In 1990 there was a song written by Salt-N-Pepa called, “Let’s Talk About Sex.” The song has a very catchy jingle, but I think today we could substitute Debt for the other term, as today we are at a very precarious place. So here is the first set of stanzas of the music with the word “debt” inserted:
Let's talk about debt, baby
Let's talk about you and me
Let's talk about all the good things
And the bad things that may be
Let's talk about debt
Let's talk about debt
Let's talk about debt
Let's talk about debt
Let's talk about debt for now
To the people at home or in the crowd
It keeps coming up anyhow
Don't be coy, avoid, or make void the topic
Cuz that ain't gonna stop it
Now we talk about debt on the radio and video shows
Many will know anything goes
Let's tell it how it is, and how it could be
How it was, and of course, how it should be
Those who think it's dirty, have a choice
Pick up the needle, press pause, or turn the radio off
Will that stop us, Pep? I doubt it.
Really quite amazing if you think about it clearly and what a perfect song to remix to discuss something not so sexy…debt. So, let’s talk about debt as these lyrics do. As we see it, debt is far more important than the current economic indicators and the Fed’s desire to put inflation in check.
Last week when the news broke that Fitch had downgraded the United States’ long-term debt rating, I thought I would provide some high-level thoughts. I mentioned it in this week’s Market Perspectives, but I think the concept of the scope and depth of our current U.S. debt situation needs to be addressed more specifically. First of all, let us remember that the major credit rating agencies lost a lot of respect during the Financial Crisis of 2007-2009. Many believe they did not do their jobs and blew it at the time of investors’ greatest need. So, I assume the agencies now feel the pressure to at least appear more proactive when it comes to downgrading problematic debt issuers.
Is the debt of the United States a problem or will it become one? Well, history and the opinions of many smart market minds certainly suggest so. According to the U.S. Treasury, the federal government budget has run a surplus only five times in the past 50 years and has not done so since 2001. Otherwise, the budget has been in a constant deficit. Those deficits were funded by issuing debt and the total national debt has consequently ballooned to over $32 trillion or about $97,500 per citizen and $253,600 per taxpayer in the country (source: usdebtclock.org). Please take a moment and examine the picture below as this is a graphic provided by the U.S. Treasury:
On a debt-to-GDP basis, we’ve gone from 52.57% in 1960 to 34.64% in 1980, and back to 56.83% in 2000, and have now hit new levels of extreme borrowing at 119.14% of GDP. In other words, our debt levels now exceed the total of what the country produces as a nation. It should not take a Ph.D. in Economics or CFA charter to grasp that this could potentially cause issues. Again, the U.S. Treasury has provided us with another picture of these facts for a more graphical analysis:
It is important to understand, however, that sovereign debt is a little different than corporate or personal debt. World governments simply have more options when it comes to servicing and managing that debt, particularly in the case of the U.S. and its massive (and massively important) economy. The government can issue more debt, raise taxes, attempt to “monetize” the debt by “printing” more money and deflating the currency and, as a last resort, they can seize and nationalize business and personal assets. They can also cut spending to help bring the debt down over time, but this is politically unpopular since it could have huge economic repercussions and make it less likely for those politicians to get reelected. This is why we are highly unlikely to see this elephant in the room addressed before the next administration is in office. Hence why the can keeps getting kicked down the road.
It is very important to remember that It’s a bipartisan issue, too. Both sides bear responsibility for the growing debt load and few running for office do so on a platform of taking things away from voters. As a result, giants of the investment world such as Ray Dalio, Stanley Druckenmiller, and Charlie Munger (among others) have all sounded the alarm on the direction we are headed. Munger last year even said that he believes the value of the U.S. Dollar will go to zero within the next 100 years. These men are very familiar with history and the destruction that too much debt eventually causes to nation-states. If there is a nation that can buck that trend, American exceptionalism suggests it would be the United States (Warren Buffett, for one, has said that the U.S. will never experience a debt crisis as long as that debt is issued in U.S. dollars, though he does caution against the runaway inflation it could produce). However, the U.S. will be fighting history and hoping that “this time is different.” Still, it matters less what the credit rating agencies and market legends think about the debt and more what the market thinks. If the market and its investors collectively believe that the U.S. debt remains the safest investment in the world and that they will receive their principal and interest, then a downgrade isn’t really going to matter much in the grand scheme of things. Part of what supports this is that the U.S. continues to be the safest ship on a turbulent sea when looking at global economies. China and the U.S. economy are the largest on the planet, currently. So, if the U.S. (the world’s biggest consumer) hits a rough patch, then China (the world’s largest manufacturer) slows as a result. Today’s measures on China below:
When I initially saw the news last week about the Fitch U.S. Debt downgrade, I thought that could be the straw that finally broke the stock market rally camel’s back, yet the reaction was rather muted all considered. It certainly wasn’t like back in 2011 when Standard & Poor's downgraded the U.S. and the S&P 500 fell by almost 7% the following session (please refer to my comments in this week’s market comment for further explanation on this). Surprisingly, long-term rates remain not too far away from where they were prior to the downgrade, once again going to show that trading the news is usually an exercise in futility. That said, rates were already rising up to their highest levels in months before the Fitch news and inflation expectations along with them. There have been many calls that inflation has been defeated and that we will now return to the low-to-no inflation days of the past. However, the market suggests otherwise, with the 5-Year Forward Inflation Expectations Rate hitting its highest level in well over a year this week. That isn’t really what we’d expect given how many Fed rate hikes we’ve experienced over that period.
These pesky inflation expectations play right into the “new environment” I have written so much about over the past months. Such an environment is characterized by higher inflation, higher rates, more volatility, and less margin for error than we enjoyed over most of the past decade. It isn’t just U.S. sovereign debt that is at issue, either. There’s frankly too much debt (leverage) all over the place and it will become less manageable as rates rise and stay higher for longer. Credit card debt continues to hit new all-time highs even as credit card interest rates do too. Student loan payments are about to resume for millions as well. In a strong jobs market with rising wages and ample discretionary income, it’s not a huge deal but, again, there is simply less margin for error now when the economy slows down. Moreover, this week Moody’s, one of the other big three credit ratings agencies, announced that they are putting the credit rating of six major U.S. banks up for review and warned of possible cuts to others. Such downgrades, both on the sovereign and corporate sides, will likely help to keep rates higher as investors demand more compensation for assuming the additional risk of loaning capital. And as companies and the U.S. government are forced to issue more debt to stay in business going forward, they will have to do so at higher rates, compounding the problem further.
Again, all of this really isn’t an issue until the market decides it is, but the consequences of such a shift in sentiment could be serious. Without the added boost of low interest rates, an increasing money supply, and large federal budget deficits, it will be up to the economy and earnings to organically grow enough to keep the party going. And if the powers-that-be cannot allow for such austerity and go right back to the printing press/fiscal stimulus days of the past few years, it will only kick the can down the road as the problems become even greater. Hence, why I have been more cautious the past couple of years and not as willing to just assume prices will keep going higher indefinitely. They certainly can go higher, but I think the repercussions of it playing out to the contrary represent too great a risk to ignore. So, when red flags present themselves, I will heed their warnings. So, like I said in the beginning:
Let's talk about debt, baby
Let's talk about you and me
Let's talk about all the good things
And the bad things that may be
I didn’t want to throw cold water on your upcoming weekend, but I did feel that this is something to keep front and center on your mind.
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