Nothing is forever, not even debt. Every borrower eventually either repays what they owe, or defaults. Lenders may or may not have remedies.

One of Western Civilization’s largest problems is that we’ve convinced ourselves debt can be permanent, and I mean governments everywhere; China, EU, Japan, as well as the US.

Our leaders have no real plan to reduce the debt, much less eliminate it. They just want to spend, spend, spend forevermore.  As a result, I think we will spend the latter part of the 2020s going through a kind of worldwide bankruptcy. We won’t call it that, and it will take a lot of argument because we won’t have a court to take charge. But we will collectively realize the situation can’t go on and find a way to end it.

How did we get here?

A decade of bailouts, Quantitative Easing (QE), Zero Interest Rate Policy (ZIRP), and so on encouraged everyone to lever up, and they have.

Much of what we see right now isn’t real economic activity. It is artificial, incentivized by the monetary policies that ended the last crisis, but should have stopped much sooner.

As we see debt-laden businesses run into difficulty—often because they were bad ideas in the first place—bankers will tighten lending standards, and the dominoes will start to fall. Think of the WeWork debacle.

Debt does matter, and there are limits to how much an economy can bear.  We learned this week that the federal deficit for the last 12 months rose above $1 trillion for the first time since 2013. The official on-budget debt is only part of it, too. Off budget will be at least another $200 billion.  Annual deficits at 5% of GDP are not sustainable.  Politically, everybody wants lower taxes (for themselves) and higher spending (on their own priorities). That’s what our political system delivers. Not good, but it’s reality. And so, the debt grows ever larger.

 

 

 

No candidate can run on anything close to fiscal balance, because doing so would mean either advocating higher taxes or cutting entitlement programs. Both are guaranteed vote killers.

With GDP weakening (today the New York and Atlanta Fed models both cut their fourth-quarter GDP growth projections to 0.4% or below) and without a significant trade deal (something more than just around the margins for optical reasons), we can expect lower government revenues and higher government spending to further increase the deficit.

Add in unfunded pension debt, both at the federal level and lower. Does anyone really think that in a serious crisis, Washington won’t bail out bankrupt state and local pension plans? And of course it will step in to save the laughably unfunded Pension Benefit Guaranty Corporation, which insures private defined benefit pensions. All these unaccounted-for liabilities will amplify future deficits at some point.

The problem has been two-fold.

  • “Deficit spending” was only supposed to be used during a recessionary period, and reversed to a surplus during the ensuing expansion. However, beginning in the early ’80s, those in power only adhered to “deficit spending part”. After all “if a little deficit spending is good, a lot should be better,” right?
  • Secondly, deficit spending shifted away from productive investments, which create jobs (infrastructure and development,) to primarily social welfare and debt service. Money used in this manner has a negative rate of return.

 

 

 

We are not going to get out of this debt trap by cutting benefits or raising taxes.

Since there isn’t enough money to fund these pension and healthcare obligations, there will likely be an ugly battle to determine how much of the gap will be bridged by 1) cutting benefits, 2) raising taxes, and 3) printing money (which would have to be done at the federal level and passed to those at the state level who need it). This will exacerbate the wealth gap battle.

While none of these three paths are good, printing money is the easiest path because it is the most hidden way of creating a wealth transfer and it tends to make asset prices rise. After all, debt and other financial obligations, that are denominated in the amount of money owed, only require the debtors to deliver money. Because there are no limitations made on the amounts of money that can be printed or the value of that money, it is the easiest path.

 

 

If policy makers can’t monetize these obligations, then the rich/poor battle over how much expenses should be cut and how much taxes should be raised will be much worse. As a result, rich capitalists will increasingly move to places in which the wealth gaps and conflicts are less severe and government officials in those losing these big tax payers’ states will increasingly try to find ways to trap them. Watch California and New York.

It will probably get ugly. We can’t yet say exactly how, because there are lots of ways this could unfold. The Fed has plenty of power already, and Congress can give it more. The only real limit is what the markets will bear in terms of currency depreciation.

It now requires nearly $3.00 of debt to create $1 of economic growth.

 

 

 

A recession that brings the US deficit to $2 trillion, possibly followed by a governmental change that raises taxes and spending. This could bring about a second “echo” recession with even higher deficits. This would force the Federal Reserve to monetize debt in order to keep interest rates from skyrocketing, thereby weakening the dollar.

One way or another, this will get to a point in which debt simply… disappears. That will inevitably create winners and losers. Some people who did everything right will get punished. Some irresponsible fools will get rewarded. Neither is good, but that’s not the point. We are talking about what will happen, not what we want.

Timing?

Remember Herbert Stein’s dictum: “If something can’t go on forever, it won’t.” But then remember also Keynes reminding us that the markets can remain irrational longer than you can remain solvent.

It will be a few years before the gut-wrenching debt reset happens. We have time, if we properly use it, to position our lives and help those around us prepare for the coming storm.

Our clients are set up, to not just weather this storm, but to profit from it with our rules-based approach.

 

Consumer Debt

The consumer makes up roughly 70% of economic growth.

As long as individuals have a paycheck, they will spend it. Give them a tax refund, they will spend it. Issue them a credit card, they will max it out. Don’t believe me, then why is consumer debt at record levels?

 

 

This record level of household debt is also why the Fed’s measure of “Saving Rates” is entirely wrong:

“The ‘gap’ between the ‘standard of living’ and real disposable incomes is shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the ‘gap.’ However, following the ‘financial crisis,’ even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $2654 annual deficit that cannot be filled.”

 

 

In the 1980’s and 90’s consumption, as a percentage of the economy, grew from roughly 61% to 68% currently.  The increase in consumption was largely built upon a falling interest rate environment, lower borrowing costs, and relaxation of lending standards.

In 1980, household credit market debt stood at $1.3 Trillion. To move consumption, as a percent of the economy, from 61% to 67% by the year 2000 it required an increase of $5.6 Trillion in debt. Since 2000, consumption as a percent of the economy has risen by 1% over the last 19 years. To support that increase in consumption, it required an increase in personal debt of more than $7 Trillion.

The importance of that statement should not be dismissed. It has required more debt to increase consumption by 1% of the economy since 2000 than it did to increase it by 6% from 1980-2000. The problem is quite clear. With interest rates already at historic lows, consumers already heavily leveraged, and economic growth running at sub-par rates – there is not likely a capability to increase consumption as a percent of the economy to levels that would replicate the economic growth rates of the past.

Are consumers currently keeping the economy out of recession? You bet.

Will it stay that way? Probably not.

 

Geopolitical Risks

This is a speech geopolitical expert Ian Bremmer of Eurasia Group gave his conference in Tokyo last week. Like me, he sees many challenges coming in the next decade but a different and better world ahead.

Key Points:

  • Today geopolitics, not economics, is the main driver of global economic uncertainty. We are in a “geopolitical recession” that will last at least another decade.
  • The lack of coordinated leadership in today’s “G-Zero” world makes crises both more likely to happen, and more difficult to manage when they do.
  • The world economy is so integrated, it is no longer meaningful to say where a product is produced. The role of labor is shrinking rapidly, reducing the advantage of producing in low-wage countries.
  • Trade disputes are encouraging companies to reduce their vulnerability to disruption by producing goods and services nearer to end customers.
  • The world needs a stable, productive and prosperous China to fuel global growth. Economic interdependence will continue but technological competition will become a major challenge.
  • Parallel technology ecosystems are a threat to both economic globalization and political freedom.
  • No matter what happens in next year’s elections, the US-led international order is finished. It is not coming back.

Bottom Line:

All that sounds discouraging, and it is, but Ian ends with a hopeful note. Personal liberty, rule of law, and freedom of expression are universal values. People everywhere will keep pushing to achieve them and the prosperity they enable. In a world without trustworthy political leadership, we all have opportunity to fill the void.

 

The Public is Wary of this Market Advance

Retail money market fund balances are climbing at a rate of 25% per year and nearing the recession-era peak.  That means people are selling their stocks and sitting with Cash.

 

 

Is it because of the stock buybacks that artificially drive earnings higher?

 

 

Or is it fueled with China deal tweets and Fed QE?

 

 

 

Good News for the Markets
  • Retail investors are waiting on and planning on a Santa Clause rally into year end.
  • The October residential building permits surprised to the upside, hitting the highest level since 2007.
  • The personal saving rate has been climbing over the past few years.
  • A bottom is likely in for the euro-area manufacturing PMI, which could boost investor confidence.
  • Japan’s budget deficit is the lowest since 1993.
  • The rebound in consumer confidence continues.

 

Bad New for the Markets
  • According to the Association of American Railroads, freight shipping activity remains weak.
  • The Conference Board’s index of leading indicators declined for the third month in a row.
  • CNN’s so-called “Fear & Greed Index” has suddenly surged higher.

This index uses the put/call ratio, market volatility, and a handful of other measures to compute a score between 0 and 100. Levels below 50 indicate some degree of fear, while levels above 50 indicate greed.

As of Friday’s close, the index had risen to 87, well into “extreme greed” territory. This is up from 50 – or “neutral” – just one month ago. And it’s nearly a mirror image of this time last year, when the index sat at just 10… deep in “extreme fear” territory.

 

Market Data
  • The S&P 500 has enjoyed gains year-to-date , yet the operating earnings for stocks in the index are on track to be negative versus where they were for the 3rd quarter last year.
  • 4 in a row. The Nasdaq exchange triggered a Hindenburg Omen for 4 days in a row.
  • The Nasdaq exchange continues to see an abnormally large number of stocks hitting 52-week highs and 52-week lows. More than 3% of securities on the exchange have hit either extreme for a week straight.
  • Dollar dump. The Federal Reserve Bank of Atlanta has a model suggesting a sharp slowdown in U.S. GDP growth for Q4.