Consumers in Canada and around the developed world have been increasing their debt levels over the past few decades to unprecedented levels. This phenomenon was fine as long as long term economic trends remained favorable. Unfortunately, demographic tides are turning and consumers in the developed world are moving into a prolonged deleveraging phase. Potential consequences are huge.
In what we call the virtuous cycle, a growing labour force and a consumer-led economic expansion results in peak economic growth. This high economic growth environment allows for solid wage gains, high returns on domestic financial and real estate assets, and, finally, rapid wealth accumulation. As wealth grows, consumers can borrow more money to buy more goods, leading to a consumer-led economic expansion and continuing the virtuous circle.
A vicious circle, on the other hand, occurs when the labour force starts shrinking. In this case, the economy shifts into lower gear, wages don’t rise as fast, and returns on domestic financial and real estate assets fall. Wealth accumulates much less quickly, forcing consumers to retrench and to start paying off their debts. The shrinking labour force and the reduction in consumer spending results in slower economic growth, thus continuing the vicious cycle.
Consumer deleveraging, and its resulting decline in economic growth, started affecting Japan and Germany in the mid-1990s and is set to hit Canada over the coming years. It is already underway in the U.S. and the U.K. Looking forward, this shift to a consumer deleveraging environment represents years of consumer retrenchment.
The lower economic growth caused by consumer deleveraging will lead to lower portfolio returns for institutional investors and will challenge many well anchored portfolio management notions. In particular, investors will have to make new decisions about how they manage their exposure to currencies.
As the Canadian economy shifts into this new regime, the Canadian dollar will look increasingly vulnerable. For one thing, it is already deeply overvalued – that is at least against the U.S. dollar and many emerging currencies. For another, Canada has never been as dependant on foreign portfolio flows, implying increased vulnerability to foreigners’ mood swings. Investors have to start thinking about what will happen once the rest of the world stops perceiving Canada as a high growth country. The bottom line is that there is an urgent need for active currency management.
Vincent Lépine is vice president, Global Asset Allocation and Currency Management with CIBC Global Asset Management Inc.