtors’ ability to
repay is at its greatest.
The best understanding of the role of debt in the economy is
obtained by looking at remittances in the big picture of the economy.
In the following equation, the sources of money are on the left and
the uses are on the right:
Money + Liabilities + Income = Consumption + Assets +
Savings
The equation is bidirectional. For example,
consumption is the income of the counterparty. Some of the increased
money supply from the left side can be consumed, some can be used to
buy assets or put into savings. When the central bank tightens its
monetary policy and interest rates rise, debt is often reduced. This
reduces consumption and / or the purchase of assets which reduces
revenue. The opposite phenomenon occurs when the interest rate
decreases. It will increase the amount of debt which is likely to
increase consumption which will increase revenue. Both are
self-reinforcing series of events. By looking at the varying amounts
of the parts of the equation, you can see how the debt cycles are
progressing.
Short debt cycle
Short debt cycles normally last 3-8 years. The length depends on
the previous cycle and some other factors like changes in central
banks´ interest rate policies. The further it progresses and / or or
the deeper the economy goes down the longer the next one will last.
What I mean is how much excesses people, companies and central banks
have made. The worse the over-indebtedness, the longer the damage
will be repaired. The short debt cycle is also called the general
economic cycle. As I mentioned earlier, central banks regulate short
debt cycles mostly by either tightening or loosening monetary policy.
This is mostly done by raising or lowering interest rates. Exceptions
arise mainly from the bursting of a debt bubble at the end of the
long debt cycle.
Short debt cycles can be divided into four parts: growth, peak,
decline and recession. Growth starts at the beginning. Interest rates
are low and borrowing is easier. Demand for interest-sensitive
products such as housing and cars is growing first. Growth is
initially rapid. Unemployment is falling and the average working week
is lengthening through rising demand and output growth. Inflation
remains low despite debt increases and economic growth. The best
investment targets can be found in equities. The situation for
commodities and inflation-hedges is deteriorating. Later, economic
growth will slow temporarily. Inflation will remain low, interest
rates will fall and stock prices will calm down. The decline in the
prices of commodities and inflation-protecting assets is slowing
down.
At the end of the growth, the pace accelerates. Wages are rising
faster and production capacity is coming back. Inflation is
accelerating, consumption is peaking and interest rates are rising.
Equities make their last rise in the cycle before falling, and
inflation-hedged investments perform best. The peak is coming because
the economy has overheated. The latter will lead to tightening of the
central bank's monetary policy. Liquidity is declining and interest
rates are rising. Economic growth is starting to decline. The amount
of money is shrinking and the growth rate of debt is declining. The
stock market will start to decline before economic growth goes into
the red. Eventually the recession will hit.
Economies are in recession on average 10-12% of the time. During
them, economic growth will average -3%. At the beginning of the
recession, the economy is shrinking. At the same time, the prices of
shares and inflation-hedged investments are falling. The central bank
is not loosening its monetary policy and inflation is falling. In the
end, the central bank fears recession and deflation, so it loosens
its monetary policy. Interest rates fall and stocks rise. Commodity
prices are low, as are inflation-hedged investments. With low
interest rates and rising stock prices, we are moving from a
recession to the beginning of a new cycle.
The operation of short cycles depends much more on external
factors such as major natural disasters like pandemics and wars. The
latter are wars between great powers and neighboring states. Less
often, export bans like OPEC`s regulation of oil production have
effects on cycles. Utilizing short debt cycles in investing requires
skill which most of us do not have. I cannot recommend anyone to take
advantage of them. It is easier to understand longer cycles.
One of the best signs of a recession is the shift of the yield
curve to negative. It refers to a situation where the interest rates
on longer government bonds are lower than those on their short-term
bonds. This usually occurs about 12 to 18 months before the
recession. The exact timing of interest rates does not tell the
future recession. This indicator is not easy for an investor to take
advantage of. It may be used as a signal to increase cash position
for future investments. It can be seen as an indication that the
leverage should not be increased. Stock prices can also predict a
future recession 6-12 months before that, but they are a more
uncertain indicator. They can be used more to invest in other asset
classes.
Recessions are poorly predicted. This is true for both amateurs and professionals. The latter manages to predict a recession when it is underway. According to an IMF research paper, between 1992 and 2014, economists out of 153 recessions in 63 different countries managed to predict only 5 in April of the previous year. Instead, in October of the recession, economists correctly predicted 118 times out of 153 recessions. It can be said that economists ’predictions of a recession are not worth reading or listening to.
