“The Vicious Cycle” was the heading for the final paragraphs of our post on August 1. It was written on the eve of the double whammy the market took from dual announcements by Fed Chairman Powell and President Trump. The former surprised observers by describing the Fed’s 25-basis-point cut to the discount rate as a technical “mid-cycle adjustment.” The latter dramatically escalated the trade war with China by tweeting out a planned 10% tariff on consumer goods by September 1. Based on the knee-jerk reaction of the equity markets, it would appear they wanted less from Trump and more from Powell.
Fast-forward to today, August 16. The intraday volatility of the S&P over the last two weeks has been tellingly extreme.
Voting Machines and Scales
As investor Benjamin Graham famously observed nearly a century ago, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” For day-to-day or even week-to-week swings, trigger-happy traders and automatic algorithms are the proximate cause. The violent intraday moves, courtesy of the recent news cycle, seem to have caught even the presumably nimble traders flat-footed.[1] The sharp drop in longer term Treasury yields since late last year, along with the recent inversion of the 10-year and 2-year Treasury yields, implies a greater risk of recession, a possibility no doubt aided by the less than accommodative comments of Fed Chairman Powell.[2]
As was made abundantly clear in our last post, it is the market as a weighing machine that concerns us the most. We believe that the phrase, “pushing on a string,” was first uttered before Congress by Fed Chairman Marriner Eccles in 1935. He used those words to explain the difficulty the Fed was having in stimulating aggregate demand with its easy-money policies. Even though the low ebb of the cycle was behind it, America was still in the midst of the Great Depression in 1935. Debt loomed large not so much because it was growing (in fact, it was actually shrinking) but because GDP was collapsing. Keynes’ “animal spirits” and “spontaneous optimism” drowned in a sea of debt. Under those conditions, monetary policy was powerless to stem the tide. Today, given the loud and clear message from the Treasury market, the Fed is woefully behind the Treasury curve. In attempting to avoid falling farther behind, it will likely have no choice but to cut the Fed funds rate by 50 basis point in September. This time, however, we don’t expect the markets to celebrate. Fed Chairman Powell may well be echoing Eccles’ lament.
In our August 1 post we highlighted the deleterious economic effect of excessive public debt. Earlier, we drilled down on corporate debt here and here. Today we’ll turn first to household indebtedness and then conclude with the 600-pound gorilla in the room: burgeoning global debt.
Debt Hitting Home in More Ways Than One
On August 9, David Rosenberg challenged the consensus that households in the U.S. are in great shape. Consumer spending posted strong 4.3% annualized growth for Q2, but this follows two very soft quarters (+1.1% in Q1 and +1.4% in Q4 of last year). It was not rising incomes that juiced the number, though. Rather, Q2 spending was supported by a decline in the savings rate from Q1. Meanwhile, consumer debt rose. Households have increased debt by $1.7 trillion this cycle. While there are some income gains behind that increase—the ratio of household debt to real personal disposable income has declined to 105% from 125% at the peak of the last cycle—it should be noted that this improvement is in reference to the epic credit bubble we saw from 2000 to 2008 (below).
Rosenberg continues. Household data in the U.S. is most often aggregated. Outliers significantly distort the average. The country’s consistently growing income disparity is a serious problem now integrated into the architecture of the economy. A study by the liberal Economic Policy Institute (EPI) reports that incomes for the top 1% of earners in the country grew at a faster rate than the remaining 99% in 43 states from 2009 to 2015. In 2015, a family in the top 1% nationally received, on average, 26.3 times as much income as a family in the bottom 99%.
The rise of top incomes relative to the bottom 99% represents a sharp reversal of the trend that prevailed in the mid-20th century. From 1928 to 1973, the share of income held by the top 1% declined in every state for which we have data. This earlier era was characterized by a rising minimum wage, low levels of unemployment after the 1930s, widespread collective bargaining in private industries (manufacturing, transportation, telecommunications, and construction), and a cultural, political, and legal environment that kept a lid on executive compensation in all sectors of the economy. (EPI study)
This income inequality runs up against the marginal propensity to consume. Rising incomes only increase consumption proportionately to a certain point, at which the higher earnings of the wealth do not continue to circulate in the consumer economy. Going further down this path means that those in the lower income brackets, having less of the economic pie, will be forced to limit their spending, cut into savings, or increase debt to finance their existence.
Why Doubling Down Is So Dangerous
Today the private sector—whether drilling down on households or, as in earlier posts, on corporate indebtedness—the United States is choking on so much debt that lowering the cost of credit doesn’t mean that this is going to cause much of a demand reaction. The most recent Fed senior loan officer survey shows that household and business demand for loans has already cooled off materially. Anecdotally, one need look no farther than the drop-offs in new home and auto sales—or, of particular interest to local readers, RV shipments.
The problem is that the vicious cycle created by excessive debt extends well beyond our borders. Total global debt—household, business, and government—has been surged this cycle.
Worrisomely, these added liabilities have not translated into stronger GDP growth. Clearly, debt has grown at a dramatically faster rate than the economy itself. While most are placated by the illusion of growth and prosperity, the economic structure underneath is nothing short of dilapidated.
More debt will only worsen the situation. In addition to aging demographics, overextended balance sheets at every level of society are a pervasive constraint on the world’s aggregate demand curve.
The Wrong Interpretation
Pundits wonder why interest rates are so low and pricing power is so anemic. Behind the calm rhetorical façade, central bankers around the world must, increasingly, be beside themselves. The problem is debt. The solution to the present malaise is rife with almost unimaginable consequences. Debt default, a debt jubilee, or debt forgiveness are all terribly painful for some and potentially all. Not before the extraordinary 290% global debt-to-GDP ratio declines substantially will policy stimulus be effective in creating the conditions for aggregate demand to catch up with the surplus in aggregate supply. That, sad to say, is the only real means of heading off a deflationary crisis.
Somewhere along the way the equity markets are going to wake up to this intransigent and intractable reality. It’s hard to conceive of any resolution that would be good news for the capital markets.
So, indeed, beware: In the long run, the market is a weighing machine. After years of mixed results of attempting to stimulate the economy with easy money, the potentially catastrophic inflection point may well be when the Fed finds itself pushing on the capital markets’ string. Thus, finally, will be written the epitaph for Greenspan’s put: RIP.
[1] To promote equitable dissemination of news, corporations generally follow the practice of making earnings and other important announcements after the markets have closed, whereas the sometimes impulsive Commander in Tweet operates under no such constraints. The precise nature of the interplay between human and algorithmic trades is unknown.
[2] The last five inversions of the 10-2 Treasury curve inversions—1978, 1980, 1988, 1998, 2005—occurred, on average, 13.1 months before the peak in the S&P 500. Since 1956, recessions followed such inversions by about 15 months. As we will make clear in a follow-up post, beware of averages.