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Weekend Reading: Fall Back

Doug Kass made an interesting observation about the market yesterday:

“The month of September started with optimism.

That optimism has faded in the last two trading days.

The most notable winners (year to date), FANG, have been particularly weak as investors begin to understand (thanks to the Congressional testimony and hearings) that the component companies’ costs will balloon in order to deliver a product that is palatable to the U.S. government and other authorities – something I have been suggesting for a while. As noted yesterday, many other former market leaders are also falling back in price.

While there has been some rotation (there always is), there have been no notable winning sectors (save the speculative marijuana space).

Meanwhile, over there, the European banks are making new lows as the European bourses dramatically underperform and diverge from the S&P Index. And China’s stock market is moving swiftly into bear market territory.

I continue to believe that we are in an ‘Acne Market’ in which Mr. Market’s complexion is changing for the worse.

Economically, global high-frequency data is growing ambiguous.

In terms of sentiment, investors seem unduly complacent in their optimism and I know no strategists who are even contemplating the possibility of a large market drawdown.

The bottom line is that the economic, policy (trade, etc.), political (midterm elections are only two months away), currency and geopolitical outcomes are numerous and growing: Many of those outcomes are market adverse.

Over the last few years, it has paid to buy the dip.

It might be different this time as a maturing economy and stock market are showing their rough edges – just when global monetary authorities are pivoting and many non-US fiat currencies are imploding.”

I addressed last week, that emerging markets are likely sending a signal which is being largely dismissed by mainstream analysis. At the end of September, unless things markedly improve over the next 3-weeks, emerging markets will trigger the 4th major “sell” signal in the last 20-years.

“In 2000, 2007 and 2012, emerging markets warned of an impending recessionary drag in the U.S. (While 2012 wasn’t recognized as a recession, there were many economic similarities to one.)”

Currently, there is a high degree of complacency among investors, and Wall Street, the current bull market advance will continue uninterrupted into 2019. Targets are already being set for the S&P 500 to hit 3200, 3300, and higher.

While anything is certainly a possibility, it doesn’t mean that such will occur in a straight line either. The lack of leadership from the technology sector is certainly concerning given its extremely heavy weighting to the overall index. But likewise, the lack of performance from international markets also suggest “something isn’t quite right.” 

This also shows up in the Baltic Dry Index which is just a representation of the demand to ship dry goods. While the index bounced from the lows in 2016, as global central banks infused massive amounts of liquidity into the system, early indications suggest that the cycle of global growth has started to wane.

The biggest concern domestically remains the strength of earnings growth going forward as well. Currently, estimates remain extremely high and the drag from a stronger dollar, tariffs, and rising rates will likely bring estimates lower. As I noted last week:

“But looking forward, year over year comparisons are going to become markedly more troublesome even as expectations for the S&P 500 index continues to rise.”

While I am certainly hopeful the analysts are correct, as bull markets are much easier to navigate, the risk of disappointment is rising. As Doug notes, the contraction of monetary policy is beginning to take effect on the markets and the economy.

Risks are always under-appreciated when bullish enthusiasm prevails. But knowing when to “fall back” and regroup has always been a better strategy than fighting to the last man.

Just something to think about as you catch up on your weekend reading list.

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“I never hesitate to tell a man that I am bullish or bearish. But I do not tell people to buy or sell any particular stock. In a bear market all stocks go down and in a bull market they go up.” – Jesse Livermore

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Weekend Reading: Are Emerging Markets Sending A Signal

I have been, and remain, bearish on emerging markets for three reasons:

  1. As discussed yesterday, the U.S. is closer to the next economic downturn than not. When the U.S. enters a recession, emerging markets are hurt considerably more given their dependence on the U.S. 
  2. International risks in countries like Turkey, Greece, Spain, France, Italy, etc. 
  3. A strong dollar from flows into U.S. Treasury bonds for a “safe haven.” 

I recommended in January of this year to remove all international and emerging market exposure from portfolios and have been updating that position since each week in the newsletter:

“Emerging and International Markets were removed in January from portfolios on the basis that “trade wars” and “rising rates” were not good for these groups. With the addition of the “Turkey Crisis,” ongoing tariffs, and trade wars, there is simply no reason to add “drag” to a portfolio currently. These two markets are likely to get much worse before they get better. Put stops on all positions.”

This has been the right call, despite the plethora of articles suggesting the opposite.

For example, in January, Rob Arnott stated:

“Look at value in emerging markets. In the U.S., value is trading about 25% cheap relative to the market. In emerging markets, it’s close to 40% cheap. 

That’s pretty cool. If you can buy half the world’s GDP for nine times earnings or buy the U.S. for 32 times earnings, I know where I’m going to put my money.”

Now, I am not arguing Rob’s point. But, my position is simply that the economic dependency of emerging markets on the U.S. is extremely high. Therefore, when the U.S. gets a “cold,” emerging markets get the “flu.” 

Over the last 25-years, this has remained a constant.

In 2000, 2007 and 2012, emerging markets warned of an impending recessionary drag in the U.S. (While 2012 wasn’t recognized as a recession, there were many economic similarities to one.)

Currently, emerging markets have once again diverged from the S&P 500 suggesting economic growth may not be as robust as many believe. While a 2-quarter divergence certainly isn’t suggesting a “financial crisis” is upon us, it does suggest that something isn’t quite right with the global economic backdrop.

Lisa Abramowicz recently noted the problem with EM default risk in some of the emerging markets.

While the markets are currently dismissing Turkey, Brazil, China and Russia as non-events, the problem is the issue of funding needs for these countries.

“The second, more salient point is that a key reason for the solid growth across emerging markets in recent years, has been the constant inflow of foreign capital, resulting in a significant external funding requirement for continued growth, especially for Turkey as discussed previously.

But what happens if this outside capital inflow stops, or worse, reverses? This is where things get dicey. To answer that question, Morgan Stanley has created its own calculation of Emerging Market external funding needs, and defined it as an ‘external coverage ratio.’ It is calculated be dividing a country’s reserves by its 12-month external funding needs, which in turn are the sum of the i) current account, ii) short-term external debt and iii) the next 12 months amortizations from long-term external debt.”

Given the ongoing pressures of “tariffs,” trade wars and rising geopolitical tensions, the risk of something going “wrong” has become increasingly elevated.

Yet, market participants are ignoring the risk simply because prices are rising. As Doug Kass noted yesterday:

There is nothing like stock price advances to change sentiment. 

Just like fear dominates politics these days, the opposite is occurring in the markets as greed has emerged as a byproduct of sharply rising prices (which have desensitized investors to risks, doubt, and fear).

Besides growing economic ambiguities, the most notable lack of criticism is the unusual nature of the last decade, in which interest rates sustained themselves around the world at generational low levels. To presume that foundation to be sound in the future (particularly when a pivot of global monetary restraint has already started), is to congratulate Lance Armstrong for his Tour de France wins without noting his use of illegal drugs.

T.I.N.A. (‘there is no alternative’) is no longer a present condition as 1-month, 3-month, 6-month and 1-year Treasury yields are now at their highest levels in 10 years:

There is now an alternative.”

“The magnitude of the market’s rise in the month of August is almost certainly borrowing from future returns. In the extreme, a more durable and significant top may be forming.”

Higher borrowing costs on the short-end reduces consumption and the demand for imported goods. Emerging markets are likely already signaling there is an issue from the Federal Reserve’s actions, and the consequence historically has not been good. But, as I quoted yesterday:

Unfortunately, Powell left the unsettling feeling that monetary policy can be summarized as ‘We plan to keep hiking until something breaks.’”Tim Duy

Just something to think about as you catch up on your weekend reading list.

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“Stay humble…or the market will do it for you.” – Anonymous

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Weekend Reading: Impeachment Risk

Yesterday, the President stated:

“If I ever got impeached, I think the market would crash. I think everybody would be very poor. Because without this thinking, you would see, you would see numbers that you wouldn’t believe in reverse.”  

It is an interesting statement because there has been little to seemingly deter the bullish momentum of the market. Trade wars, tariffs, geopolitical stresses, a stronger dollar, and tighter monetary policy have all been quickly dismissed in exchange for hopes that corporate earnings and profitability will continue to accelerate into the future.

Even as I write this note this morning, the market is opening higher in the attempt to push the S&P 500 to “all-time” highs despite the fact the recent rally over the past week was attributed to “trade resolutions” with China which completely fell apart overnight.

“When reports emerged last week of a low-level Chinese delegation coming to meet with members of the Treasury department ahead of what the WSJ described would be a November trade summit in the US, stocks spiked and yields ran up (they have since tumbled with the 2s10s yield curve collapsing to just 20 basis points) on hopes that the long-running trade feud between the US and China may finally be coming to an end.

The skeptics were right because, after the conclusion on Thursday of the second day of the closely watched trade talks between the U.S. and China, there was ‘no major progress’ according to Bloomberg, with the stage once again set for further escalation of the trade war between the US and China.”

As you know, I was one of those skeptics.

Despite the headline rhetoric, the drive of the market is simply the momentum chase or more commonly known as the “Fear Of Missing Out (FOMO).” The momentum push is historically the last stage of a bull market cycle and is very difficult to stop. It is at this point in the cycle where “everything is as good as it can get,” literally. Confidence is at a peak, earnings and profitability are expanding and economic data is optimistic. Such provides the support to discount overvaluation and investment related risk.

But as I penned last week:

“’Record levels’” of anything are ‘records for a reason.’

When a ‘record level’ is reached it is NOT THE BEGINNING, but rather an indication of the PEAK of a cycle. Records, while they are often broken, are often only breached by a small amount, rather than a great stretch. While the media has focused on record low unemployment, record stock market levels, and record confidence as signs of an ongoing economic recovery, history suggests caution. For investors, everything is always at its best at the end of a cycle rather than the beginning.”

But the cracks are already starting to appear as underlying economic data is beginning to show weakness. While the economy grinds higher over the last few quarters, it was more of the residual effects from the series of natural disasters in 2017 than “Trumponomics” at work. The “pull forward” of demand is already beginning to fade as the frenzy of activity culminated in Q2 of 2018.

For the stock market, an impeachment process, which is a very low probability event, is likely the least of concerns over the next 9-12 months. What will matter to investors, in my opinion, are three things:

  • The Fed
  • China 
  • The 2nd Derivative

The Fed is important as they continue to hike rates which is already impacting, as we discussed yesterday, some of the more economically sensitive areas of the market.

China matters because they are a major trading partner with the U.S. and the potentially negative impact on corporate earnings from trade, tariffs, and a stronger dollar should not be quickly dismissed. While those things may not be immediately noticeable, even though they have been mentioned in recent corporate earnings reports, the longer they persist, the more they will matter. 

Lastly, the annual rate of change in earnings and economic data will begin to weaken as the year-over-year comparisons become much more difficult. Importantly, the explosive earnings growth in earnings this year, due to a lowered tax rate, has been key to supporting higher stock prices. That growth rate is set to slow markedly beginning in Q3 as the “tax rate effect” is absorbed and discounted. 

As far as the political backdrop goes, the biggest risk is the upcoming mid-term elections. If the House and/or Senate falls to the Democrats, the inability to push forward, or even the potential reversal of, any of the “Trumponomic” agenda will likely be much more unsettling for the markets in the short-term.

Nonetheless, the trend and momentum remains bullish, and bullish sentiment is an extremely hard thing to turn.

But it will eventually turn. The only question is what causes it?

There are certainly plenty of reasons for investors to be concerned, however, none of those “reasons” have seemed to matter so far. Most likely, the one that does is likely the one we aren’t even talking about yet.

Just something to think about as you catch up on your weekend reading list.

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“The trick of successful investors is to sell when they want to, not when they have to.” – Seth Klarman

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Weekend Reading: Why We Don’t Talk Anymore

I have been doing a daily radio talk show for 18-years. I started out, totally by accident, doing a financial talk show on a business radio station in early 2000 as the “dot.com” crash was underway. It was the genesis of what would eventually become Real Investment Advice.com Then, in 2007, I got picked up by a larger radio station in Houston, Texas to do my own radio program and was eventually asked to expand the show to cover conservative politics.

As a “fiscal conservative,” discussing the intersection of political and fiscal policies as it relates to the economy, financial markets, and our families was an easy transition. As the “financial crisis” ensued our commentary regarding capital preservation and risk management brought on a larger audience. During the next 8-years under the Obama Administration, I openly disagreed with policies like the Affordable Care Act, IRS suppression of conservative groups, and unbridled spending and debt expansion in Government.

I didn’t disagree with these policies because they were from an opposing party, but because they weren’t good for the country, the economy, or our families.

Importantly, my show allowed for open and honest discussions by those on both sides of the argument. While we certainly had our share of “heated” debates, they were always civil, respectful and honest. We discussed facts, exposed fallacies, and shared beliefs in an educational format.

However, over the last two years, having those open and honest discussions are no longer viable. The “heated” exchanges are now simply vitriolic. There is no ability to “simply disagree” with those on the “right” or the “left” as debates are have devolved into yelling matches.

The hypocrisy of both sides has become acidic. During the Obama Administration, the “right” consistently droned on about the flaws in the U-3 unemployment rate. Now, they use it as proof that Trump’s policies are working. The “left” is just as bad in switching arguments to support their narrative as well.

Who would have ever believed that #FakeNews would actually be “a thing.”

Just as in any marriage, when two people are no longer “talking,” the end is near.

The same is true in this country.

A recent PEW study shows the political divide that engulfed our country.

Don’t dismiss this divide lightly. As Ben Hunt recently noted:

“Has all this happened before? Sure. Time to dust off your copy of Gibbon’s Decline and Fall. Time to reread Will and Ariel Durant. Just be forewarned, the widening gyre can go on for a loooong time, particularly in the case of a major empire like Rome or America. It took the Romans about four centuries to officially exhaust themselves, at least in the West, with a few headfakes of resurgence along the way. Four centuries of mostly ridiculousness. Four centuries of profitable revenge and costly gratitude. Four centuries of a competitive equilibrium in a competitive game.

Has this happened before in American history? Hard to say for sure (how dare the Pew Research Center not be active in the 1850s!), but I think yes, first in the decade-plus lead-up to the Civil War over the bimodally distributed issue of slavery, and again in the decade-plus lead-up to World War II over the bimodally distributed issue of the Great Depression. I really don’t think it was an accident that both of these widening gyres in American politics ended in a big war.”

Even the Bible notes the importance of unity:

“And if a house be divided against itself, that house cannot stand.” – Mark 3:25

We are currently on a path that can not end well.

We are no longer talking.

Yesterday, was the end of my “political” talk show.

I am returning to my roots beginning September 4th to help prepare you for the coming crash. 

It is not a bearish view.

It’s not a “doom and gloom” forecast.

It is just the simple the reality we are on a collision course in this country which won’t be stopped. I hope you will tune in and listen.

Just something to think about as you catch up on your weekend reading list.

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“The contrary investor is every human when he resigns momentarily from the herd and thinks for himself” – Archibald MacLeish

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Weekend Reading: Mathematical Adjustments Don’t Change Reality

Yesterday, I discussed the mathematical adjustment to the GDP calculation that added $1 trillion to economic growth. To wit:

“Where did a bulk of the change come from? A change in the calculation of “real” GDP from using 2009 dollars to 2012 dollars which boosted growth strictly from a lower rate of inflation.  As noted by the BEA:

“For 2012-2017, the average rate of change in the prices paid by U.S. residents, as measured by the gross domestic purchasers’ price index, was 1.2 percent, 0.1 percentage point lower than in the previously published estimates.”

Of course, when you ask the average household about “real inflation,” in terms of healthcare costs, insurance, food, energy, etc., they are likely to give you quite an earful that the cost of living is substantially higher than 1.2%. Nonetheless, the chart below shows “real” GDP both pre- and post-2018 revisions.”

Importantly, the entire revision is almost entirely due to a change in the inflation rate. On a nominal basis, there was virtually no real change at all. In other words, stronger economic growth came from a mathematical adjustment rather than increases in actual economic activity.

The change to a lower inflation rate also boosted disposable incomes and personal consumption expenditures which also boosted the savings rate. However, what doesn’t change is economic reality. The chart below shows what we call “real DPI” or rather it is disposable incomes (which is gross income minus taxes) less spending. What we have left over after paying our bills, healthcare costs, food, tuition, etc. is what is really disposable for spending on other “stuff” or “saving.”

Despite the adjusted bump in savings, consumer activity continues to remain weak. Given that roughly 70% of the economic calculation comes from personal consumption, watching consumer activity is a good leading indicator of where the economy is headed next. PCE figures also suggest the recent bump in economic growth is likely transitory. Looking back historically, GDP tends to follow PCE and not vice-versa.

More importantly, weaker economic growth rates will also be met with much tougher year-over-year comparisons on corporate earnings which likely further hamper equity returns in the near term.

As we summed up yesterday:

“As an investor, it is important to remember that in the end corporate earnings and profits are a function of the economy and not the other way around. Historically, GDP growth and revenues have grown at roughly equivalent rates.

Forget the optimism surrounding “’Trumpenomics’ and focus on longer-term economic trends which have been declining for the past 30+ years. The economic trend is a function of a growing burden of debt, increasing demographic headwinds and, very importantly, declining productivity growth. I see little to make me believe these are changing in a meaningful way.”

Changing the math doesn’t change reality.

Just something to think about as you catch up on your weekend reading list.

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“Everything eventually reverts to the mean.”Frank Holmes

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Weekend Reading: Price Is What You Pay

Yesterday, I discussed the failure of tax cuts to “trickle down” as they have primarily been used for corporate share repurchases. As I was digging into the data, Doug Kass emailed me a quick note:

“Berkshire Hathaway, likely under the weight of an enormous cash horde and more scarce alternative investment opportunities, has announced that it is loosening the terms of its buyback policy. It is also a signpost that the company has matured and will only duplicate GDP-like growth.”

While the announcement set the shares of Berkshire (BRK/A) (BRK/B) surging higher yesterday, there is a much more important message that investors should be heeding.

We recently delved into the performance of Berkshire as it has become the 10th-largest company in the world in terms of revenues. To wit:

“The graph below highlights this concern. It shows that 90-day rolling correlation of price changes in BRK/A and the S&P 500 are statistically similar. In the market crash of 2008/09 BRK/A’s price was cut in half, similar to the S&P 500. Based on correlations we suspect a similar relationship will hold true for the next big market drawdown.”

Both the sheer size of Berkshire, and the chart above, confirm Doug’s comment that Berkshire is likely to only generate rates of growth equivalent to GDP going forward.

So what’s the message that Mr. Buffett is sending? Simple:

“Price is what you pay, value is what you get.”

Investing is about maximizing the return on invested dollars by buying something that is undervalued and selling it when it is overvalued. This is the point missed by those who promote “buy and hold” investing which is the same as “buy at any price.” 

Corporations are, in many ways, held hostage by Wall Street and short term investors. An earnings miss can be disastrous to a companies stock price which can have severe consequences to stock option compensated executives and employees, shareholders and even bondholders. So, with pressure on companies to deploy excess cash, what are the options considering the “beat the estimate” game that must be played.

  • Hire Workers? Employees are a high cost and have a direct impact on profitability. Companies hire as needed to meet excess demand. Demand has remained stable and increased at the rate of population growth which is also the rate of employment increases: (Read this)
  • Invest To Produce More Products? Investments in future growth are accompanied by a negative short-term impact to profitability. Further, with rates rising the cost of borrowing for CapEx adds to the negative impact on current earnings.
  • Mergers & Acquisitions? Using cash to acquire revenue can be accretive to bottom line profitability. However, with stock price valuations elevated the costs to acquire revenue in many cases is becoming less attractive and often not immediately accretive.
  • Share Repurchases? While share repurchases do not increase top-line revenue growth or bottom line profitability, it does make it APPEAR the company is more profitable when they report earnings on a per share basis. The illusion of an immediate increase in profitability supports asset prices in the short-term despite potentially decreasing fundamental value.

From an investment standpoint, share repurchases by companies are a message that companies simply have no better options available with which to grow earnings and protect shareholder value.

So, back to Mr. Buffett who has been sitting on over $100 Billion in cash and T-bills over the last few quarters. With a dearth of value in the market, there have been few opportunities for a legendary value investor to deploy capital in a manner that will generate an attractive future rate of return. However, sitting on cash, in a low interest rate environment, is also not conducive as the purchasing parity power of cash is eroded by inflation.

So, what does the “World’s Greatest Value Investor” do when there is no better use for cash – buy back shares of your own company, of course.

The message from Buffett is quite clear – there is little value left in the market today otherwise he would be allocating his cash hoard very differently.

While many suggest that individuals should just “buy and hold” investments regardless of what the market does, Mr. Buffett’s actions reinforce the view that buying assets at current valuations is likely to have a disappointing outcome. 

Does this mean you should never invest? Of course, not.

But as Mr. Buffett himself has stated:

“Be fearful when others are greedy. Be greedy when others are fearful.” 

Just something to think about as you catch up on your weekend reading list.

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“Predicting rain doesn’t count. Building arks does.”Warren Buffett

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Weekend Reading: Renter Nation

“The psychological factors are harder to assess. People aren’t flipping condos for sport the way they were during the bubble when mortgages were available to anyone regardless of whether they had income or assets. Yet it seems there’s a widespread desire to own assets – stocks, bonds, and real estate – regardless of price. It’s not an obviously happy mania, where people are motivated by promises of great wealth. It’s more like a need to be an asset owner in an economy that continues to hurt workers without college degrees and becomes more automated. Nevertheless, the price insensitivity of many buyers is enough to cause concern.” – John Coumarianos

It is an interesting comment and John is correct. Low rates, weak economic growth, cheap and available credit, and a need for income has inflated the third bubble of this century.

But when it comes to housing, as I was digging through the employment data yesterday, I stumbled across the “rental income” component which is included in national compensation. When I broke the data out into its own chart, I was a bit surprised.

Let’s step back for a moment to build a bit of a framework first. While there has been much speculation about a resurgent “housing boom” in the economy, the data suggests something very different which is that housing has simply become an asset class for wealthy investors to turn into rentals.

As the “Buy-to-Rent” game drives prices of homes higher, it reduces inventory and increases rental rates. This in turn prices out “first-time home buyers” who would become longer-term homeowners, hence levels of homeownership rates first seen in the 1970’s. (Also, note surging debt levels are supporting higher homeownership.)

The chart below shows the number of homes that are renter-occupied versus the seasonally adjusted homeownership rate. As noted above, with owner-occupied housing at the lowest levels since the 1970’s, “renters” have become the norm. 

The surge in “renters” since the financial crisis, due to a variety of financial reasons, has pushed rental income to record levels of nearly $800 billion a year. Given the sharp surge in incomes, it is not surprising that multifamily home construction and “buy to rent” continues apace in the economy for now. For investors, it has become an alternative asset class with increasing asset values and income yielding well above the current 10-year Treasury rate.

With roughly a quarter of the home buying cohort either unemployed or underemployed and living at home with their parents, the ability to create households has become more problematic. The remaining members of the home buying, household formation, contingent are employed but at lower ends of the pay scale and are choosing to rent due to budgetary considerations. This explains why the 12-month moving average of household formation, used to smooth very volatile data, is near its lowest levels going back to 1955.

The risk to the “renter nation” bubble is a “rush for the exits” by the herd of speculative buyers turning into mass sellers. With a large contingent of homes being held for investment purposes, if there is a reversion in home prices a cycle of liquidation could quickly occur. Combine that with the onset of a recession, and/or a bear market, and the problem could well be magnified. Of course, it isn’t just the liquidation of homes that is an issue but the inability to find a large enough pool of qualified buyers to absorb the inventory.

Just something to think about as you catch up on your weekend reading list.

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“Risk comes from not knowing what you are doing.” – Warren Buffett

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Weekend Reading: The Japanification Of America Continues

Last week, I discussed the ongoing debt issue in the U.S. with respect to the recent CBO report and the trajectory of debt growth over the next 30-years.

The fiscal issues facing the U.S. are nothing new and have been a frequent discussion on this site. More importantly, I have discussed these issues directly with members of Congress, and especially with Congressman Kevin Brady, Chairman of the House Ways and Means Committee, who agree with my concerns yet have been unable, and unwilling, to tackle the “tough” issues. While conservatives in Congress talk a great game of fiscal responsibility, the reality is there is little “will” to actually be “fiscally responsible.”

While the country today is more politically divided than at just about any other point in history, “spending money” is the one thing that all members of Congress willingly agree to.

As I discussed previously, this is the same path Japan took previously.

“Debt is a retardant to organic economic growth as it diverts dollars from productive investment to debt service. 

The problems that face Japan are similar to what we are currently witnessing in the U.S.:

  • A decline in savings rates to extremely low levels which depletes productive investments
  • An aging demographic that is top heavy and increasingly drawing on social benefits.
  • A heavily indebted economy with debt/GDP ratios above 100%.
  • A decline in exports due to a weak global economic environment.
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases to offset reduced employment

The lynchpin to Japan, and the U.S., remains demographics and interest rates. As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.”

“Japan, like the U.S., is caught in an on-going “liquidity trap”  where maintaining ultra-low interest rates are the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go – the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.”

I was reminded of this previous discussion this past week when Tyler Durden discussed a new bill in Japan limiting overtime work to 99-hours a month to cure “Death by Overwork.”

“Recently released government data revealed that Japan’s jobless rate touched 2.2% in May, the lowest level in 26 years. And as Japan’s working-age population dwindles, job openings have outpaced the number of workers available to fill them: As a reference, two months ago, there were 160 job offers available for every 100 workers seeking a job.”

What got my attention was the similarity to an issue that has stumped economists over the last couple of years – surging job openings that go unfilled. We can restate quote above to apply to the U.S.:

“Recently released government data revealed the U.S. jobless rate touched 3.8% in June, the lowest level in 48 years. And as Japan’s working-age population dwindles, job openings have outpaced the number of workers available to fill them: As a reference, two months ago, the ratio of offers to unemployed hit the highest level of this century.”

Employment growth has essentially done little more than to absorb population growth over the last several years but has begun to deteriorate over the last few years. With net hires (hires less layoffs and quits) declining the ratio of job openings to hires is likely to rise further.

While the surge in “job openings” has remained a conundrum for economists, the answer may not be so difficult as employers continue to report the problems with filling jobs as:

  1. unfit to do the job (too fat/unhealthy/old),
  2. lack of requisite skills (education/training), and; 
  3. unwilling to accept the job for the rate of pay.

This was noted in the recent FOMC minutes:

Contacts in several Districts reported difficulties finding qualified workers, and, in some cases, firms were coping with labor shortages by increasing salaries and benefits in order to attract or retain workers. Other business contacts facing labor shortages were responding by increasing training for less-qualified workers or by investing in automation.”

A recent job posting revealed what we already suspected about the “new economy.”

While these are anecdotal examples, it potentially explains why labor force participation remains stuck at multi-decade lows as government benefits provide more income than working. Currently, social welfare makes up a record high of 22% of disposable incomes. The reality is that if the jobless rate was actually near 4%, job openings would be filled, wages would be surging for the bottom 80% of workers along with interest rates and economic growth. Instead, we see more evidence of economic stagflation than anything else.

Despite many exuberant hopes of an “economic resurgence,” the vast majority of the data continues to point to a very late stage economic cycle. While I am not suggesting the U.S. actually IS Japan, I am suggesting we can look to Japan as “road map” as to the consequences of high debt levels, aging demographics, deflationary pressures and opting for “short-term fixes” rather than fiscal responsibility.

Unfortunately, the Administration has chosen to follow the path of Japan which is unlikely to have a different outcome. There is no evidence that monetary interventions and government spending create organic, and sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever-growing void in the future that must be filled. Eventually, the void will be too great to fill.

There is certainly time to change our destination, but it will require a massive shift in perspective and desire to do so. With a rising number of Millennials starting to embrace socialism over capitalism, the future of the U.S. may be more like Japan than we readily wish to admit. 

Just something to think about as you catch up on your weekend reading list.

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Weekend Reading: #MAMI – Make America More Indebted

I have spilled a lot of digital ink over the last few years on the trajectory of debt, spending and the impact of fiscal irresponsibility. Most of it has fallen on “deaf ears” particularly in the rush to pass “tax reform” without underlying fiscal restraints. To wit:

“The recently approved budget was an anathema to any fiscally conservative policy. As the Committee for a Responsible Federal Budget stated:

‘Republicans in Congress laid out two visions in two budgets for our fiscal future, and today, they choose the path of gimmicks, debt, and absolutely zero fiscal restraint over the one of responsibility and balance.

Passing fiscally irresponsible budgets just for the sake of passing “tax cuts,” is, well, irresponsible. Once again, elected leaders have not listened to, or learned, what their constituents are asking for which is simply adherence to the Constitution and fiscal restraint.’

I then followed this up this past Monday with “3 Myths Of Tax Cuts” stating:

‘Tax cuts do not pay for themselves; they can create growth, but in the amount of tenths of percentage points, not whole percentage points. And they certainly cannot fill in trillions in lost revenue. Relying on growth projections that no independent forecaster says will happen isn’t the way to do tax reform.

As the chart below shows there is ZERO evidence that tax cuts lead to stronger sustained rates of economic growth. The chart compares the highest tax rate levels to 5-year average GDP growth. Since Reagan passed tax reform, average economic growth rates have only gone in one direction.'”

The reason for the history lesson is the CBO (Congressional Budget Office) has just released a new report confirming exactly what we have been saying for the last two years.

“In CBO’s projections, the federal budget deficit, relative to the size of the economy, grows substantially over the next several years, stabilizes for a few years, and then grows again over the rest of the 30-year period, leading to federal debt held by the public that would approach 100 percent of gross domestic product (GDP) by the end of the next decade and 152 percent by 2048. Moreover, if lawmakers changed current laws to maintain certain policies now in place—preventing a significant increase in individual income taxes in 2026, for example—the result would be even larger increases in debt.

The federal government’s net interest costs are projected to climb sharply as interest rates rise from their currently low levels and as debt accumulates. Such spending would about equal spending for Social Security, currently the largest federal program, by the end of the projection period.”

My friends at the Committee for a Responsible Federal Budget summed up the issues well.

  • Debt Is Rising Unsustainably
  • Spending Is Growing Faster Than Revenue
  • Recent Legislation Will Substantially Worsen the Long-Term Outlook if Extended. 
  • High And Rising Debt Will Have Adverse and Potentially Dangerous Consequences (Will lead to another financial crisis.)
  • Major Trust Funds Are Headed Toward Insolvency. 
  • Fixing the Debt Will Get Harder the Longer Policymakers Wait. 

While the CRFB suggests that lawmakers need to work together to address this bleak fiscal picture now so problems do not compound any further, there is little hope that such will actually be the case given the deep partisanship currently running the country.

As I have stated before, choices will have to be made either by choice or force. The CRFB agrees with my assessment.

“CBO continues to remind us what we’ve known for a while and seem to be ignoring: the federal budget is on an unsustainable course, particularly over the long term. If policymakers make the tough decisions nowrather than wait until there’s a crisis point for action – the solutions will be fairer and less painful.”

I am not hopeful. With government dependency at record levels as a percentage of disposable incomes (22.05%), the outlook for the economy will continue to become less bright as Government transfer payments only offset a small fraction of the increase in pre-tax inequality.

These payments fail to bridge the gap for the bottom 50% because they go mostly to the middle class and the elderly. With wage growth virtually stagnant over the last 20-years, the average American is still living well beyond their means which explains the continued rise in debt levels. The reality is that economic growth will remain mired at lower levels as savings continue to be diverted from productive investment into debt service.

The “structural shift” is quite apparent as burdensome debt levels prohibit the productive investment necessary to fuel higher rates of production, employment, wage growth, and consumption. Many will look back at this point in the future and wonder why governments failed to use such artificially low-interest rates and excessive liquidity to support the deleveraging process, fund productive investments, refinance government debts, and restructure unfunded social welfare systems.

Instead, those in charge continue to “Make America More Indebted.”

As individuals, we must realize we can only depend on ourselves for our financial security and work to ensure our own fiscal solvency.

As my father used to preach:

“Hope for the best, prepare for the worst, and remember the best rescue is a self-rescue.” 

Be hopeful. Just don’t be dependent.

Just something to think about as you catch up on your weekend reading list.

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The Risk To Markets – Global Growth

The stock market has been rallying on the surge in global economic growth (recently monikered global synchronized growth) over the past year. The hope, as always, is that growth is finally here to stay. The surge in growth has also given cover to the Federal Reserve, and Central Banks globally, to start reducing the flood of liquidity that has been propping up markets globally since the “financial crisis.”

That optimism has bled over in recent months as improving confidence has pushed leverage back to record levels, investors carry the highest levels of risk assets since the turn of the century, and yield spreads remain near record lows. It certainly seems as “things are as good as they can get.”

But it is when things are “as good as they can get” that we find the rest of the story.

recent report from the Brookings Institute highlights one of the biggest risks to investors currently – global growth.

“The world economy’s growth momentum remains strong but is leveling off as the winds of a trade war, geopolitical risks, domestic political fractures, and debt-related risks loom, with financial markets already reflecting mounting vulnerabilities. The latest update of the Brookings-Financial Times TIGER index provides grounds for optimism about the current state of the world economy matched by some pessimism about the sustainability of the growth momentum.”

This has been a key concern of mine of the last several months. The recent uptick in the U.S. economy has been undeniably the strongest we have seen in the last few years. As Brookings notes:

The U.S. economy remains in robust shape, with growth in GDP, industrial production, and investment holding up well. In tandem with strong consumer confidence and employment growth, wage and inflationary pressures have picked up slightly, although less than would be typical at this stage of the cycle.

The issue, however, is that much of that uptick was attributable to a series of natural disasters in 2017. To wit:

“The Trump Administration has taken a LOT of credit for the recent bumps in economic growth. We have warned this was not only dangerous, credibility-wise, but also an anomaly due to three massive hurricanes and two major wildfires that had the ‘broken window’ fallacy working overtime.”

As shown in the chart below, the ECRI’s index and the Chicago Fed National Activity Index suggests that bump in growth may be waning. Historically, spikes in activity have historically noted peaks in the economic cycle. Such should not be surprising as growth breeds optimism which drives activity. Just remember, everything cycles.

While current optimism is high, it is also fragile.

For investors, when things are “as good as they can get,” that is the point where something has historically gone wrong. It is always an unexpected, unanticipated event that causes a revulsion of risk assets across markets. Currently, there are a host of competing forces at play within the markets and the economy. These competing forces weave a delicate balance that can be easily disrupted creating a reversion in behaviors.

As Brookings notes:

The U.S. is engaged in a perilous macroeconomic experiment, with the injection of a significant fiscal stimulus even as the economy appears to be operating at or above its potential. The Fed is likely to lean hard against potential inflationary pressures as this stimulus plays out. Export growth has been buoyed by a weak dollar and strong external demand, but the U.S. trade deficit has still risen over the past year. The large bilateral trade deficit with China remains a flashpoint, setting in motion trade tensions that could have implications for China, the U.S., and the entire world economy.”

But this isn’t just in the U.S. It is also on a global scale.

“In 2017, the Euro-zone turned in its fastest pace of growth over the last decade. Growth in overall GDP as well as in the manufacturing and services sectors remains solid but has cooled off slightly this year. Centrifugal political forces in many countries, rising global trade frictions, and the withdrawal of monetary stimulus could lay bare some of the unresolved structural problems and tensions in the zone.”

The last point was recently noted by Michael Lebowitz:

“Global central banks’ post-financial crisis monetary policies have collectively been more aggressive than anything witnessed in modern financial history. Over the last ten years, the six largest central banks have printed unprecedented amounts of money to purchase approximately $14 trillion of financial assets as shown below. Before the financial crisis of 2008, the only central bank printing money of any consequence was the Peoples Bank of China (PBoC).”

The central banks’ goals, in general, were threefold:

  • Expand the money supply allowing for the further proliferation of debt, which has sadly become the lifeline of most developed economies.
  • Drive financial asset prices higher to create a wealth effect. This myth is premised on the belief that higher financial asset prices result in greater economic growth as wealth is spread to the masses.
    • “And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”– Ben Bernanke Editorial Washington Post 11/4/2010.
  • Lastly, generate inflation, to help lessen the burden of debt.

QE has forced interest rates downward and lowered interest expenses for all debtors. Simultaneously, it boosted the amount of outstanding debt. The net effect is that the global debt burden has grown on a nominal basis and as a percentage of economic growth since 2008. The debt burden has become even more burdensome.

However, that liquidity support is now being removed.

That extraction of liquidity is potentially already showing up in slower rates of global economic growth. As recently noted by the ECRI:

“Our prediction last year of a global growth downturn was based on our 20-Country Long Leading Index, which, in 2016, foresaw the synchronized global growth upturn that the consensus only started to recognize around the spring of 2017.

With the synchronized global growth upturn in the rearview mirror, the downturn is no longer a forecast, but is now a fact.”

The ECRI goes on to pinpoint the problem facing investors currently which is a “willful blindness” to changes in the economic fabric.

“Still, the groupthink on the synchronized global growth upturn is so pervasive that nobody seemed to notice that South Korea’s GDP contracted in the fourth quarter of 2017, partly due to the biggest drop in its exports in 33 years. And that news came as the country was in the spotlight as host of the winter Olympics.

Because it’s so export-dependent, South Korea is often a canary in the coal mine of global growth. So, when the Asian nation experiences slower growth — let alone negative growth — it’s a yellow flag for the global economy.

The international slowdown is becoming increasingly obvious from the widely followed economic indicators. The most popular U.S. measures seem to present more of a mixed bag. Yet, as we pointed out late last year, the bond market, following the U.S. Short Leading Index, started sniffing out the U.S. slowdown months ago.”

While at the headline, things may seem to “firing on all cylinders,” there are many indicators showing rising “economic stress” such as:

The shift caused by the financial crisis, aging demographics, massive monetary interventions and the structural change in employment has skewed many of behaviors of politicians, central bankers, and investors. We are currently sailing in very unchartered waters where a single unexpected wave could easily capsize the ship. Not just domestically, but on a global scale.

As Brookings concludes:

“The era of growth fueled by macroeconomic stimulus, with no apparent adverse side effects such as high inflation, appears to be drawing to an end. In the absence of deep-rooted reforms to improve productivity, it will be difficult to ratchet up or even sustain high growth in the major economies.”

Mounting public debt in the U.S. and other advanced economies, compounded by unfavorable demographics, and rising external debt levels of some emerging market economies are risk factors that also reduce policy space for responding to shocks.”

There are a multitude of risks on the horizon, from geopolitical, to fiscal to economic which could easily derail growth if policymakers continue to count on the current momentum continuing indefinitely. The dependency on liquidity, interventions, and debt has displaced fiscal policy that could support longer-term economic resilience.

We are at war with ourselves, not China, and the games being played out by Washington to maintain the status quo is slowly creating the next crisis that won’t be fixed with another monetary bailout.

CBO – “Making America More Indebted”

In December of last year, as Congress voted to pass the “Tax Cut & Jobs Act,” I wrote that without “real and substantive cuts to spending,” the debt and deficits will begin to balloon. At that time, I mapped out the trajectory of the deficit based on the cuts to revenue from lower tax rates and sustained levels of government spending.

Since that writing, the government has now lifted the “debt ceiling” for two years and passed a $1.3 Trillion “omnibus spending bill” to operate the government through the end of September, 2018. Of course, since the government has foregone the required Constitutional process of operating on a budget for the last decade, “continuing resolutions,” or “C.R.s,” will remain the standard operating procedure of managing the country’s finances. This means that spending will continue to grow unchecked into the foreseeable future as C.R.’s increase the previously budgeted spending levels automatically by 8% annually. (Rule of 72 says spending doubles every 9-years) 

The chart below tracks the cumulative increase in “excess” Government spending above revenue collections. Notice the point at which nominal GDP growth stopped rising.

Trillion dollar deficits, of course, are nothing to be excited about as rising debts, and surging deficits, as shown, impede economic growth longer-term as money is diverted from productive investments to debt-service.

While many suggest that “all government spending is good spending,” the reality is that “recycled tax dollars” have a very low, if not negative, “multiplier effect” in the economy. As Dr. Lacy Hunt states:

“The government expenditure multiplier is negative. Based on academic research, the best evidence suggests the multiplier is -0.01, which means that an additional dollar of deficit spending will reduce private GDP by $1.01, resulting in a one-cent decline in real GDP. The deficit spending provides a transitory boost to economic activity, but the initial effect is more than reversed in time. Within no more than three years the economy is worse off on a net basis, with the lagged effects outweighing the initial positive benefit.

Dr. Hunt is absolutely correct when he notes that due to the aging of America, the mandatory components of federal spending will accelerate sharply over the next decade, causing government outlays as a percent of economic activity to move higher. According to the Center On Budget & Policy Prioritiesnearly 75% of every tax dollar goes to non-productive spending. 

As Dr. Hunt concludes:

“The rising unfunded discretionary and mandatory federal spending will increase the size of the federal sector, which according to first-rate econometric evidence will contract economic activity. Two Swedish econometricians (Andreas Bergh and Magnus Henrekson, The Journal of Economic Surveys (2011)), substantiate that there is a ‘significant negative correlation’ between the size of government and economic growth. Specifically, ‘an increase in government size by 10 percentage points is associated with a 0.5% to 1% lower annual growth rate.’ This suggests that if spending increases, the government expenditure multiplier will become more negative over time, serving to confound even more dramatically the policy establishment and the public at large, both of whom appear ready to support increased, but unfunded, federal outlays.”

The evidence is pretty clear.

Trillion Dollar Deficits

The Committee For A Responsible Federal Budget just released the following analysis:

“The Congressional Budget Office (CBO) released its ten-year budget and economic outlook today, showing that recent legislation has made an already challenging fiscal situation much worse. CBO’s report projects that:

  • The budget deficit will near one trillion dollars next year, after which permanent trillion-dollar deficits will emerge and continue indefinitely. Under current law, deficits will rise from $665 billion (3.5 percent of Gross Domestic Product) last year to $1.5 trillion (5.1 percent of GDP) by 2028.
  • As a result of these deficits, debt held by the public will increase by more than $13 trillion over the next decade – from $15.5 trillion today to $28.7 trillion by 2028. Debt as a share of the economy will also rise rapidly, from today’s post-war record of 77 percent of GDP to above 96 percent of GDP by 2028.
  • Cumulative deficits through 2027 are projected to be $1.6 trillion higher than CBO’s last baseline in June 2017. The entirety of this difference is the result of recent legislation, most significantly the 2017 tax law.
  • Spending will increase significantly over the next decade, from 20.8 percent of GDP in 2017 to 23.6 percent by 2028. Revenue will dip from 17.3 percent of GDP in 2017 to 16.5 percent by 2019 before rising to 18.5 percent of GDP by 2028 as numerous temporary tax provisions expire.
  • Deficits and debt would be far higher if Congress extends various temporary policies. Under CBO’s Alternative Fiscal Scenario, where Congress extends expiring tax cuts and continues discretionary spending at its current level, the deficit would eclipse $2.1 trillion in 2028, and debt would reach 105 percent of GDP that year – nearing the record previously set after World War II.

CBO’s latest projections show that recent legislation has made an already challenging fiscal situation much more dire. Under current law, trillion-dollar deficits will return soon and debt will be on course to exceed the size of the economy. Under the Alternative Fiscal Scenario, the country would see the emergence of $2 trillion deficits, and debt would reach an all-time record by 2029.”

This analysis certainly isn’t the policy prescription to “Make America Great Again,” but rather “Make America More Indebted.” 

I encourage you to read the entire analysis by the CRFB, but the bottom line is what we already know, more debt equals less economic growth.

“As a result of this and other effects, CBO estimates real GDP growth of 1.5 to 1.8 percent each year after 2020, with an annual average of 1.8 percent over the 2018-2028 period. This is very similar to the average growth rate projected in June 2017.

Notably, CBO’s projected average growth rate is significantly lower than the roughly 3 percent assumed in the President’s FY 2019 budget. Such rapid levels of growth are far below what others – including the Federal Reserve – have projected; and they are highly unlikely to occur based on available economic evidence. The fact that 3 percent growth could be sustained for two years does not suggest it could be continued indefinitely over the long term.”

As I noted previously, it now requires $3.71 of debt to create $1 of economic growth which will only worsen as the debt continues to expand at the expense of stronger rates of growth.

CBO – Always Wrong

Furthermore, it is highly likely the CBO will be incorrect in their assumptions, as they almost always are, because there are many items the CBO is forced to exclude in its calculations.

First, the CBO’s governing statutes essentially require a distorted view of the finances by not allowing for an accounting of the tax breaks Congress routinely extends. As William Gale from the Tax Policy Institute explained:

“Here’s the bad part:  Under current law, CBO projects that the debt – currently 77 percent as large as annual GDP – will rise to 96 percent of GDP by 2028.  And that’s if Congress does nothing.  If instead, Congress votes to extend expiring tax provisions – such as the many temporary tax cuts in the 2017 tax overhaul – and maintain spending levels enacted in the budget deal (which is called the “current policy” baseline), debt is projected to rise to 105 percent of GDP by 2028, the highest level ever except for one year during World War II (when it was 106 percent).”

So, once you understand what the CBO isn’t allowed to calculate or show, it is not surprising their predictions have consistently overstated reality over time. However, it’s how Congress wants the projections reported so they can continue to ignore their fiscal responsibilities.

This is a big problem which David Stockman, former head of Government Accountability Office, pointed out:

“What that leads to is a veritable fiscal nightmare. Whereas the CBO report already forecasts cumulative deficits of $12.5 trillion during the next decade, you’d get $20 trillion of cumulative deficits if you set aside Rosy Scenario and remove the crooked accounting from the CBO baseline.

In a word, what was a $20 trillion national debt when the Donald arrived in the White House is no longer. Now it’s barreling toward $40 trillion within the next decade.

We have no ideas how much economic carnage that will cause, but we are quite sure it will not make America Great Again.”

However, besides those flaws, the CBO gives no weight to the structural changes which will continue to plague economic growth going forward. The combination of fiscally irresponsible tax cuts combined with:

  • Spending hikes
  • Demographics
  • Surging health care costs
  • Structural employment shifts
  • Technological innovations
  • Globalization
  • Financialization 
  • Global debt

These factors will continue to send the debt to GDP ratios to record levels. The debt, combined with these numerous challenges, will continue to weigh on economic growth, wages and standards of living into the foreseeable future. As a result, incremental tax and policy changes going forward will have a more muted effect on the economy as well.


The CBO’s latest budget projections confirm what we, and the CRFB, have been warning about. The current Administration has taken a path of fiscal irresponsibility which will take an already dismal fiscal situation and made it worse.

While the previous Administration was continually chastised by “conservative” Republicans for running trillion-dollar deficits, the Republicans have now decided trillion dollar deficits are acceptable.

That is simply hypocritical.

Given the flaws in the CBO’s calculations, their current projections of $1 trillion in deficits next year, and exceeding that mark every year after, will likely turn out to be overly optimistic. Even the CBO’s Alternative Fiscal Scenario of $2 trillion deficits over the next decade could turn out worse.

But William Gale summed up the entirety of the problem nicely.

“Here’s the worse part: The conventional comparison is misleading.  The projected budget deficits in the coming decade are essentially ‘full-employment’ deficits. This is significant because, while budget deficits can be helpful in recessions by providing an economic stimulus, there are good reasons we should be retrenching during good economic times, including the one we are in now. In fact, CBO projects that, over the 2018-2028 period, actual and potential GDP will be equal.

As President Kennedy once said ‘the time to repair the roof is when the sun is shining.’  Instead, we are punching more holes in the fiscal roof. 

In order to do an ‘apples to apples’ comparison, we should compare our projected Federal budget deficits to full employment deficits. From 1965-2017, full employment deficits averaged just 2.3 percent of GDP, far lower than either our current deficit or the ones projected for the future. 

The fact that debt and deficits are rising under conditions of full employment suggests a deeper underlying fiscal problem.”

The CBO’s budget projections are a harsh reminder the fiscal largesse that Congress and the Administration lavished on the country in the recent legislation is not a free lunch.

It is just a function of time until the “bill comes due.”