THE UNITED STATES’ ECONOMIC MACHINE

Welcome back my friends, to the show that never ends….or does it?

The “show” being, of course, the perpetual growth machine that is the largest economy in the world, and our home, sweet, home, the good ol’ U – S – of – A.

But can America just keep growing and growing…forever?  Can stocks build you a little golden stairway to heaven, with a never-ending pile of profits for you to rest your little head on?  Or does a big bad bear lurk in the deep dark woods, waiting to maul us to pieces?

Let’s take a look, shall we?

As always, I will be looking at the economy through a “transaction-based” approach, which simply means at the bottom of everything, an economy is just someone selling something, and someone buying something, multiplied a gazillion times.  That’s really it.

I will look at 3 main factors to determine how the Economic Machine is working:

(1) Productivity Growth

(2) The Long Term Debt Cycle

(3) The Short Term Debt Cycle.

Let’s get started!

Productivity

United States is the largest economy in the world, with personal consumption accounting for 68% of GDP (roughly 23% goods and 45% services).  To begin our analysis we first look at current GDP Growth Rate, which expanded at an annualized rate of 0.7% in the 4th quarter of 2015, which was below estimates of 0.8% growth.

GDP Annual Growth Rate in United States seems to have been operating within a range in the last decade, with an upward bound of 5%.  But as you look back farther there are peaks and troughs clearly seen.  At our current levels I think we have some downside risk here, but how much is the key question.

Now, keep in mind, recessions/depressions don’t occur because a drop in Productivity, as traditional economy theory teaches.  I have learned, primarily from studying Ray Dalio, that they occur because of a drop in demand, and that is largely due to a drop in credit creation, which I will explain further below.

Let’s look at the Long Term Debt cycle to clear up the picture a bit.

The Long Term Debt Cycle

Long Term debt cycles typically occur over a period of 50-75 years, and are a result of debts rising faster incomes, until you get to a point where people/countries can no longer afford to service their debts.

We look at the Long Term Debt Cycle because the availability of credit(debt) allows people/countries to essentially spend more than they make.  Why save and wait to buy that new boat or build that new infrastructure project, when you can just borrow the money and get it now, right?  One person’s spending is another person’s income.  So, an increase in credit, increases spending, which increases income levels, which increases spending more, which increases demand, which increases production, and as production increases so should income levels.

The above events are what cause the long term debt cycle.

This cycle churns and churns, and the bubble inflates and inflates, and everyone is happy.  But this cannot go on forever.  Eventually debts grow faster than incomes, and debt service payments become too high and people/countries can’t afford to service that debt.  That is when the entire thing comes crashing down, and everything works in reverse.

Knowing where a country is in this process, and where it is likely headed, will give you insights as to how certain assets will perform.

To begin, the below chart shows the Government Debt to GDP in United States. United States recorded a Government Debt to GDP of 102.98 percent of the country’s Gross Domestic Product in 2014 (most recent available data), and looks headed for levels we haven’t seen since World War II.  This, of course, is due to QE.  And is a very important number, as explained below.

When debt levels get too high government find themselves in situations where they can no longer afford to service their debt, and thus have to cut back on spending, which pulls down the economy, since the government is one of the largest participants in the economy.  At these levels we are obviously in an environment of relatively high debt levels.  We’re not at Japan levels of debt here, but it is worrisome to me.

Now, let’s talk about something very important, and that is deleveragings, which are the process of reducing debt burdens when they become too high (i.e., debt and debt service relative to incomes).

Deleveragings typically end via a mix of 1) debt reduction, 2) austerity, 3) redistributions of wealth, and 4) debt monetization.

A depression is the economic contraction phase of a deleveraging. It occurs because the contraction in private sector debt cannot be improved by central banks lowering the cost of money. In depressions,

1. Many people/countries owe more money than they have, so they can’t pay back their debts, and
2. monetary policy is ineffective in reducing debt service costs and stimulating credit growth.

Typically, monetary policy is ineffective in stimulating credit growth because interest rates are near 0% and can’t be lowered (this produces deflationary deleveragings), or because money growth is used to buy assets to hedge against inflation (investors believe that the value of any money they lend out will be eroded by inflation, so they hedge against that), and doesn’t help expand credit growth, in which case you get an inflationary deleveraging.

Central Banks typically print money to end depressions in an effort to ease the pain felt by the reduction in credit, and austerity (if that trap was sprung).

Sorry for all the details, but I like to try to explain my thinking as clearly as possible.

Moving on!  Next we consider Interest Rates in United States, which, as everyone knows was just raised recently 25 basis points.

As may be obvious to readers, with rates at this level, Yellen has little to no ammo if a recession/depression were to occur.  Personally, I think the Fed has backed themselves into a tough spot here.  Some think this leads to more QE, or even negative rates, in our near future, and I certainly think that is a possibility.  But I think things would have to get very bad, very quickly, for that to occur.

Let’s switch to Money Supply (M0) in United States, which has been steadily rising since the 50s, but saw a dramatic increase since 2008.

With an increase in the money supply you will typically see an increase in purchases, increased incomes, increased demand, and fast economic growth.  Which would, of course, lead to inflation.

But there is no inflation???

The inflation rate in United States was recorded at 0.70% in December of 2015.  Personally, I think this is due to stagnate wage growth, and people using savings from cheap gas to pay down their debts, which have accumulated over the past decade or so.

Bottom line, with all the money the Fed has pumped into the system (most of which went into financial assets and propped up the wealthy, since they own the financial assets, which in turn has inadvertently caused a furthering of the economic divide in this country), and no inflation to show for it, something is wrong here.  Very worrisome to me.

I like to look at the 10 Yr Breakevens to get an expectation of inflation in a market.  This measures the gap between the 10yr treasury and TIPS.  The lower the spread, the lower trader’s inflation expectations.  Right now, the 10-year in United States has is at an astounding 1.73 % as of this writing, and the TIPS is at 1.33%, for a spread of 40 Bps.  This is a narrow spread, which seems to suggest that trader’s are not pricing in any inflation risk in the future.

Note: Inflation kills bond portfolios.  Here’s how….as inflation rises so do interest rates, by and large.  And as interest rates rise, bond prices falls (remember, they move in opposite directions!).  Add to that the principal you get back in, say, 10 years is worth less if inflation has risen 2% in those 10 years.

Recently, there has been a rush to safety, as the yield on the 10-yr has fallen off a cliff since the start of 2016, when it was around 2.3%.  This would further suggest the market does not anticipate inflation rising any time soon.

Now, very important point here!!!  –  debt problems typically occur because financial assets are bought at high prices with credit…then they fall and people can’t afford to service the debt they racked up.  Let’s look at the overall United States Stock market to get a general picture of where financial assets are currently.

Obviously, we had a significant pull back since January.  But look at the march up since 2008!!  Look at that bull market we’ve all been a part of, and might not have even realized, for the past 7 years.

This chart clearly shows that the stock market in United States has seen some cycles in the last couple of decades.   This is a bit worrisome as assets prices have gaped up, and it appears that we are entering the down draft of our cycle.  Just have far will we fall, though?

Another key indicator is how much the Government is spending, as the Government is one of the most important aspects of the economy.  If the government is increasing its spending, that will increase demand, increased demand leads to increased incomes, which leads to more spending, and eventually an increase in prices.

As seen above, Government spending in United States has come down off the 2009-10 peak.  That was an unsustainable level, so I actually think bringing down spending is a good thing.  However, it looks to be back on the rise again.  Just something to keep an eye on.

IMPORTANT NOTE: The top of the long term debt cycle occurs when 1) debt service payments are high and/or 2) monetary policy doesn’t spur credit growth.

Long Term Debt Cycle Summary:  With a slight expansion in GDP growth, interest rates at 0.25%, a large money supply with inflation practically non-existent, the main worries right now for me are the inflated Stock Market (there is still a lot of potential down side) and a high government Debt to GDP (but when didn’t America have huge debt issues ;-).

Still, the machine in America is humming along.  We’ve been battered since that start of 2016.  But consumers are still buying.  Companies are still hiring.  There is no blood in the streets…yet.

My next level of thinking though says that we might have already seen the peak in this cycle.  And part of me wonders if it was also the peak of the Long Term Debt Cycle.  We have a scary condition here with roughly 0% inflation, high asset prices, falling GDP growth, basically 0% interest rates and the 10yr falling off a cliff.

One can never be sure, and timing the cycles in the short term, is by and large, impossible.  However, the Long Term Debt Cycle has been growing for decades now.  At some point, it will reverse, and come crashing down.

Examining the Short Term Debt Cycle will hopefully give us some more insight.  Let’s see!

The Short Term Debt Cycle

Short term debt cycles occur when you have 1) spending growing faster than 2) the capacity to produce, which then leads to 3) increases in prices (inflation), and that continues until 4) spending is slowed by tightening monetary policy, and that is when a recession happens.

Recessions typically arise from a contraction in private sector debt growth, which is typically the results of central banks tightening (increasing rates) to tamp down inflation.  If we work that backwards we see that increasing inflation will drive central banks to tighten, which will slow private sector debt growth and bring about a recession.

So, to begin, we want to examine the growth rate in Consumer Spending (money and credit) and Government spending, and see if total spending is growing faster than the growth rate of the capacity to produce.

Below is a chart showing Consumer Spending for the last decade.

Steadily rising!  Now, take a look at consumer credit.

While Consumer Credit increased to $21.27 Billion in December, it is nowhere near the levels we saw in 2006 or 2011.  And this is part of the reason why we are not seeing any inflation, in my opinion.

As well, when discussing the short term debt cycle, we have to examine whether total spending is growing faster than the growth rate of the capacity to produce, because that leads to inflation, until spending is curtailed by tightened monetary policy, which brings about a recession.

Let’s take a look at Capacity Utilization to get a picture of production.  In United States, levels decreased to 76.5% in the December.

Utilization levels have an upper bound of 100%, but never get there.  Levels at 82-85% are seen as “TIGHT”, and typically forecast rises in prices or shortage of supply in the near term.  Levels below 80% mean there is some slack in the economy, which could lead to recession worries and employment losses.

We can also look at Industrial Production, which slowed to -1.8% in December of 2015, the lowest level in 6 years.  A worrisome sign.

Conclusion:

I hate to say it, but I think there is the potential for something catastrophic to happen here…the likes of which none of us have ever experienced.  I think “the Big One” is coming.  It could be 2016…or 2017…or 2019.  I’m not sure.  One thing I am certain of though is that markets are cyclical.  And right now, we look to be at the peak of a very…very long cycle.

However, even considering the recent pull back we had in the markets, America is still a beautiful bald Eagle, and she is flapping her wings, soaring high over the Rockies right now.  Just keep in mind that probably won’t last forever.

Economic growth expanded marginally 0.7% in the 4th quarter.

Government debt is high at around 102%, but that not that atypical for the US, and not a real worry at this point.

Interest rates are at 0.25%, which leaves Central Banks with few options.

Money supply has been steadily growing since the 50s.

Inflation is practically non-existent.  Even with low oil prices and a steady rise in consumer spending.

The 10-yr is at 1.73%, down from 2.3% 5-6 weeks ago!

Capacity Utilization is at 76.5%, establishing that there is probably a bit deal of slack in the economy, but not too much to make me worry.

And Industrial Production slowed to a 6 year low of -1.8%, which is worrisome.

Bottom line, there are problems with the United States’ Economic Machine.  Now, relatively speaking, we are considered by some to be the bell at the ball right now.  But that might just be due to the fact that the rest of the party (i.e. the global market) is filled with a bunch of ugly monsters.

I believe, by and large, we are at the end stage of this short term cycle.  More worrisome to me though is whether or not we are reaching the peak of the Long Term Debt Cycle, and it looks like we might be getting there soon, say within the next year, or couple of years.

So, if you’re a value investor, the above is all great news.  Keep some powder dry, value investors.  Seek some safety out there.  I would look into medium to long term treasuries, and gold.  I think there will be a huge flight to safety in the next 6-12 months, pushing down treasuries and pushing gold up.  And if there is a strong pull back, start your hunting.  Look for good companies at fair prices.  You’re never going to catch the absolute bottom.  So don’t try to time it perfectly.  You’ll do just fine focusing on buying good companies, at reduced, fair prices.  And don’t be afraid to jump in when everyone around you is screaming and crying about how they lost 40% in their 401k.  That’s precisely when you want to pounce.

The bargains of a life-time are coming, my friends.  The bargains of a life-time!

But heck, I could be totally wrong.  What do you think?

ABOUT THE AUTHOR:

Philip Decker is a quantitative impact investment advisor that seeks to mobilize and democratize impact investing for the retail investor.  Prior to founding 11 Point 0, Philip was a lawyer and a fixed income analyst.  His research primarily focuses on value investing, and country specific macro themes that seek to decipher how economies work.  He has a B.A. in Economics from the University of Maryland, and a Juris Doctorate from Seton Hall University School of Law.