How To Invest In An Era Of $100 Trillion Financial Obligations
August 6, 2018
The four most expensive words in the English language are ‘this time it’s different.’
It’s different this time, and it’s also not different this time.
It’s different this time because the credit-driven U.S. economy is burdened with a monumental level of financial obligations relative to GDP. According to the Bank of International Settlements (BIS), outstanding loans and debts that burden U.S. corporations, households, and government entities have reached $48.3 trillion or 250% of U.S. GDP. Including off-balance sheet items, the effective level of debt outstanding is almost $100 trillion or more than 500% of GDP. It’s different this time because the U.S. economy has never in its history piled on so many financial obligations.
With that said, it’s also not at all different this time, because this is not the first time that a society’s financial obligations have grown to unsustainable levels. This story has been repeated often through history, and it usually ends poorly. The downside risk today for investors is captured in Charles Bullock’s account of Dionysus of Syracuse, from more than 2000 years ago.
Having borrowed money from citizens of Syracuse and being pressed for repayment, he [Dionysus] ordered all the coin in the city to be brought to him, under penalty of death. After taking up the collection, he re-stamped the coins, giving to each drachma the value of two drachmae, so that he was enabled to pay back both the original loan and the money he had ordered brought to the mint.
Displaying a level of creativity that could compete with today’s central bankers, Dionysus defaulted on his debts by debasing the currency, to the detriment of Syracusans who held their savings in drachmae. When a debt obligation becomes too big to repay, it is no longer a problem for the debtor; it becomes a problem for the creditor. The warning caveat emptor, which translates to “buyer beware,” remains timeless because “this time” is hardly ever different.
$100 Trillion of Financial Obligations
Let’s review the U.S. economy’s financial obligations one-by-one to better understand what makes up the $100 trillion of financial obligations of U.S. consumers, households, and government entities:
- Credit to households ($15.25 trillion or 79.7% of GDP): U.S. household debt includes $10.1 trillion of mortgage debt, $1.5 trillion of student debt, $1.1 trillion of auto loan debt, and $0.8 trillion of credit card debt. While still very high, the level of household debt relative to GDP has declined slightly over the past ten years due to the many mortgage-related defaults that have occurred since the financial crisis. Nevertheless, household debt has increased dramatically at a rate of over 7.1% per annum over the past forty years as household income has simply not kept pace with increases in living expenses for most Americans, particularly with regards to healthcare, housing, and education expenses.
- Credit to non-financial corporations ($14.26 trillion or 73.5% of GDP): Corporate debt stands at a record level and continues to grow, driven by corporate buybacks and the growth of leveraged buyouts. Record issuance of corporate bonds and leveraged loans in recent years has boosted the share prices of both public and private companies, driving outsized compensation increases for management teams and private equity firms through financial engineering. As interest rates increase and corporate bankruptcies accelerate, investors and employees will see the unfortunate downside of this level of leverage.
- Government debt ($18.81 trillion or 97.0% of U.S. GDP): Government debt includes $3.1 trillion owed by various state and local governments along with $15.4 trillion owed to the public by the Federal government. These debts are also at record levels and continue to grow at a faster rate than GDP, driven by demographics, military spending, deficits generated during the Financial Crisis, and a persistent mismatch between tax revenues and spending levels. Unfortunately, Congress and the Trump administration further impaired the Federal government’s financial strength by passing the Tax Cuts and Jobs Act (TCJA) of 2017, which is projected to increase future U.S. government deficits by almost $1.5 trillion per annum over the next decade and by approximately $1.0 trillion per annum thereafter.
- Pension underfunding ($2.25 trillion or 11.6% of GDP): While not officially tallied on anyone’s balance sheet, pension plans are woefully underfunded and represent an enormous off-balance sheet liability for cities like Chicago, states like Illinois, and multi-employer pensions. According to the Center for Retirement Research at Boston College, state and local pension plans are only 72% funded today, representing a total shortfall of $1.7 trillion. Surprisingly, these unfunded obligations have more than doubled since 2009 despite a strong bull market in the prices of all kinds of financial assets, from stocks to bonds to private equity investments. Meanwhile, multi-employer pension plans are only 46% funded, with a corresponding unfunded liability of $500 billion
- Social insurance obligations ($49.0 trillion or 253% of GDP):Every day, roughly 10,000 baby boomers retire and begin collecting Social Security and Medicare benefits for the first time. As the retiree to worker ratio increases, demographic challenges will increasingly put cash flow pressure on the Federal budget. According to U.S. General Accountability Office (GAO) estimates, the net present value of the Federal government’s Social Security obligations is $15.4 trillion, or 79% of GDP, while the net present value of Medicare obligations is $33.5 trillion, or 173% of GDP. These costs are driven by both demographics and runaway healthcare price inflation.
Why These Obligations Are Problematic
As debts have increased and as interest rates have begun increasing, interest payments for U.S. corporations, households, and government entities are now almost $2 trillion annually. Even without the Federal Reserve raising interest rates further from current levels, interest payments should exceed 10% of GDP in 2018. If interest rates were to rise to levels close to the historical average, interest rate payments would devastate the U.S. economy and likely result in another debt crisis.
Thus far our discussion has centered on the U.S. economy, but the excessive financial obligations are widespread across the world. The Financial Crisis was, after all, a global crisis, affecting large multi-national banks across the world, and other countries’ challenges are similar to or even worse than that of the United States. For example, while the combined private and public debt/GDP ratio is 252% in the United States, countries like the United Kingdom, China, Japan, and Canada have debt/GDP ratios of 283%, 256%, 373%, and 289%, respectively. Put simply, many of the largest economies across the world are seemingly drowning in excessive financial obligations.
These financial obligations are deflationary and make the global financial system more fragile. If the world were to enter a deep recession and global GDP were to decline by 5%, the debt ratios listed above would materially increase. As corporations, consumers, and perhaps even some governments defaulted on their debts, global GDP would likely decline further, creating a vicious cycle which economist John Maynard Keynes famously described as a liquidity trap, whereby everyone just wants to own cash. During the Great Depression, many banks failed because cash was no longer available for depositors to withdraw.
To prevent a liquidity trap, in advanced economies like the United States, Europe, and Japan, policymakers are likely to continue a set of policies known as financial repression until debt/GDP ratios decline to historically normal levels. Financial repression was also the playbook of advanced economy policymakers after World War II when the debt/GDP ratio in the United States was similarly high. Dr. Carmen Reinhart, who wrote the book about debt crises and financial repression (ironically titled This Time is Different) suggests that most advanced economy countries pursue financial repression when trying to alleviate excessive domestic debt. Financial repression policy includes the following:
- Maintaining negative real interest rates: Keeping real (e., inflation-adjusted) interest rates persistently negative over several decades is the cornerstone of financial repression. While harmful to fixed income investors, negative real interest rates make it easier for GDP to grow faster than public debt, thereby reducing the debt/GDP ratio. Alternatively, a surprise burst of inflation accomplishes the same goal, but in a shorter timeframe.
- Herding domestic investors into public debt: Laws and regulations that force or coax investors into owning more public debt represent the other critical component of financial repression. For example, regulatory changes regarding money market funds have thus far resulted in a trillion dollars of additional domestic capital that own U.S. government debt since 2016.
So far, these policies have not worked as successfully as they did after World War II; the debt/GDP ratio has only continued to increase since the Financial Crisis. Also, more recently, Congress and the Trump administration have enacted revenue cuts along with budget increases which should further increase the budget deficit and government debt. For those reasons, we believe the likelihood of a surprise burst of elevated inflation seems to be increasing.
At the present moment, interest rates and inflation are rising, U.S. stocks are generally expensive, geopolitical risks are increasing and the economy, while seemingly firing on all cylinders, has been expanding for nearly a decade. Given this backdrop, we are investing carefully and probably erring on the side of prudence and defensiveness.
Set forth below are our thoughts on the relative attractiveness of various asset classes:
- Short-term bonds: Depends
We generally view our short-term bond portfolio as a portfolio of “cash equivalent” investments. Our expectation is that this capital can be deployed into attractive, undervalued, equity investments when the opportunity arises. While not generating a particularly attractive return per se, our short-term bond portfolio provides us with optionality during market downturns.
- Long-term bonds: Unattractive
If inflation grinds on for years at a rate slightly above the long-term interest rate or if an inflation surprise arrives, long-term bonds will not be a good way to generate positive real returns. Accordingly, we do not own any long-term bonds in Appleseed Fund.
- Technology growth stocks Unattractive
Facebook, Amazon, Netflix, and Google (the so-called “FANG” stocks) have promising businesses with quickly growing revenues and profits. These companies have no less promise than Cisco Systems had in 2000. However, a great business alone does not make a sound long-term investment, because the price we pay for any investment matters. Cisco Systems shares generated a negative return during the decade that followed its peak in 2000, and we suspect that the FANG stocks will have a similarly difficult decade between 2018 and 2028. We do not own any FANG stocks in Appleseed Fund.
- Commodities and commodity-related stocks: Attractive
Commodities and companies whose earnings increase with commodity prices tend to do well in an environment of rising inflation. The agricultural sector in particular appears attractive right now, as agricultural commodity prices have been depressed due to bumper crops in recent years. In Appleseed Fund, we own Titan International (TWI), a producer of tractor wheels and tires, and Mosaic Company, a fertilizer producer. We also own other companies whose earnings should benefit from an increase in commodity prices, including Stagecoach (SGC-London), Sberbank (SBER-London), and Bollore (BOL-Paris).
- Selected value stocks: Attractive
Just as bargains could be found at the peak of the Dot-Com bubble, we are finding bargains today. We are seeking to avoid exposure to the most wildly overvalued sectors of the stock market while investing in out-of-favor companies which are ignored or temporarily out-of-favor. If inflation accelerates, equity valuation ratios (such as the P/E ratio) should compress, but more so for those companies that trade at an expensive P/E ratio than for those companies that already trade at a discounted P/E ratio. We own a number of companies, including BMW (BMW-Germany), Sberbank, SK Telecom (SKM), Stagecoach, Air Lease Corporation (AL), and Samsung Electronics (057050-Korea) which have a P/E ratio of less than 10x.
- Foreign stocks: Attractive
Equities outside the United States are generally more attractively valued than U.S. stocks, and emerging market stocks, while somewhat more volatile, look particularly attractive as long-term investments. If a U.S.-centric inflation surprise happens, companies with profits denominated in foreign currencies should perform better than U.S. companies. At the end of the quarter, 29.1% of Appleseed’s equity exposure are U.S.-based companies, 12.7% are based in developed market countries outside the United States, and 22.0% are based in emerging market countries.
- Gold: Attractive
Historically, gold has generated better returns than bonds in negative real interest rate environments. As the dollar’s role as the world’s reserve currency weakens, we believe that it is likely that gold will become an important reserve asset once again. Finally, if an unexpected large burst of inflation arrives, gold should serve as a useful inflation hedge and store of value. At the end of the quarter, 16.8% of the Fund’s net assets were invested in gold bullion trusts.
In summary, we are wary of rising interest rates and compressing P/E ratios which often accompany inflation. We believe we are positioned for an environment where inflation accelerates, but we are also trying to hold enough capital in the form of cash and short-term bonds so that we can take advantage of investment opportunities as they arise.
Appleseed Capital is the impact investing arm of Pekin Singer Strauss Asset Management. The views and opinions expressed in this material are those of the authors. While we believe we have a reasonable basis for our appraisals and we have confidence in our opinions, actual results may differ materially from those we anticipate. These opinions are current as of the date of this letter but are subject to change. There is no guarantee that any forecasts or opinions in this material will be realized. Information should not be construed as investment advice nor be considered a recommendation to buy, sell or hold any particular security. This is not an offer to buy or sell, nor a solicitation of an offer to buy or sell an interest in any fund, security, or other financial instrument. Any investment in the strategy is speculative and involves a high degree of risk. Investors could lose their entire investment. An investor must be able to bear the risks involved and must meet suitability requirements relating to such investment.
Appleseed Capital is not, and does not purport to be, an advisor as to legal, taxation, accounting, financial or regulatory matters in any jurisdiction. The recipient should independently evaluate and judge the matters referred to in this Presentation in consultation with their own tax, legal and financial advisors.