Current Risks Create Future Rewards: A Debt Story
Central banks across the globe have been on an almost decade-long printing spree (quantitative easing) since the 2008 “Great Recession” in an effort to encourage economic activity through low borrowing rates and promote greater spending at multiple levels of society. While this well-meaning policy was intended to stimulate the economy, one of its major drawbacks is that it is undiscerning as to who or what institutions benefit from its largesse. This means that any borrower, regardless of quality, has easier access to low cost debt, which makes it possible for unsound ideas with unlikely future success rates to receive financing. This set the stage for future negative economic shocks when debt use by governments, corporations and individuals explodes as a result. Now that the Federal Reserve is attempting to drain the party’s punchbowl, there is a significant concern that the economy could end up with one heck of a chaotic hangover as normalization occurs. The good news about chaos, and the risk inherently present in such times, is that it is the environment where asset mispricing and opportunity can be created.
A Twitter-Worthy Executive Summary
Recent Federal Reserve rate hikes and balance sheet tapering have resulted in substantially tighter borrowing conditions. This will likely make it harder for those surviving on cheap debt and creates opportunity for those able to benefit from now higher interest rates.
The Federal Reserve is Keeping its Promises
A frequent topic of conversation in past CWM articles and live events has been around Federal Reserve (Fed) monetary policy and the question of when will the committee begin to normalize, and to what magnitude, that policy. Policy normalization involves the hiking of interest rates and the tapering of the Fed balance sheet, reversing the excesses of previous quantitative easing efforts (a.k.a. the reduction of money printing and buying debt to lower interest rates). This normalization process will not be just an exclusively American phenomenon but is expected to be a global event as major central banks across the world move to unwind their balance sheets in the coming years. The graphic below has been frequently featured in past articles and displays the expected drawdown rate for the Fed, the Bank of Japan (BoJ), European Central Bank (ECB) and the Bank of England (BoE).
Source: Kelly, D. et. al. (March 31, 2018). Guide to the Markets. J.P. Morgan Asset Management.
As expected, the Fed is keeping its tightening promises by raising rates and beginning to reduce its balance sheet. A review of the Fed balance sheet shows that the value of U.S. treasuries held by the Fed has now shrunk from its all-time high of $2.465 trillion by a little over 3 percent (as of May 18). Wall Street reporters have been giving the below chart a lot of press lately because it makes this recent drawdown seem like a dramatic drop.
Source: U.S. Treasury Securities Held by the Federal Reserve: All Maturities. (May 17, 2018). Federal Reserve Bank of St. Louis.
Viewed from a greater context, it can be seen that the recent balance sheet decline is but a drop in the ocean compared to how much Treasury debt has been purchased by the Federal Reserve over the last ten years. The red circle in the chart below depicts the same balance sheet decline shown in the chart above, but shown over a longer timeframe. However, this longer-term perspective should not completely discount the Fed’s recent tightening efforts. It should be noted that the declining trend, obvious even in the longer-term chart below, is a marked change in behavior from what has occurred over the last decade. This change is likely going to force many governments, corporations and individuals to change their borrowing behavior, willingly or not.
Source: U.S. Treasury Securities Held by the Federal Reserve: All Maturities. (May 17, 2018). Federal Reserve Bank of St. Louis.
When a Government Behaves Like a Drunken Sailor
The U.S. government balance sheet of 11 years ago (pre-financial crisis: March 2007) had a vastly different appearance. Since that time, the total U.S. public debt has more than tripled while Federal Reserve activity (discussed in the section above) has kept government borrowing costs affordable.
Source: Podkul, C. (March 27, 2018). 10 Years After the Crisis. The Wall Street Journal.
The $15 trillion mountain of government debt continues to grow. The 2017 Federal government budget shows an expected deficit of an ominous $666 billion dollars for the current fiscal year. A number that is expected to get larger, not smaller in coming years.
Source: Kelly, D. et. al. (March 31, 2018). Guide to the Markets. J.P. Morgan Asset Management. Emphasis added by Comprehensive Wealth Management.
The current $666 billion deficit may soon seem a paltry sum if forecasts by the Congressional Budget Office (CBO) are accurate. The CBO projects that the annual deficit will be between $1.5 - 2 trillion by 2028.
Source: Akabas, S., Shaw, T, and Remetta, J. (April 12, 2018). CBO Confirms Trillion Dollar Deficits Coming Soon. Here’s Why It Matters. Bipartisan Policy Center.
On top of a high and rising debt level there is also spiking interest rates. The 5-year yield has risen from 1.62 percent on September 7, 2017 to 2.89 percent as of May 21, 2018. If the government keeps the average maturity of its debt near where it is currently (about 5.73 years), then this rise in rates will effectively raise government borrowing costs by approximately 78 percent over time as refinancing occurs and new debt is issued.
Source: U.S. 5 Year Treasury Note. (May 21, 2018). MarketWatch.
The rising debt level and cost of debt is a huge future risk even at current, near record low, rates. The CBO forecasts that by 2025 the federal government will spend more on debt interest payments than it does on defense and non-discretionary budget items (example: The Department of Education). Bloomberg reports that, “over the next decade, the U.S. government will spend almost $7 trillion -- or almost $60,000 per household -- servicing the nation’s massive debt burden.” Net interest costs could rise from today’s $263 billion per year to almost $800 billion per year in just the next seven years.
Source: Tanzi, A. (April 11, 2018). Massive Debt, Massive Interest Payments. Bloomberg Businessweek.
The rising interest cost on the U.S. government’s massive pile of debt will likely constrain the ability of the Federal Reserve to raise rates and fight inflation due to the inability of the government to afford higher borrowing costs. There are those that suggest an independently run Fed will not allow this consideration to prevent it from raising rates if it deems necessary, but it is the CWM opinion that the Fed will give in and support the U.S. government if solvency becomes a real concern. As it stands, the government will borrow/refinance an equivalent value to 25 percent of GDP this year, which is a worse borrowing level than Italy, a country thought of to be a bit of an economic basket case. This borrowing/refinancing need should put upward pressure on government debt yields over time.
Source: Slok, T. and Brody, Q. (April 25, 2018). A Coming Debt Crisis in the US? Deutsche Bank Markets Research.
Despite the above negativity, major risks to U.S. debt are probably some years off. For now, this event can be likened to a slow-moving train wreck that will likely cause significant economic hardship in the future (depending on how it is handled), but it is not something investors need to run screaming in terror from just yet.
Near Record High Corporate Debt Levels; Near Record Low Default Rate
U.S. corporate debt levels have reached a point relative to GDP that has marked previous credit and economic cycle tops. GDP (gross domestic product) is a numeric reflection of the total wealth created by a country in a given year. The ratio of corporate debt to GDP suggests that at certain high levels of debt relative to national economic activity the high debt burden becomes a headwind to future economic growth. The most recent credit cycle tops saw this ratio top out around 45 percent corporate debt-to-GDP, meaning that the current total U.S. corporate debt (depicted in the chart below) has an equivalent value to the high levels of previous cycle tops that occurred just prior to economic recessions. Think of this like having a very high level of credit card debt relative to personal income, and it likely becomes a bit clearer why the current high ratio reading is problematic for the overall economy. The grey vertical bars in the chart below reflect periods of economic recession that soon followed credit cycle peaks in the corporate debt-to-GDP ratio.
Source: Mauldin, J. (May 17, 2018). A Liquidity Crisis of Biblical Proportions Is Upon Us. Mauldin Economics.
Despite very high corporate debt levels, the high yield default rate (the default rate for the lowest quality corporate borrowers, left vertical axis below) is near all-time lows. Historically there is a very strong positive relationship between high debt levels and a high default rate. The current spread between the two metrics is something that hasn’t been seen in the available record going back to the 1980s. A reversion to the norm would suggest a much higher default rate or lower debt level, which would most likely mean losses for high yield corporate bond holders at some point in the future.
Source: Borodovsky, L. (April 30, 2018). The Daily Shot: Is the Market Pricing in a Fed Policy Mistake? The Wall Street Journal.
The spread shown above is a statistical outlier, meaning it’s something unusual based on history. This suggests there is increased and immediate risk for high yield bonds, and prudent investors should be reducing their exposure to assets that would be harmed if the debt-to-default relationship returns to normal levels. It is far more likely that default rates rise sharply than it is for highly indebted companies to suddenly become more frugal and prioritize reducing their debt.
Consumer Debt: Repeating Old Patterns
Revolving debt (credit cards, HELOCs, etc.) levels are now higher on a nominal dollar basis than they were prior to the 2008 market crash. It should be noted that adjusted for inflation, the real comparable dollar amount to May 2008’s $1.019 trillion would be approximately $1.181 trillion in 2018 dollars. Today’s levels are only at $1.026 trillion currently. Like with high government and corporate debt, high levels of personal debt represent a risk to the future U.S. economy.
Source: Donisanu, P. (April 24, 2018). Rising Household Debt – Canary in the Coal Mine? Wells Fargo Investment Institute.
If non-revolving credit (mortgages, student loans, car loans, etc.) is also included, it can be seen that total consumer debt is nearing $4 trillion dollars and well above the 2008 high levels even on an inflation adjusted basis.
Source: Konish, L. (May 21, 2018). Consumer Debt is Set to Reach $4 Trillion by the End of 2018. CNBC.
High debt values alone are not a reason to become overly pessimistic until those debt levels become unsustainable and defaults begin occurring. Unfortunately, there are some signs of debtor weakness beginning to emerge. For instance, credit card charge-offs (a.k.a. defaults) have been steadily rising since 2015 (grey line) and are forecasted to increase sharply (orange line).
Source: Sonders.L. (May 22, 2018). Economists Expect US Credit Card Delinquency Rate to Climb. Twitter @LizAnnSonders
Debt, whether government, corporate, or personal, functions as a method for bringing future spending into the present. The tradeoff for that action requires greater rates of saving in the future than would have otherwise been required. Current high levels of debt across the spectrum of potential borrowers is of great concern for a national economy, like the U.S., that is largely dependent on consumer, business and government spending for its function and growth.
How All This Bad News Creates Opportunity
While the above items are concerning, especially as we get further into the 2020s, current trends are creating some immediate shorter-term opportunities. Yields on traditionally less risky bonds have risen sharply from the all-time lows and bond prices have consequently fallen, especially on the shorter end of the bond yield curve. Lower valuations, combined with higher yields, creates opportunity as traditionally safer assets are now providing a more reasonable level of income at a better overall valuation. This allows the prudent investor to trade higher risk debt, like the high yield corporate bonds mentioned above, for assets with less default risk.
Source: Martin, C. (April 10, 2018). Short-Term Investment Options for a Rising-Rate, Volatile-Market Environment. Charles Schwab.
The recent 100-day loss in bonds is on par with some of the worst similar selloffs since 2000. It should be noted that subsequent timeframes have been positive for bond valuations after that point. This examination of history suggests bond investors, as an aggregate, should be able to be more confident in expecting a near-term positive outcome as that is what has occurred after similar levels of price drop in the past.
Source: Gutscher, C. (May 21, 2018). Corporate Bonds Sink Fast in One of Worst Tumbles Since 2000. Bloomberg.
Rising yields have also created another unusual phenomenon as U.S. yields are now higher than other major developed countries for the first time since the year 2000.
Source: Sonders, L. (May 16, 2018). US 10y Treasury Yield. Twitter @LizAnnSonders.
This spread of U.S. debt to foreign rates is also unusually high at over 1 percent to comparable aggregated global bonds. Meaning U.S. bond investors earn 1 percent more in income annually than a comparable group of foreign bonds. This high statistical spread is another occurrence that is typically followed by a more positive environment for U.S. bonds, which should again give U.S. bond investors confidence in expecting future positive outcomes. The chart below shows that the spread between U.S. and global bonds typically falls after reaching similarly high levels of positive difference. At the very least, this suggests that U.S. debt typically outperforms global debt in the environments following those readings.
Source: Abramowicz, L (May 18, 2018). U.S. 10-year Yields are More than One Percentage Point Higher than Global Yields. Twitter @lisaabramowicz1.
What Does it All Mean?
To sum up all of the above sections and contained data, we believe prudent investors should be concerned about the debt situation in the U.S. and what that means for its economy over the long-term. For now, recent negative bond market moves have created opportunity in traditionally safer assets through higher yields that are now competitive with more aggressive income assets; those bonds also now have lower overall valuations. This opportunity is presenting itself when risks appear to be rising for the more aggressive income assets, like international and high yield bonds, that have held up a bit better than their typically safer counterparts so far this year.
The Current CWM PTS® Indication
Our CWM PTS metric currently stands at 1.58 as of May 17, 2018, down from 1.81 in January. Markets have traded lower to sideways since January’s article which, along with other factors, moved this indicator back towards a more normalized indication since valuations are not quite as high as they used to be. At this level we can be highly confident that future stock market returns will be subdued with a significant potential to underperform bonds/non-correlated investable assets over the next couple of years, though nothing is ever guaranteed of course. As it stands, the current 1.58 indication suggests we should remain overweight to bonds/non-correlated assets versus stock investments.
Source: Macro PTS® Score. (May 17, 2018). Comprehensive Wealth Management.
Though there is potential for stocks to move higher, current valuations reflect a high probability of a negative future outcome, a risk we are striving to mitigate for our clients. CWM PTS models continue to be invested conservatively, as they have been for some time. The CWM team will continue to be disciplined in our efforts to provide the best risk adjusted returns possible for our clients.
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Chief Investment Officer
P.S. When considering anything, it is important to keep be aware of the perspective, or framing, being used to reach a conclusion. For instance, more people are scared of swimming in the ocean because of fears of being bitten by sharks than they are of walking in the woods and risking a mosquito bite. Framed with proper information, it can be seen that mosquitoes should easily be considered the more terrifying creature when judged by the number of human deaths caused by each creature.
Source: Gates, B. (April 23, 2018). This Animal Kills More People in a Day than Sharks Do in a Century. Gates Notes.
1Tanzi, A. (April 11, 2018). Massive Debt, Massive Interest Payments. Bloomberg Businessweek.
This article has been prepared and distributed for informational purposes only and is not a solicitation or an offer to buy any security or investment or to participate in any trading strategy. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary. For specific advice about your situation, please consult with a financial professional. Past performance is no guarantee of future results.
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