“There have been 13 Fed rate hike cycles in the post-WWII era and 10 landed the economy in recession.
Soft landings are rare and when they have occurred, they have come in the third year of the expansion, not the eighth.”
- David Rosenberg, Gluskin Sheff + Associates Inc.
The Fed finds itself in a tricky place. Next week will likely be rate hike number three. “Three steps and a stumble?” We’ll see. My dad used to always say, “Stuck between a rock and a hard place.” I’ll try my best to explain what I see.
A few weeks ago I wrote about debt. If your brother earns $100,000 per year and has very little debt, he can borrow on his credit card and buy stuff. That’s good for the economy. In the early phase and for much of a credit cycle, income spending and credit expansion is good for the economy. But at some point an end point is reached.
Creditable academic studies show that the stress point is reached when the debt-to-GDP ratio reaches 90%. In English, as it relates to your brother, that is the point in which his total debt grows to $90,000 vs. his $100,000 income. Debt is 90% of his “GDP.”
At the end of the line for your brother is a point in which he can borrow no more. You can see how his personal economy begins to unwind. His deleveraging and inability to spend is deflationary for him and collectively if this happens to all our brothers at the same time it is deflationary for the entire system.
We reach a point in time when the system must deleverage. The economy slows. Is it any wonder that growth since 2010 has been the worst on record (blue line next chart).
Trillions here, trillions there… It gets confusing and frankly what do trillions really mean to you and me? Take a zero or two off, big whoop. But those zeroes do matter. To make it easier to understand, economists like to look at debt relative to income (as in my example) or debt-to-GDP in the economic world.
Here’s the skinny: The debt-to-GDP ratio in the U.S. is 352%. Way north of that problematic 90% threshold. It’s 450% in the Eurozone, near 300% in China and 500% in Japan. For simplicity purposes, think of GDP the same way you think about your brother’s annual income. In the U.S., it’s like your brother earning $100,000 and owing $352,000.
OK — he’s got issues. We’ve got issues. Raise interest rates and your brother feels more pressure. Raise again, more pressure. Raise again… defaults and subsequent recession. Bottom line is that we are facing something few of us has ever witnessed. We are near the end of a long-term secular debt super-cycle. Something has to give.
It is important to understand how the complexities of all of this effect your life. So what I want to do is focus in on the banking system because that is where the big debt fault line sits. If too many of our brothers default on their loans to the bank, like sub-prime before it, it will shake us all.
So let’s take a simple look at banking. Janus’ Bill Gross wrote a great piece this week titled, “Show Me the Money.” He shares a story of a conversation he had with his children. As he put it, feeling “the necessity to teach my own kids the complexities and pitfalls of investing.” From Bill’s piece:
“Pretend,” I told the “fam” huddled around the kitchen table, that there is only one dollar and that you own it and have it on deposit with the Bank of USA – the only bank in the country. The bank owes you a buck any time you want to withdraw it. But the bank says to itself, “she probably won’t need this buck for a while, so I’ll lend it to Joe who wants to start a pizza store.” Joe borrows the buck and pays for flour, pepperoni and a pizza oven from Sally’s Pizza Supplies, who then deposits it back in the same bank in their checking account. Your one and only buck has now turned into two. You have a bank account with one buck and Sally’s Pizza has a checking account with one buck. Both parties have confidence that their buck is actually theirs, even though there’s really only one buck in the bank’s vault.
The bank itself has doubled its assets and liabilities. Its assets are the one buck in its vault and the loan to Joe; its liabilities are the buck it owes to you – the original depositor – and the buck it owes to Sally’s Pizza. The cycle goes on of course, lending and relending the simple solitary dollar bill (with regulatory reserve requirements) until like a magician with a wand and a black hat, the fractional reserve system pulls five or six rabbits out of a single top hat. There still is only one dollar bill but fractional reserve banking has turned it into five or six dollars of credit and engineered a capitalistic miracle of growth and job creation. And importantly, all lenders of credit believe that they can sell or liquidate their assets and receive the single solitary buck that rests in the bank’s vault. Well . . . not really.
“And so,” my oldest son, Jeff, said as he stroked his beardless chin like a scientist just discovering the mystery of black holes. “That sounds like a good thing. The problem I’ll bet comes when there are too many pizza stores (think subprime mortgages) and the interest on all of the loans couldn’t be paid and everyone wants the dollar back that they think is theirs. Sounds like 2008 to me – something like Lehman Brothers.” “Yep,” I said, as I got up to get a Coke from the refrigerator. “Something like Lehman Brothers.”
You can read his full letter here. I love how he summed up the risks that exist today, “our highly levered financial system is like a truckload of nitro glycerin on a bumpy road.”
To this end, we must keep our eyes on the banks. We must keep an eye on risk. The banking system is once again sitting at the epicenter of another potential earthquake. Too much debt is the issue in Italy, France, Germany, Japan, China, Spain and the U.S.
We are not talking 90% debt-to-GDP here, we are four times that number and higher in many countries. The Fed, the ECB and the JCB are walking a tight line. We need to find a global solution to this global problem. Some solution that makes this debt problem go away.
And potential solutions exist. But they require bringing our leadership together in a productive way. Maybe? Can we find great coordination between the Fed and our Fiscal Authorities (Trump and Congress)? That’d be a good start. Can we work closely with our global friends? Everything is connected.
What are the odds of cooperation between U.S., European, Japan and China leadership? How about the EU, the ECB? How about German with France? Who’s going to bail out the Italian banks? And growing protectionism? Brexit, Le Pen and Merkel.
Beautiful resolution or ugly? Absolutely everything is connected. We just don’t yet know how it will play out.
Now, with all that said, our equity trend indicators are bullish. Don’t worry. Just have a plan in place to manage risk so that you can be in a position to take advantage of the next great opportunity. Grab a coffee and find that favorite chair. I share with you (and please share it with your clients and children) Gross’s explanation. He does such a good job at explaining how banks leverage your and my money up… your kids will totally get it.
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