The Tapped Out American Economy
Following my update last week, a friend (and neighbor) asked me about productive and unproductive debt, because he was surprised to learn that nearly half of the money our government borrowed in 2017 went to pay Social Security benefits. This brought up the question: what is the difference between productive and unproductive debt? Productive debt is any debt that generates a positive return, whereas unproductive debt is any debt that generates a negative return. Our economy is rife with unproductive debt because the Federal Reserve has kept interest rates near zero percent for nearly eight years. As our unproductive debt levels rise, economic growth and interest rates will continue to fall because unproductive debt is deflationary.
In 2017 the Federal government borrowed $2.7 trillion – 36% went to pay Social Security benefits and 28% went to pay Medicare benefits. The average interest rate on government debt in 2017 was 1.8%; $972 billion was paid to Social Security recipients leaving American taxpayers with principal and interest payments of $989.5 billion. Even if 100% of all Social Security transfers were taxed at the Federal level, taxpayers would still be on the hook for $17.5 billion in interest payments.
This is a perfect example of unproductive debt because the economic benefit of entitlement transfers is less than the cost to provide them. As government debt and deficits rise, the cost to provide entitlement transfers will grow faster than the entitlement benefits. This problem of unproductive debts isn’t limited to the U.S. government; U.S. corporations have taken advantage of the Federal Reserve’s low-interest-rate policy and engaged in share buyback schemes for the past eight years.
Rather than invest in capital expenditures to increase revenues, corporations have been borrowing money for the past eight years to buy back their own stock. Corporations have bought back $4 trillion worth of their own shares. Coincidentally, this matches the amount of bonds the Federal Reserve bought to reflate the economy. During the next recession, just as they did during the 2008-09 recession, corporations will struggle to make payments on this debt as revenues fall.
Let’s say a small oil company decided to borrow money to increase the salary and benefits of its employees. While that would make the employees happy and temporarily boost efficiency, without a new form of revenue, pay and benefit increases would turn into future cuts. This is an example of unproductive debt. If that same company borrowed money to purchase and develop a new field that, if successful, would lead to pay and benefit increases, it would be an example of productive debt.
The American consumer has also been borrowing for unproductive uses. For the past two years, consumer prices have risen faster than wages, but there has been no noticeable change in economic growth. The reason the economy hasn’t slowed is because American’s are using their credit cards and draining their savings to make up for the shortfall.
Using debt to pay bills or buy things like TVs are not productive uses of debt. That money is spent into the economy today, but over time, that debt must be paid and this acts as a drain on future growth. Borrowing money to purchase an asset that generates positive cash flow or to increase one’s income, are productive uses of debt.
For the past eight years, the Federal Reserve has lowered interest rates and implemented easy-money policies in hopes to cover up an indebtedness problem with more debt. Unfortunately, most of the new debt issued has been unproductive. The problem with unproductive debt is that it crowds out the ability to generate productive debt.
This crowding out effect isn’t new. Japan has been borrowing money for decades in an attempt to fuel consumption. Yields on Japanese 10-year sovereign bonds are nearly zero, yet that hasn’t stopped them from continuing to print. The reason Japan hasn’t imploded into a massive debt spiral is because the Japanese have figured out that if they don’t buy their debt, nobody else well. With the public being large buyers of Japanese debt, the government can continue to print without causing hyperinflation.
In America, the public prefers to buy stocks over government debt, but that will eventually change. Due to the excessive amount of unproductive debt, our government has started to unintentionally disrupt capital markets. This effect was most notable early in 2016 when our government issued a large amount of debt. As our government seeks to borrow a record amount of debt this year, the same effects should repeat.
When our government borrows money, it pulls U.S. dollars from the economy, which reduces the amount of money in circulation. Borrowing doesn’t destroy money, it just repositions it. Our government borrows a large amount of money typically in the first quarter of each year, puts the proceeds in the twelve Federal Reserve banks, and draws against that cash over the next 12-24 months.
The money the U.S. Treasury borrows comes from domestic and foreign holders of U.S. Dollars who exchange them for U.S. Treasuries of varying maturities. This has the effect of pulling money out of the economy. What we have seen in the recent past is this drain on the circulating money supply causes the economy to slow down. This is why GDP growth in the first quarter of 2016 and 2017 were both below 1%. Odds are favorable this will happen again in the first quarter of 2018 as the U.S. Treasury is poised to borrow a record amount of debt.
What we should expect as a result of this liquidity drain is that stocks should fall, interest rates should fall, oil prices should fall, the values of gold and bonds should rise, along with volatility. This is happening at a particularly interesting time because interest rates are already elevated and the Fed is reducing their balance sheet, both of which pull liquidity out of the system. In addition, the January economic data shows clear signs that our economy is slowing, which could exacerbate the effects on stock prices.
All of this is happening at a time where corporations have announced record levels of stock repurchases, which will attempt to counteract the draining forces of the Fed and the U.S. Treasury. The Fed and the U.S. Treasury are a powerful force that most investors are choosing to ignore. They believe that asset prices will indefinitely rise, yet investors don’t know that the forces that pushed asset prices higher are now moving in reverse. Stock repurchase programs may be able to counteract some of the effects, but there’s one force they can’t counteract – a tapped out American consumer.
Dr. Lacy Hunt will be speaking at the upcoming SIC Conference next week. While I will not be attending, I did purchase a “virtual pass” so I will get to see Dr. Hunt speak and I will receive a copy of his speaker notes along with the slides. In the weeks that follow I will share with you Dr. Hunt’s views along with that of the other speakers.
Q&A with Steve – Your Questions Answered
- Thoughts on the new Fed Chairman Jerome Powell?
This week Powell had his first Congressional testimony where he indicated there could be four rate hikes this year instead of three. Given the economy can and will change this year, the number of rate hikes will likely change as well.
The bigger issue is that there are no plans to change the Fed’s balance sheet unwind.
- I’m hearing there will be a record amount of corporate stock buybacks this year. Isn’t that bullish for stocks?
Yes, having a large price-insensitive buyer is always good for asset prices. Experts indicate that $50 billion per month will go to repurchase stocks.
However, this is being offset by the Fed who is currently unwinding at a rate of $20 billion per month which is expected to increase each quarter. While on the surface it appears the buybacks will outweigh the balance sheet unwind, the Fed’s balance sheet has a multiplier effect that buybacks don’t.
When the Fed injects money into the banking system it can be lent out at a rate of ten times the amount injected. If the Fed increases “liquidity” by $20 billion, it has the effect of $200 billion. If the Fed decreases liquidity by $20 billion, it has the effect of removing $200 billion from the economy.
+$50 billion in share buybacks – $200 billion in the Fed unwinding = -$150 billion per month in liquidity being removed from the markets.
Video Topic of the Week – Liquidity
The recent price movements in the stock market can all be explained by the Fed draining liquidity out of the system.
Chart of the Week – Tariffs
How do the stock market, the dollar, and bond yields react to tariffs? Check out this week’s update to find out!
Portfolio Shield™ Update – The Impossible Momentum Algorithm is Here!
A few months or so ago I mentioned that creating a momentum algorithm was impossible. Last week I changed my opinion on that as I figured it out. It was much closer to the solution than I realized, but I’m quite excited to say it is here. That is why I shared with you in last week’s update how annual momentum of the S&P 500 charted against a price chart of the S&P 500.
Portfolio Shield™ Annual Momentum Prototype-A: S&P 500
This chart shows the S&P 500 vs the S&P 500 with the momentum algorithm applied to it.
Highlights: Momentum doubled the historic return. Momentum beat the S&P 500 17 out of the past 20 years. Momentum beat the S&P 500 price return by more than double over the past ten years and did that with 36% less risk.
Portfolio Shield™ Annual Momentum Prototype-B: Nasdaq-100
This chart shows the Nasdaq-100 vs the Nasdaq-100 with the momentum algorithm applied to it.
Highlights: Momentum more than doubled the historic return. Momentum beat the Nasdaq-100 15 out of the past 20 years. Momentum matched the Nasdaq-100 price return over the past ten years but did it with 25% less risk.
I hope this gives you an idea of why momentum is such a powerful force and why I wanted to develop an investing strategy around it. More on my thoughts on this next week!