- KPB & Co Research
The US economy is still prodding along, registering what appears to be solid numbers on the surface. The December-2018 issue of the Manufacturing ISM Report on Business was mostly good. The overall index continued to grow on the back of a 27-month uptrend. Continued positive trends can also be seen in the various components of the overall index. Gross domestic product growth remains fairly solid at 3.5%, and labour market conditions remain tight. Many would argue that these numbers are better than even Lebron's over his NBA career, but there are risks to these headline numbers, risks that have been magnified by a rising rate environment. Though it is still early to call a change in trend, the recent ISM numbers do show early indictions of weakness with new orders leading the decline.
Mr. Market has Suddenly Picked up the Flu
I can bet that many investors have had their Christmas ruined by the recent uptick in the volatility of asset prices and stock prices in particular. The CBOE Volatility Index spiked, the S&P 500 Index fell by around 15% in the space of a few weeks. Many portfolios have been viciously stabbed by red candles, and death crosses, and grinch-like chart patterns. Why all the fuss? In our view, the fuss has to do with debt.
It is difficult to discern why debt has suddenly caught the attention of Mr. Market. Ray Dalio's Principles?? Hmmmm maybe, but he has been marketing that book for over a god damn year. Many pundits have argued that perhaps it is the US Federal Reserve hiking interest rates multiple times of late, or the Republicans losing the house. Certainly, the US Federal Reserve has been, for multiple months now, guiding for higher rates, so higher interest rates cannot be a surprise. There are arguments in support of the idea that the Republicans losing the house was a surprise, but there are also valid reasons in support of the opposite. After all, it has been well publicized that Trump is not a popular President. Whatever the reasons are behind Mr. Market's call to action, we believe that his/her concerns are valid. Debt, Debt, and More Debt.
Debt, Debt, and More Debt
US government debt has risen to 21.6 trillion or 105% of Gross domestic product, which is already dangerously high. The prospect for a further rapid increase in public debt has intensified since the election, within the context of the recent fiscal policy changes. The tax reform bill was passed in late 2017, leading to a rapid fall in the amount of revenues flowing to the government, at the same time rate of decline in government expenditures has not matched the decline in revenues. Control of the house has been passed to the Democrats, since the tax reform bill was passed, making it more difficult for President Trump to fully implement his expenditure agenda. Rightly so, many would be concerned about whether expenditure will be reduced to match the revenue gap. Already there are tense political bickering, and government shut downs over the border wall.
Private debt is also steadily on the rise in recent times, moving from just under 195% of Gross domestic product in 2015 to 202% of Gross domestic product in 2016. Please remember that private debt was 213% at the height of the 2008 recession. The consumer plays a very big role in the size of US Gross domestic product, and so any sort of forced deleveraging in private debt could reverse the positive headline numbers seen thus far, as the consumer would have to cut their budget aggressively.
If interest rates remain at multi-year lows, Mr. market and friends would not need to worry. High debts can be managed down, or as wall street would say "oh you can have a beautiful deleverage". On the other hand, if Mr. Powell of the US Federal Reserve increases rates too quickly, the cost of servicing that debt goes up rapidly, and the deleveraging moves from beautiful to painful. In a painful deleveraging scenario, there might be haircuts on the debt outstanding or an aggressive pull back in expenditure by businesses, households, and the government. Either way, haircuts or expenditure cuts, the consequences would certainly be a recession.
Having said all of that, we are smart enough to know that we are not the only smart guys in the room. The US Federal Reserve knows all about what we have written about. The Fed's mandate is to strive for full employment while keeping inflation in check, and so the Federal Reserve is also motivated to keep the economy on a steady footing. We are confident that the US Federal Reserve will make the right moves according to the signals provided by the data. At the same time, one has to be aware that economics is an imprecise science, and so flexibility is needed to adopt to ever changing conditions.