Tag Archives: economic growth

Debt & The Failure Of Monetary Policy To Stimulate Growth

A fascinating graphic was recently produced by Oxford Economics showing compounded economic growth rates over time.

What should immediately jump out at you is that the compounded rate of growth of the U.S. economy was fairly stable between 1950 and the mid-1980s. However, since then, there has been a rather marked decline in economic growth.

The question is, why?

This question has been a point of a contentious debate over the last several years as debt and deficit levels in the U.S. have soared higher.

Causation? Or Correlation?

As I will explain, the case can be made the surge in debt is the culprit of slowing rates of economic growth. However, we must start our discussion with the Keynesian theory, which has been the main driver both of fiscal and monetary policies over the last 30-years.

Keynes contended that ‘a general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.’

In such a situation, Keynesian economics states that government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.”

Keynes’ was correct in his theory. In order for deficit spending to be effective, the “payback” from investments being made must yield a higher rate of return than the debt used to fund it.

The problem has been two-fold.

First, “deficit spending” was only supposed to be used during a recessionary period, and reversed to a surplus during the ensuing expansion. However, beginning in the early ’80s, those in power only adhered to “deficit spending part” after all “if a little deficit spending is good, a lot should be better,” right?

Secondly, deficit spending shifted away from productive investments, which create jobs (infrastructure and development,) to primarily social welfare and debt service. Money used in this manner has a negative rate of return.

According to the Center On Budget & Policy Priorities, roughly 75% of every tax dollar goes to non-productive spending. 

Here is the real kicker. In 2018, the Federal Government spent $4.48 Trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of that total spending, ONLY $3.5 Trillion was financed by Federal revenues and $986 billion was financed through debt.

In other words, if 75% of all expenditures is social welfare and interest on the debt, those payments required $3.36 Trillion of the $3.5 Trillion (or 96%) of revenue coming in

Do you see the problem here? (In the financial markets, when you borrow from others to pay obligations you can’t afford it is known as a “Ponzi-scheme.”)

Debt Is The Cause, Not The Cure

This is one of the issues with MMT (Modern Monetary Theory) in which it is assumed that “debts and deficits don’t matter” as long as there is no inflation. However, the premise fails to hold up when one begins to pay attention to the trends in debt and economic growth.

I won’t argue that “debt, and specifically deficit spending, can be productive.” As I discussed in American Gridlock:

“The word “deficit” has no real meaning. Dr. Brock used the following example of two different countries.

Country A spends $4 Trillion with receipts of $3 Trillion. This leaves Country A with a $1 Trillion deficit. In order to make up the difference between the spending and the income, the Treasury must issue $1 Trillion in new debt. That new debt is used to cover the excess expenditures, but generates no income leaving a future hole that must be filled.

Country B spends $4 Trillion and receives $3 Trillion income. However, the $1 Trillion of excess, which was financed by debt, was invested into projects, infrastructure, that produced a positive rate of return. There is no deficit as the rate of return on the investment funds the “deficit” over time.

There is no disagreement about the need for government spending. The disagreement is with the abuse, and waste, of it.”

The U.S. is Country A.

Increases in the national debt have long been squandered on increases in social welfare programs, and ultimately higher debt service, which has an effective negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever growing amount of dollars away from productive investments to service payments.

The relevance of debt versus economic growth is all too evident, as shown below. Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. With economic growth rates now at the lowest levels on record, the growth in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.

The irony is that debt driven economic growth, consistently requires more debt to fund a diminishing rate of return of future growth. It now requires $3.02 of debt to create $1 of real economic growth.

However, it isn’t just Federal debt that is the problem. It is all debt.

When it comes to households, which are responsible for roughly 2/3rds of economic growth through personal consumption expenditures, debt was used to sustain a standard of living well beyond what income and wage growth could support. This worked out as long as the ability to leverage indebtedness was an option. Eventually, debt reaches levels where the ability to consume at levels great enough to foster stronger economic growth is eroded.

For the 30-year period from 1952 to 1982, debt-free economic growth was running a surplus. However, since the early 80’s, total credit market debt growth has sharply eclipsed economic growth. Without the debt to support economic growth, there is currently an accumulated deficit of more than $50 Trillion.

What was the difference between pre-1980 and post-1980?

From 1950-1980, the economy grew at an annualized rate of 7.70%. This was accomplished with a total credit market debt to GDP ratio of less 150%. The CRITICAL factor to note is that economic growth was trending higher during this span going from roughly 5% to a peak of nearly 15%.

There were a couple of reasons for this.

  1. Lower levels of debt allowed for personal savings to remain robust which fueled productive investment in the economy.
  2. The economy was focused primarily on production and manufacturing which has a high multiplier effect on the economy.  

The obvious problem is the ongoing decline in economic growth. Over the past 35 years, slower rates of growth has kept the average American struggling to maintain their standard of living. As wage growth stagnates, or declines, consumers are forced to turn to credit to fill the gap in maintaining their current standard of living. (The chart below is the inflation-adjusted standard of living for a family of four as compared to disposable personal incomes and savings rate. The difference comes from debt which now exceeds $3400 per year.)

It isn’t just personal and corporate debt either. Corporations have also gorged on cheap debt over the last decade as the Fed’s “Zero Interest Rate Policy” fostered a scramble for cash for diminishing investment opportunities, such as share buybacks. These malinvestments ultimately have a steep payback.

We saw this movie play out “real-time” previously in everything from sub-prime mortgages to derivative instruments. Banks and institutions milked the system for profit without regard for the risk. Today, we see it again in non-financial corporate debt. To wit:

“And while the developed world has some more to go before regaining the prior all time leverage high, with borrowing led by the U.S. federal government and by global non-financial business, total debt in emerging markets hit a new all time high, thanks almost entirely to China.”

“Chinese corporations owed the equivalent of more than 155% of Global GDP in March, or nearly $21 trillion, up from about 100% of GDP, or $5 trillion, two decades ago.”

The Debt End Game

Unsurprisingly, Keynesian policies have failed to stimulate broad based economic growth. Those fiscal and monetary policies, from TARP, to QE, to tax cuts, only delayed the eventual clearing process. Unfortunately, the delay only created a bigger problem for the future. As noted by Zerohedge:

“The IIF pointed out the obvious, namely that lower borrowing costs thanks to central banks’ monetary easing had encouraged countries to take on new debt. Amusingly, by doing so, this makes rising rates even more impossible as the world’s can barely support 100% debt of GDP, let alone 3x that.”

Ultimately, the clearing process will be very substantial. As noted above, with the economy currently requiring roughly $3 of debt to create $1 of economic growth, a reversion to a structurally manageable level of debt would involve a nearly $40 Trillion reduction of total credit market debt from current levels. 

This is the “great reset” that is coming.

The economic drag from such a reduction in debt would be a devastating process. In fact, the last time such a reversion occurred, the period was known as the “Great Depression.”

This is one of the primary reasons why economic growth will continue to run at lower levels going into the future. We will witness an economy plagued by more frequent recessionary spats, lower equity market returns, and a stagflationary environment as wages remain suppressed while cost of living rise.

The problem of debt will continue to be magnified by the changes in structural employment, demographics, and deflationary pressures derived from changes in productivity. As I showed previously, this trend has already been in place for the last decade and will only continue to confound economists in the future.

“The U.S. is currently running at lower levels of GDP, productivity, and wage growth than before the last recession. While this certainly doesn’t confirm Shelton’s analysis, it also doesn’t confirm the conventional wisdom that $33 Trillion in bailouts and liquidity, zero interest rates, and surging stock markets, are conducive to stronger economic growth for all.”

Correlation or causation? You decide.

Yes, The Yield Curve Matters

Recently several subscribers asked us why an inverted yield curve is a strong predictor of a coming recession. We will address the question in this article but first, we provide current context with two graphs that update you on the status of yield curves, and in the process help explain why this question is being asked with increasing frequency.

The first graph below, courtesy of the St. Louis Federal Reserve, clearly shows why the yield curve is becoming more and more of a concern for the Federal Reserve, along with many economists and the media. Since 1976, the last five recessions, denoted by gray bars, were preceded by a flattening and inversion of the 2yr/10yr Treasury yield curve. Currently, the curve is sitting at a mere 17 basis points (0.17%) and threatening inversion.

While the 2yr/10yr curve is the most popular yield curve to follow, it can be somewhat limiting as it only applies to those that borrow and lend in the two and ten-year maturity sectors. For example, the 2yr/10yr curve is not as important for a bank considering using customer deposits to make five-year auto loans. In this case, the bank’s chief concern is likely the 3-month/5yr curve.

The next graph steps beyond the 2yr/10yr curve to examine many variations of Treasury curves and provide a broader perspective of the entire Treasury yield curve.

As shown, 70% of 10 important yield curves are inverted, up from 40% in early April.

With an understanding of the current state of the yield curves, we examine the profitability of lending to explain better why the yield curve has such a big effect on the economy.

The Profitability of Lending

There are essentially two ways that a bank or lender makes money lending. They can arbitrage time or credit, and most frequently they do both at the same time. Lenders employ time arbitrage when they borrow for short periods and lend that same money out for longer periods. Credit arbitrage occurs when a higher rated entity with a lower cost of capital borrows and then lends to a borrower with a lower credit standing and higher cost of capital.

Time Arbitrage: This is the oldest money-making trick in the book. It is frequently referred to as borrowing short and lending long. The risk to the lender of using time arbitrage is that short term borrowing rates rise in the future and effectively reduce or eliminate profits. An inverted yield curve, coupled with poor lending practices was the cause of the Savings and Loan crisis of 1987-1989.

The steeper the yield curve, the more potential profit, and the more incentive for a bank to borrow short and lend long. Conversely, the flatter the curve the less incentive. An inverted curve can lead to losses for lenders employing this strategy.

The key takeaway is that in an economy heavily dependent on the creation and refunding of debt, anything that detracts from a willingness to lend money causes economic weakness.

Credit Arbitrage: The riskier a borrower, the higher the interest rate to borrow money. Banks tend to be highly rated, thus allowing them to borrow at lower rates and then turn around and lend the money to lesser rated borrowers at higher rates. As the shape of the yield curve greatly affects time arbitrage, credit spreads play a big role in credit arbitrage. When spreads are tight, as they are now, the potential profit of lending is reduced, and therefore lenders are less incentivized to lend. Currently, credit spreads, as quantified by BBB-rated corporate bonds, are historically tight. Once default expectations are factored in the incentive to lend is minimal. 

Quantifying Profitability

With an understanding of the two predominant types of lender arbitrages, we now provide a rough estimate of banking profitability based on the 2yr/10yr yield curve as a proxy for time arbitrage and BBB-rated corporate OAS spreads as a proxy for credit arbitrage. The following graph combines the two measures of probability to quantify the incentive for banks to lend.

Not surprisingly, the most recent recessions occurred when profitability, using these measures collapsed. The current reading is at levels seen before the 2001 recession and slightly above those preceding the financial crisis of 2008.

Data Courtesy St. Louis Federal Reserve

Summary

Tax reform, hurricane/fire disaster relief and a surge in the government’s deficit all provided an economic boost over the last few years. As we have written in the past, these economic tailwinds will no longer meaningfully contribute to economic growth. Real gross domestic production (GDP) will likely shrink to its natural growth rate of 1.5-2.0%. However, flat to inverted yields curves and tight credit spreads are becoming a headwind to growth.

If the yield curves stay flat and/or flattens or inverts further and credit spreads remain tight, it is highly likely lending will be curtailed. Assuming this were to happen, we could be staring down the barrel of another recession, which is what the bond markets appear to be telegraphing. That is why the yield curve matters!

QE – Then, Now, & Why It May Not Work

Since the beginning of the year, the market has rallied sharply. That rally has been fueled by commentary from both the Trump Administration and the Federal Reserve of the removal of obstacles which plagued stocks in 2018. The chart below is an abbreviated, and a bit sarcastic, version of events.

While the resolution of the trade war is certainly beneficial to the economy, as it removes an additional tax on consumers, the biggest support for the market has been the assumption the Fed will return to a much more accommodative stance.

As we summed up previously for our RIA PRO subscribers (try it FREE for 30-days)

  • The Fed will be “patient” with future rate hikes, meaning they are now likely on hold as opposed to their forecasts which still call for two to three more rate hikes in 2019 and more in 2020.
  • The pace of QT, or balance sheet reduction, will not be on “autopilot” but instead driven by the current economic situation and tone of the financial markets. It is expected the Fed will announce in March that QT will end and the balance sheet will stabilize at a much higher level.
  • QE is a tool that WILL BE employed when rate reductions are not enough to stimulate growth and calm jittery financial markets.

In mid-2018, the Federal Reserve was adamant a strong economy, and rising inflationary pressures, required tighter monetary conditions. At that time they were discussing additional rate hikes and a continued reduction of their $4 Trillion balance sheet.

All it took was a rough December, pressure from Wall Street’s member banks, and a disgruntled White House to completely flip their thinking.

The Fed isn’t alone.

China has launched its version of “Quantitative Easing” to help prop up its slowing economy.

Lastly, the ECB downgraded Eurozone growth, and as announced today, not only will they not raise rates in 2019, they also extended the TLTRO program, which is the Targeted Longer-Term Refinancing Operations scheme which gives cheap loans to struggling Eurozone banks, into 2021.

But there is nothing to worry about, right?

Think about this for a moment.

For a decade the global economy has been growing. Market participants are crowing about the massive surge in asset prices as clear evidence of the strength of the economy.

However, such hasn’t been the case. As I discussed previously for the Fed, China, and the ECB, are signaling their concerns about “economic reality,” which as the data through the end of December shows, the U.S. economy is beginning to slow.

“As shown, over the last six months, the decline in the LEI has been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

More importantly, monetary policy never really impacted the economy as prolifically as was anticipated following the financial crisis. The two 4-panel charts below show the percentage change in the Fed’s balance sheet from 2009-present (309%) versus the total percentage change in various economic components. I have also included the amount of stimulus required to create those changes.

First, it is interesting to note that despite headlines of strong employment growth, the percentage of people considered “Not In Labor Force or NILF” has grown more than full-time employment. Of course, and not surprisingly, the biggest beneficiary of monetary policy was…corporate profits.

Secondly, where monetary policy did work was lifting asset prices as shown in the chart and table below.

The table above shows that QE1 came immediately following the financial crisis and had an effective ratio of about 1.6:1. In other words, it took a 1.6% increase in the balance sheet to create a 1% advance in the S&P 500. However, once market participants figured out the transmission system, QE2 and QE3 had an almost perfect 1:1 ratio of effectiveness. The ECB’s QE program, which was implemented in 2015 to support concerns of an unruly “Brexit,” had an effective ratio of 1.5:1.

Clearly, QE worked well in lifting asset prices, but not so much for the economy as shown above. In other words, QE was ultimately a massive “wealth transfer” from the middle class to the rich which has created one of the greatest wealth gaps in the history of the U.S., not to mention an asset bubble of historic proportions.

But Will It Work Next Time?

This is the single most important question for investors.

The current belief is that QE4 will be implemented at the first hint of a more protracted downturn in the market. However, as we noted above, QE will likely only be employed when rate reductions aren’t enough. Such was noted in 2016 by David Reifschneider, deputy director of the division of research and statistics for the Federal Reserve Board in Washington, D.C., released a staff working paper entitled “Gauging The Ability Of The FOMC To Respond To Future Recessions.” 

The conclusion was simply this:

“Simulations of the FRB/US model of a severe recession suggest that large-scale asset purchases and forward guidance about the future path of the federal funds rate should be able to provide enough additional accommodation to fully compensate for a more limited [ability] to cut short-term interest rates in most, but probably not all, circumstances.”

In other words, the Federal Reserve is rapidly becoming aware they have become caught in a liquidity trap keeping them unable to raise interest rates sufficiently to reload that particular policy tool. There are certainly growing indications, as discussed recently, the U.S. economy maybe be heading towards the next recession. 

Interestingly, David compared three policy approaches to offset the next recession.

  1. Fed funds goes into negative territory but there is no breakdown in the structure of economic relationships.
  2. Fed funds returns to zero and keeps it there long enough for unemployment to return to baseline.
  3. Fed funds returns to zero and the FOMC augments it with additional $2-4 Trillion of QE and forward guidance. 

In other words, the Fed is already factoring in a scenario in which a shock to the economy leads to additional QE of either $2 trillion, or in a worst case scenario, $4 trillion, effectively doubling the current size of the Fed’s balance sheet.

Here is what is interesting, as reported by Jennifer Ablan:

So, 2-years ago David lays out the plan and yesterday Williams reiterates that plan.

Does the Fed see a recession on the horizon? Is this the reason for the sudden change in views by Powell in recent weeks?

Maybe.

But there is a problem with the entire analysis. The effectiveness of QE, and zero interest rates, is based on the point at which you apply these measures. This was something I pointed out previously:

“In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%.

If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But there is more to the story than just the Fed’s balance sheet and funds rate. The entire backdrop is completely reversed. The table below compares a variety of financial and economic factors from 2009 to present.

The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been “blown out,” deviations from the “norm” are negatively extended, confidence is hugely negative.

In other words, there is nowhere to go but up.

Such was the case in 2009. Even without Federal Reserve interventions, it is highly probable that the economy would have begun a recovery as the normal economic cycle took hold. No, the recovery would not have been as strong, and asset prices would be about half of where they are today, but an improvement would have happened nonetheless.

The extremely negative environment that existed, particularly in the asset markets, provided a fertile starting point for monetary interventions. Today, as shown in the table above, the economic and fundamental backdrop could not be more diametrically opposed.

This suggests that the Fed’s ability to stem the decline of the next recession, or offset a financial shock to the economy from falling asset prices, may be much more limited than the Fed, and most investors, currently believe.

The Fed’s hope has always been that at some point they would be able to wean the economy off of life support and it would operate under its own strength. This would allow the Fed to raise interest rates back to more normalized levels and provide a policy tool to offset the next recession. However, given the Fed has never been able to get rates higher than the last crisis, it has only led to bigger “booms and busts” in recent decades.

Summary

It has taken a massive amount of interventions by Central Banks to keep economies afloat globally over the last decade and there is rising evidence that growth is beginning to decelerate.

While another $2-4 Trillion in QE might indeed be successful in further inflating the third bubble in asset prices since the turn of the century, there is a finite ability to continue to pull forward future consumption to stimulate economic activity. In other words, there are only so many autos, houses, etc., which can be purchased within a given cycle. There is evidence the cycle peak has been reached.

If I am correct, and the effectiveness of rate reductions and QE are diminished due to the reasons detailed herein, the subsequent destruction to the “wealth effect” will be far larger than currently imagined. There is a limit to just how many bonds the Federal Reserve can buy and a deep recession will likely find the Fed powerless to offset much of the negative effects. 

If more “QE” works, great. But as investors, with our retirement savings at risk, what if it doesn’t.

The Fed Doesn’t Target The Market?

Earlier this month, I penned an article asking if we “really shouldn’t worry about the Fed’s balance sheet?” The question arose from a specific statement made by previous New York Federal Reserve President Bill Dudley:

“Financial types have long had a preoccupation: What will the Federal Reserve do with all the fixed income securities it purchased to help the U.S. economy recover from the last recession? The Fed’s efforts to shrink its holdings have been blamed for various ills, including December’s stock-market swoon. And any new nuance of policy — such as last week’s statement on “balance sheet normalization” — is seen as a really big deal.

I’m amazed and baffled by this. It gets much more attention than it deserves.”

As I noted, there is a specific reason why “financial types” have a preoccupation with the balance sheet.

The preoccupation came to light in 2010 when Ben Bernanke added the “third mandate” to the Fed – the creation of the “wealth effect.”

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. 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, Washington Post Op-Ed, November, 2010.

As he noted, the Fed specifically targeted asset prices to boost consumer confidence. Given that consumption makes up roughly 70% of economic growth in the U.S., it makes sense. So, not surprisingly, when the economy begins to show signs of deterioration, the Fed acts to offset that weakness.

This is why the slowdown in global growth became an important factor behind the central bank’s decision to put plans for interest rate increases on hold. That comment was made by Federal Reserve Vice Chairman Richard Clarida during a question-and-answer session last week.

“The reality is that the global economy is slowing. You’ve got negative growth in Italy, Germany may just grow…1% this year, [and] a slowdown in China. These are all things that we need to factor in. 

Slower global growth would crimp U.S. exports and could also negatively influence financial and asset markets, a primary transmission mechanism for monetary policy.”

As we noted previously in “Data or Markets,” the Fed is not truly just “data dependent.” They are, in many ways, co-dependent on each other. A strongly rising market allows the Fed to raise rates and reduce accommodative as higher asset prices support confidence. However, that “leeway” is quickly reduced when asset prices reverse. This has been the Fed cycle for the last 40-years.

The problem for the Fed is they have now become “liquidity trapped.”

What is that? Here is the definition:

“A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

The chart below shows the correlation between the decline of GDP and the Fed Funds rate.

There are two important things to notice from the chart above. The first is that prior to 1980, the trend of both economic growth and the Fed Funds rate were rising. Then, post-1980, as then Fed Chairman Paul Volker and President Ronald Reagan set out to break the back of inflation, each successive cycle of rate increases were started from a level lower than the previous cycle.

The difference between the two periods was the amount of debt in the system and the shift from an expansive production and manufacturing based economy to one driven primarily by services which have a substantially lower multiplier effect. Since 1980, it has required increasing levels of debt to manufacture $1 of GDP growth.

In every case, the rate cycle increase ALWAYS led to either a recession, bear market, crisis, or all three. Importantly, those events occurred not when the Fed STARTED hiking rates, but when they recognized that their tightening process was confronted by weakening economic growth. 

The Trap

The problem for the Fed is that while lower interest rates may help spur economic growth in the short-term, the growth has come from an increasing level of debt accumulation. Therefore, the economy cannot withstand a reversal of those rates. As shown above, each successive round of rate increases was never able to achieve a rate higher than the previous peak. For example, in 2007, the Fed Funds rate was roughly 5% when the Fed started lowering rates to combat the financial crisis. Today, if the Fed started lowering rates to combat economic weakness,  they would do so from less than half that previous rate.

As Richard Clarida noted in his speech, one of the potential risks to Central Banks globally is the lack of monetary policy firepower available. We previously pointed out that in 2009, the Fed went to work to rescue the economy with a $915 billion balance sheet and Fed Funds at 4.2%. Today, that balance sheet remains above $4 trillion and rates are at 2.5%.

It isn’t lost on the Fed that if a recession were to occur, their main lever for stimulating economic activity, interest rate reductions, will have little value. Given the amount of debt outstanding and the onerous burden of servicing it, the marginal benefit of lower rates will likely not be enough to lift the country out of a recession. In such a tough situation the next lever at their disposal is increasing their balance sheet and flooding the markets with liquidity via QE.

However, even that may not be enough as both Ben Bernanke and Janet Yellen have acknowledged that they were aware that each successive round of QE was somewhat less effective than the last. That certainly must be a concern for Powell if he is called upon to re-engage QE in a recession or another economic crisis.

For the Federal Reserve, they are now caught in the same “liquidity trap” that has been the history of Japan for the last three decades. One only needs to look at Japan for an understanding that QE, low-interest rate policies, and expansion of debt have done little economically. Take a look at the chart below which shows the expansion of the BOJ assets versus the growth of GDP and levels of interest rates.

Notice that since 1998, Japan has not achieved a 2% rate of economic growth. Even with interest rates still near zero, economic growth remains mired below one-percent, providing little evidence to support the idea that inflating asset prices by buying assets leads to stronger economic outcomes.

But yet, the current Administration believes our outcome will be different.

With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs.

This is the same problem that Japan has wrestled with for the last 30-years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. 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 drawing on social benefits at an advancing rate.
  • 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 real concern for investors, and individuals, is the actual economy. We are likely experiencing more than just a ‘soft patch’ currently despite the mainstream analysts’ rhetoric to the contrary. There is clearly something amiss within the economic landscape and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get out of the ‘liquidity trap’ they have gotten themselves into without cratering the economy, and the financial markets, in the process.

The One Thing

However, the one statement, which is arguably the most important for investors, is what Bill Dudley stated relative to the size of the balance sheet and it’s use a tool to stem the next decline.

“The balance sheet tool becomes relevant only if the economy falters badly and the Fed needs more ammunition.”

In other words, it will likely require a substantially larger correction than what we have just seen to bring “QE” back into the game. Unfortunately, as I laid out in “Why Another 50% Correction Is Possible,” the ingredients for a “mean-reverting” event are all in place.

“What causes the next correction is always unknown until after the fact. However, there are ample warnings that suggest the current cycle may be closer to its inevitable conclusion than many currently believe. There are many factors that can, and will, contribute to the eventual correction which will ‘feed’ on the unwinding of excessive exuberance, valuations, leverage, and deviations from long-term averages.

The biggest risk to investors currently is the magnitude of the next retracement. As shown below the range of potential reversions runs from 36% to more than 54%.”

“It’s happened twice before in the last 20 years and with less debt, less leverage, and better-funded pension plans.

More importantly, notice all three previous corrections, including the 2015-2016 correction which was stopped short by Central Banks, all started from deviations above the long-term exponential trend line. The current deviation above that long-term trend is the largest in history which suggests that a mean reversion will be large as well.

It is unlikely that a 50-61.8% correction would happen outside of the onset of a recession. But considering we are already pushing the longest economic growth cycle in modern American history, such a risk which should not be ignored.”

While Bill makes the point that “QE” is available as a tool, it won’t likely be used until AFTER the Fed lowers interest rates back to the zero-bound. Which means that by the time “QE” comes to the fore, the damage to investors will likely be much more severe than currently contemplated.

Yes, the Fed absolutely targets the financial markets with their policies. The only question will be what “rabbit” they pull out of their hat if it doesn’t work next time?

I am not sure even they know.

The Fed Conundrum – Data Or Markets?

Following the Fed’s last meeting, we published for our RIA PRO subscribers (use code PRO30 for a 30-day free trial) a simple question:

“What does the Fed know?”

Of course, this meeting followed the stock market plunge at the end of 2018 where their tone that turned from “hawkish” to “dovish” in the span of just a few weeks. Seemingly, despite the previous commentary about concerns over rising inflationary pressures, it was pressure from Wall Street and the White House that quickly “realigned” the Fed’s views.

  • The Fed will be “patient” with future rate hikes, meaning they are now likely on hold as opposed to their forecasts which still call for two to three more rate hikes this year.
  • The pace of QT or balance sheet reduction will not be on “autopilot” but instead driven by the current economic situation and tone of the financial markets.
  • QE is a tool that WILL BE employed when rate reductions are not enough to stimulate growth and calm jittery financial markets.

This change in stance, not surprisingly, buoyed the stock market as the proverbial “Fed Put” was back in place.

But the change view may have also just trapped the Fed in their own “data dependent” decision-making process.

The Fed Should Be Hiking Rates

As we noted in our RIA Pro article:

“During the press conference, the Chairman was asked what has transpired since the last meeting on December 19, 2019, to warrant such an abrupt change in policy given that he recently stated that policy was accommodative, and the economy did not require such policy anymore.

In response, Powell stated:

‘We think our policy stance is appropriate right now. We do. We also know that our policy rate is now in the range of the committee’s estimates of neutral.'”

Powell’s awkward response, and unsatisfactory rationale to a simple and obvious question, the question must be asked if it is possible that economic or credit risks are greater than currently believed which would account for the policy U-turn?

However, given that the Fed’s two primary mandates are supposed to be “full employment” and “price stability,” the conflict between managing inflation and supporting the markets is a conundrum.

For example, there is currently sufficient data which suggests “real inflationary pressures” are mounting in the economy. For example, with a 300,000 job print in January and rising wage pressures, the Fed should raise interest rates. The chart below of labor costs clearly show the problem business owners are facing.

As noted employment remains strong and data suggests there is upward pressure on companies to hire more workers.

That pressure to hire is coming from the reality there are currently more demands on labor than there are people to fill them.

Wage pressures are clearly rising in recent months putting additional upward pressures on pricing as companies pass on higher labor costs.

More importantly, inflationary pressures as measured by both PPI, CPI, and the Fed’s preferred measure of Core PCE, continue to rise as well.

The chart below is the spread between PPI and CPI, historically, when “producer price” inflation rises faster than consumer prices, it has impacted economic growth by suggesting that inflation can’t be passed on to consumers.

The composite inflation index is also screaming higher suggesting that if the Fed pauses they could potentially get well “behind the curve.” 

Even the Federal Reserve’s favorite measure of inflation, PCE, is also suggesting the Fed should be hiking rates rather than pausing.

All of this data clearly suggests that the Fed should be hiking rates currently, rather than pausing. 

The Conundrum

However, all of this data is also consistent with the end of an economic cycle rather than a continued expansion. As we quoted last week from John Mauldin:

I think because unemployment is lowest when the economy is in a mature growth cycle, and stock returns are in the process of flattening and rolling over. Sadly, that is where we seem to be right now. Unemployment is presently in the ‘low’ range which, in the past, often preceded a recession.

That loss of confidence is already beginning to show signs as noted recently by Zerohedge:

“American small-business owners are growing increasingly anxious about a looming economic slowdown.

After a report published last week by Vistage Worldwide suggested that small-business confidence had collapsed with the number of small business owners worried that the economy could worsen in 2019 numbering more than twice those who expected it to improve, the NFIB Small Business Optimism Index – a widely watched sentiment gauge – apparently confirmed that more business owners are growing fearful that economic conditions might begin to work against them in the coming months.”

Furthermore, most of these data points are at levels that typically precede economic slowdowns and recession, so hiking rates further from current levels could exacerbate the recessionary risk.

The problem the Fed faces currently, as we discussed previously, is that when the last recession started the Fed Funds rate was at 4.2% not 2.2% and the Fed balance sheet was $915 billion not $4+ trillion.

“If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion dollar balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But…what do you do?

The Trap

There are clearly rising inflationary pressures on the market, which are also beginning to impede economic growth. Those pressures, combined with a sharp decline in asset prices, spurred the Fed to react to political and market pressures.

The Fed is most likely aware that if a recession were to occur, their main lever for stimulating economic activity, interest rate reductions, will have little value. Given the amount of debt outstanding and the onerous burden of servicing it, the marginal benefit of lower rates will likely not provide enough benefits to lift the country out of a recession. In such a tough situation the next lever at their disposal is increasing their balance sheet and flooding the markets with liquidity via QE.

Sure, Powell might be taking a dovish tone to placate the markets, the President and his member banks and concurrently buying time to further normalize the balance sheet? But this approach is like pouring liquid out of your cup so you can add more when the time is right. You would do this because it is not clear just how much “the cup” will ultimately hold.

Bernanke and Yellen have both acknowledged that they were aware that each successive round of QE was somewhat less effective than prior rounds. That certainly must be a concern for Powell if he is called upon to re-engage QE in a recession or another economic crisis.

If this is the case, Powell will continue to publicly discuss minimizing reductions to the balance sheet and refrain from further rate hikes. Despite such dovish Fed-speak, he would continue to shrink the balance sheet at the current pace. This tactic may trick investors for a few months but at some point, the market will question his intentions and damage Fed credibility.

So, therein lies the trap. Do you hike rates and reduce the balance sheet anyway to be better prepared for the onset of the next recession, OR reverse policy to try to “kick the recession can” down the road a bit which leaves you under-prepared for the next crisis?

For the Fed, it is a choice between the lesser of two evils. The only question is did they make the right one?

While the Fed has a long history of using economic jargon and, quite frankly, non-truths to help promote their agenda, they also have a long history of making the wrong policy moves which spark either some sort of crisis, recession or both.

As Michael Lebowitz concluded for our RIA PRO subscribers last week:

“The market has largely recovered from the fourth quarter swoon, as such the Fed should be resting more comfortably. Economic data remains strong, and if anything it is slightly better than December when the Fed was ready to raise rates three times and put balance sheet reduction on “autopilot.”

Today the Fed has all but put the kibosh on further rate hikes and, per Mester’s comments, will end balance sheet reduction (QT) in the months ahead.

It is becoming more suspect that the Fed knows something the market does not.”

But, exactly what is it?

Recession Risks Are Likely Higher Than You Think

It is often said that one should never discuss religion or politics as you are going to wind up offending someone. In the financial world it is mentioning the “R” word.

The reason, of course, is that it is the onset of a recession that typically ends the “bull market” party. As the legendary Bob Farrell once stated:

“Bull markets are more fun than bear markets.”

Yet, recessions are part of a normal and healthy economy that purges the excesses built up during the first half of the cycle.

economic_cycle-2

Since “recessions” are painful, as investors, we would rather not think about the “good times” coming to an end. However, by ignoring the risk of a recession, investors have historically been repeatedly crushed by the inevitable completion of the full market and economic cycle.

But after more than a decade of an economic growth cycle, investors have become complacent in the idea that recessions may have been mostly mitigated by monetary policy.

While monetary policy can certainly extend cycles, they cannot be repealed.

Given that monetary policy has consistently inflated asset prices historically, the reversions of those excesses have been just as dramatic. The table below shows every economic recovery and recessionary cycle going back to 1873.

Importantly, note that the average recessionary drawdown historically is about 30%. While there were certainly some recessionary drawdowns which were very small, the majority of the reversions, particularly from more extreme overvaluation levels as we are currently experiencing, have not been kind to investors.

So, why bring this up?

“In the starkest warning yet about the upcoming global recession, which some believe will hit in late 2019 or 2020 at the latest, the IMF warned that the leaders of the world’s largest countries are ‘dangerously unprepared’ for the consequences of a serious global slowdown. The IMF’s chief concern: much of the ammunition to fight a slowdown has been exhausted and governments will find it hard to use fiscal or monetary measures to offset the next recession, while the system of cross-border support mechanisms — such as central bank swap lines — has been undermined.” – David Lipton, first deputy managing director of the IMF.

Despite recent comments that “recession risk” is non-existent, there are various indications which suggest that risk is much higher than currently appreciated.  The New York Federal Reserve recession indicator is now at the highest level since 2008.

Also, as noted by George Vrba recently, the unemployment rate may also be warning of a recession as well.

“For what is considered to be a lagging indicator of the economy, the unemployment rate provides surprisingly good signals for the beginning and end of recessions. This model, backtested to 1948, reliably provided recession signals.

The model, updated with the January 2019 rate of 4.0%, does not signal a recession. However, if the unemployment rate should rise to 4.1% in the coming months the model would then signal a recession.”

John Mauldin also recently noted the same:

“This next chart needs a little explaining. It comes from Ned Davis Research via my friend and business partner Steve Blumenthal. It turns out there is significant correlation between the unemployment rate and stock returns… but not the way you might expect.

Intuitively, you would think low unemployment means a strong economy and thus a strong stock market. The opposite is true, in fact. Going back to 1948, the US unemployment rate was below 4.3% for 20.5% of the time. In those years, the S&P 500 gained an annualized 1.7%.”

“Now, 1.7% is meager but still positive. It could be worse. But why is it not stronger? I think because unemployment is lowest when the economy is in a mature growth cycle, and stock returns are in the process of flattening and rolling over. Sadly, that is where we seem to be right now. Unemployment is presently in the ‘low’ range which, in the past, often preceded a recession.

The yield spread between the 10-year and the 2-year Treasury yields is also suggesting there is a rising risk of a recession in the economy.

As I noted previously:

“The yield curve is clearly sending a message that shouldn’t be ignored and it is a good bet that ‘risk-based’ investors will likely act sooner rather than later. Of course, it is simply the contraction in liquidity that causes the decline which will eventually exacerbate the economic contraction. Importantly, since recessions are only identified in hindsight when current data is negatively revised in the future, it won’t become ‘obvious’ the yield curve was sending the correct message until far too late to be useful.

While it is unwise to use the ‘yield curve’ as a ‘market timing’ tool, it is just as unwise to completely dismiss the message it is currently sending.”

We can also see the slowdown in economic activity more clearly we can look at our RIA Economic Output Composite Index (EOCI). (The index is comprised of the CFNAI, Chicago PMI, ISM Composite, All Fed Manufacturing Surveys, Markit Composite, PMI Composite, NFIB, and LEI)

As shown, over the last six months, the decline in the LEI has actually been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

With the exception of the yield curve, which is “real time,” the rest of the data is based on economic data which has a multitude of problems.

There are many suggesting currently that based on current economic data, there is “no recession” in sight. This is based on looking at levels of economic data versus where “recessions” started in the past.

But therein lies the biggest flaw.

“The problem with making an assessment about the state of the economy today, based on current data points, is that these numbers are ‘best guesses’ about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

‘The Federal Reserve is not currently forecasting a recession.’

In hindsight, the NBER called an official recession that began in December of 2007.”

The issue with a statement of “there is no recession in sight,” is that it is based on the “best guesses” about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

“The Federal Reserve is not currently forecasting a recession.”

In hindsight, the NBER called an official recession that began in December of 2007.

But this is almost always the case. Take a look at the data below of real (inflation-adjusted)economic growth rates:

  • September 1957:     3.07%
  • May 1960:                 2.06%
  • January 1970:        0.32%
  • December 1973:     4.02%
  • January 1980:        1.42%
  • July 1981:                 4.33%
  • July 1990:                1.73%
  • March 2001:           2.31%
  • December 2007:    1.97%

Each of the dates above shows the growth rate of the economy immediately prior to the onset of a recession.  In 1957, 1973, 1981, 2001, 2007 there was “no sign of a recession.” 

The next month a recession started.

So, what about now?

“The recent decline from the peak in the market, is just that, a simple correction. With the economy growing at 3.0% on an inflation-adjusted basis, there is no recession in sight.” 

Is that really the case or is the market telling us something?

The chart below is the S&P 500 two data points noted.

The green dots are the peak of the market PRIOR to the onset of a recession. In 8 of 9 instances, the S&P 500 peaked and turned lower prior to the recognition of a recession. The yellow dots are the official recessions as dated by the National Bureau of Economic Research (NBER) and the dates at which those proclamations were made.

At the time, the decline from the peak was only considered a “correction” as economic growth was still strong.

In reality, however, the market was signaling a coming recession in the months ahead. The economic data just didn’t reflect it as of yet. (The only exception was 1980 where they coincided in the same month.) The chart below shows the date of the market peak and real GDP versus the start of the recession and GDP growth at that time.

The problem is in waiting for the data to catch up.

Today, we are once again seeing many of the same early warnings. If you have been paying attention to the trend of the economic data, the stock market, and the yield curve, the warnings are becoming more pronounced. In 2007, the market warned of a recession 14-months in advance of the recognition. 

So, therein lies THE question:

Is the market currently signaling a “recession warning?”

Everybody wants a specific answer. “Yes” or “No.

Unfortunately, making absolute predictions can be extremely costly when it comes to portfolio management.

There are three lessons to be learned from this analysis:

  1. The economic “number” reported today will not be the same when it is revised in the future.
  2. The trend and deviation of the data are far more important than the number itself.
  3. “Record” highs and lows are records for a reason as they denote historical turning points in the data.

As Doug Kass noted on Tuesday there are certainly plenty of risks to be aware of:

  1. Domestic economic growth weakens, Chinese growth fails to stabilize and Europe enters a recession
  2. U.S./China fail to agree on a trade deal
  3. Trump institutes an attack on European Union trade by raising auto tariffs
  4. U.S. Treasury yields fail to ratify an improvement in economic growth
  5. The market leadership of FANG and Apple (AAPL) subsidies
  6. Earnings decline in 2019 and valuations fail to expand
  7. The Mueller Report jeopardizes the president
  8. A hard and disruptive Brexit
  9. Crude oil supplies spike and oil prices collapse, taking down the high-yield market
  10. Draghi is replaced by a hawk

While the call of a “recession” may seem far-fetched based on today’s economic data points, no one was calling for a recession in early 2000, or 2007, either. By the time the data is adjusted, and the eventual recession is revealed, it won’t matter as the damage will have already been done.

Pay attention to the message markets are sending. It may just be saying something very important.

Dalio’s Fear Of The Next Downturn Is Likely Understated

“What scares me the most longer term is that we have limitations to monetary policy — which is our most valuable tool — at the same time we have greater political and social antagonism.” – Ray Dalio, Bridgewater Associates

Dalio made the remarks in a panel discussion at the World Economic Forum’s annual meeting in Davos on Tuesday where he reiterated that a limited monetary policy toolbox, rising populist pressures and other issues, including rising global trade tensions, are similar to the backdrop present in the latter part of the Great Depression in the late 1930s.

Before you dismiss Dalio’s view Bridgewater’s Pure Alpha Strategy Fund posted a gain of 14.6% in 2018, while the average hedge fund dropped 6.7% in 2018 and the S&P 500 lost 4.4%.

The comments come at a time when a brief market correction has turned monetary and fiscal policy concerns on a dime. As noted by Michael Lebowitz yesterday afternoon at RIA PRO

“In our opinion, the Fed’s new warm and cuddly tone is all about supporting the stock market. The market fell nearly 20% from record highs in the fourth quarter and fear set in. There is no doubt President Trump’s tweets along with strong advisement from the shareholders of the Fed, the large banks, certainly played an influential role in persuading Powell to pivot.

Speaking on CNBC shortly after the Powell press conference, James Grant stated the current situation well.

“Jerome Powell is a prisoner of the institutions and the history that he has inherited. Among this inheritance is a $4 trillion balance sheet under which the Fed has $39 billon of capital representing 100-to-1 leverage. That’s a symptom of the overstretched state of our debts and the dollar as an institution.”

As Mike correctly notes, all it took for Jerome Powell to completely abandon any facsimile of “independence” was a rough December, pressure from Wall Street’s member banks, and a disgruntled White House to completely flip their thinking.

In other words, the Federal Reserve is now the “market’s bitch.”

However, while the markets are celebrating the very clear confirmation that the “Fed Put” is alive and well, it should be remembered these “emergency measures” are coming at a time when we are told the economy is booming.

“We’re the hottest economy in the world. Trillions of dollars are flowing here and building new plants and equipment. Almost every other data point suggests, that the economy is very strong. We will beat 3% economic growth in the fourth quarter when the Commerce Department reopens. 

We are seeing very strong chain sales. We don’t get the retail sales report right now and we see very strong manufacturing production. And in particular, this is my favorite with our corporate tax cuts and deregulation, we’re seeing a seven-month run-up of the production of business equipment, which is, you know, one way of saying business investment, which is another way of saying the kind of competitive business boom we expected to happen is happening.” – Larry Kudlow, Jan 24, 2019.

Of course, the reality is that while he is certainly “spinning the yarn” for the media, the Fed is likely more concerned about “reality” which, as the data through the end of December shows, the U.S. economy is beginning to slow.

“As shown, over the last six months, the decline in the LEI has actually been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

Limited Monetary Tool Box

As Dalio noted, one of the biggest issues facing global Central Banks is the ongoing effectiveness of “Quantitative Easing” programs. As previously discussed:

“Of course, after a decade of Central Bank interventions, it has become a commonly held belief the Fed will quickly jump in to forestall a market decline at every turn. While such may have indeed been the case previously, the problem for the Fed is their ability to ‘bail out’ markets in the event of a ‘credit-related’ crisis.”

“In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%.

If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion dollar balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But it isn’t just the issue of the Fed’s limited toolbox, but the combination of other issues, outside of those noted by Dalio, which have the ability to spur a much larger

The nonprofit National Institute on Retirement Security released a study in March stating that nearly 40 million working-age households (about 45 percent of the U.S. total) have no retirement savings at all. And those that do have retirement savings don’t have enough. As I discussed recently, the Federal Reserve’s 2016 Survey of consumer finances found that the mean holdings for the bottom 80% of families with holdings was only $199,750.

Such levels of financial “savings” are hardly sufficient to support individuals through retirement. This is particularly the case as life expectancy has grown, and healthcare costs skyrocket in the latter stages of life due historically high levels of obesity and poor physical health. The lack of financial stability will ultimately shift almost entirely onto the already grossly underfunded welfare system.

However, that is for those with financial assets heading into retirement. After two major bear markets since the turn of the century, weak employment and wage growth, and an inability to expand debt levels, the majority of American families are financially barren. Here are some recent statistics:

  1. 78 million Americans are participating in the “gig economy” because full-time jobs just don’t pay enough to make ends meet these days.
  2. In 2011, the average home price was 3.56 times the average yearly salary in the United States. But by the time 2017 was finished, the average home price was 4.73 times the average yearly salary in the United States.
  3. In 1980, the average American worker’s debt was 1.96 times larger than his or her monthly salary. Today, that number has ballooned to 5.00.
  4. In the United States today, 66 percent of all jobs pay less than 20 dollars an hour.
  5. 102 million working age Americans do not have a job right now.  That number is higher than it was at any point during the last recession.
  6. Earnings for low-skill jobs have stayed very flat for the last 40 years.
  7. Americans have been spending more money than they make for 28 months in a row.
  8. In the United States today, the average young adult with student loan debt has a negative net worth.
  9. At this point, the average American household is nearly $140,000 in debt.
  10. Poverty rates in U.S. suburbs “have increased by 50 percent since 1990”.
  11. Almost 51 million U.S. households “can’t afford basics like rent and food”.
  12. The bottom 40 percent of all U.S. households bring home just 11.4 percent of all income.
  13. According to the Federal Reserve, 4 out of 10 Americans do not have enough money to cover an unexpected $400 expense without borrowing the money or selling something they own. 
  14. 22 percent of all Americans cannot pay all of their bills in a typical month.
  15. Today, U.S. households are collectively 13.15 trillion dollars in debt.  That is a new all-time record.

Here is the problem with all of this.

Despite Central Bank’s best efforts globally to stoke economic growth by pushing asset prices higher, the effect is nearly entirely mitigated when only a very small percentage of the population actually benefit from rising asset prices. The problem for the Federal Reserve is in an economy that is roughly 70% based on consumption, when the vast majority of American’s are living paycheck-to-paycheck, the aggregate end demand is not sufficient to push economic growth higher.

While monetary policies increased the wealth of those that already have wealth, the Fed has been misguided in believing that the “trickle down” effect would be enough to stimulate the entire economy. It hasn’t. The sad reality is that these policies have only acted as a transfer of wealth from the middle class to the wealthy and created one of the largest “wealth gaps” in human history.

The real problem for the economy, wage growth and the future of the economy is clearly seen in the employment-to-population ratio of 16-54-year-olds. This is the group that SHOULD be working and saving for their retirement years.

The current economic expansion is already set to become the longest post-WWII expansion on record. Of course, that expansion was supported by repeated artificial interventions rather than stable organic economic growth. As noted, while the financial markets have soared higher in recent years, it has bypassed a large portion of Americans NOT because they were afraid to invest, but because they have NO CAPITAL to invest with.

To Dalio’s point, the real crisis will come during the next economic recession.

While the decline in asset prices, which are normally associated with recessions, will have the majority of its impact at the upper end of the income scale, it will be the job losses through the economy that will further damage and already ill-equipped population in their prime saving and retirement years.

Furthermore, the already grossly underfunded pension system will implode.

An April 2016 Moody’s analysis pegged the total 75-year unfunded liability for all state and local pension plans at $3.5 trillion. That’s the amount not covered by current fund assets, future expected contributions, and investment returns at assumed rates ranging from 3.7% to 4.1%. Another calculation from the American Enterprise Institute comes up with $5.2 trillion, presuming that long-term bond yields average 2.6%.

The massive amount of corporate debt, when it begins to default, will trigger further strains on the financial and credit systems of the economy.

Dalio’s View Is Likely Understated. 

The real crisis comes when there is a “run on pensions.” With a large number of pensioners already eligible for their pension, the next decline in the markets will likely spur the “fear” that benefits will be lost entirely. The combined run on the system, which is grossly underfunded, at a time when asset prices are dropping will cause a debacle of mass proportions. It will require a massive government bailout to resolve it.

But it doesn’t end there. Consumers are once again heavily leveraged with sub-prime auto loans, mortgages, and student debt. When the recession hits, the reduction in employment will further damage what remains of personal savings and consumption ability. The downturn will increase the strain on an already burdened government welfare system as an insufficient number of individuals paying into the scheme is being absorbed by a swelling pool of aging baby-boomers now forced to draw on it. Yes, more Government funding will be required to solve that problem as well. 

As debts and deficits swell in the coming years, the negative impact to economic growth will continue. At some point, there will be a realization of the real crisis. It isn’t a crash in the financial markets that is the real problem, but the ongoing structural shift in the economy that is depressing the living standards of the average American family. There has indeed been a redistribution of wealth in America since the turn of the century. Unfortunately, it has been in the wrong direction as the U.S. has created its own class of royalty and serfdom.

The issue for future politicians won’t be the “breadlines” of the 30’s, but rather the number of individuals collecting benefit checks and the dilemma of how to pay for it all.

The good news, if you want to call it that, is that the next “crisis,” will be the “great reset” which will also make it the “last crisis.”

Exclusive Interview: Peter Boockvar

Last week, I visited with Peter Boockvar, Chief Investment Officer at Bleakley Advisory Group and Editor of The Boock Report. He previously was the Chief Market Analyst for The Lindsey Group, a macro economic and market research firm started by Larry Lindsey. Prior to this, Peter spent a brief time at Omega Advisors, a New York-based hedge fund, as a macro analyst and portfolio manager. Before this, he was an employee and partner at Miller Tabak + Co for 18 years where he was recently the equity strategist and a portfolio manager with Miller Tabak Advisors.

Peter and I cover a wide range of topics from the market, the coming recession, the impact and risks of higher rates, and the Federal Reserve.

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Exclusive Interview: Chris Martenson

I recently spent some time with Chris Martenson from Peak Prosperity about the market, the economy, and the “Great Reset” which is approaching.

Chris Martenson, PhD (Duke), MBA (Cornell) is an economic researcher and futurist specializing in energy and resource depletion, and co-founder of PeakProsperity.com (along with Adam Taggart). As one of the early econobloggers who forecasted the housing market collapse and stock market correction years in advance, Chris rose to prominence with the launch of his seminal video seminar: The Crash Course which has also been published in book form (Wiley, March 2011). It’s a popular and extremely well-regarded distillation of the interconnected forces in the Economy, Energy and the Environment (the “Three Es” as Chris calls them) that are shaping the future, one that will be defined by increasing challenges to growth as we have known it. In addition to the analysis and commentary he writes for his site PeakProsperity.com, Chris’ insights are in high demand by the media as well as academic, civic and private organizations around the world, including institutions such as the UN, the UK House of Commons and US State Legislatures.

The interview has been broken down into 3-chapters for your viewing consumption.

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Exclusive Interview: Daniel LaCalle

My interview with Daniel LaCalle on everything from Central Bank policy, interest rates, market risk, and the future of economic growth.

Read more from Daniel Lacalle at D-Lacalle.com

Daniel Lacalle is a PhD in Economy and fund manager. He holds the CIIA financial analyst title, with a post graduate degree in IESE and a master’s degree in economic investigation (UCV).

  • Chief Economist at Tressis SV
  • Fund Manager at Adriza International Opportunities.
  • Member of the advisory board of the Rafael del Pino foundation.
  • Commissioner of the Community of Madrid in London.
  • President of Instituto Mises Hispano.
  • Professor at IE business school, IEB and UNED.
  • Ranked Top 20 most influential economist in the world 2016

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Exclusive Interview: Doug Kass

My interview with the brilliant Doug Kass on the recent market rout, his views on the world, economic growth, and earnings outlook going into next year. We also talk bonds, market cycles, and why the bull market remains at risk.

You can subscribe to Doug’s excellent commentary at Real Money Pro

Doug cut his teeth as an investigator and truth-teller as a member of “Nader’s Raiders,” Ralph Nader’s crusaders for consumer protection and safety. In fact, he co-authored Citibank: The Ralph Nader Report with Ralph Nader and the Center for the Study of Responsive Law.

Kass started his investment career as a housing analyst at Kidder, Peabody in 1972 after receiving his bachelor’s from Alfred University and his MBA in Finance from the University of Pennsylvania’s Wharton School.

After holding a number of senior positions at brokerages, hedge funds and other institutions for the next three decades, he launched his own hedge fund, Seabreeze Partners Management, where he is President.

At Seabreeze, and as the top investor at Real Money Pro, Doug Kass identifies big winners again and avoids nasty losses by challenging Wall Street’s conventional wisdom.

He’s appeared in the New York Times, Wall Street Journal, Bloomberg, Barron’s, The Washington Post, The New York Post, CNBC and most major financial media.


Why The Dominant Investor Is The Most Dangerous


Three Ways To Most Gainfully Spend Time As An Investor


How To Navigate A Market Dominated By Passivity


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VLOG: Rising Rates Send A Warning & Why It Matters

While it has been stated that rising interest rates don’t matter, the reality is that they do. I take a deeper look at the impact of higher rates across the financial and economic spectrum and the warning that rates are currently sending to investors.

Orignal Article: Did Something Just Break?



 

VLOG – Why $1 Million Ain’t What It Used To Be

Clarity Financial Chief Investment Strategist Lance Roberts reviews the ugly truth behind numbers revealing that being a millionaire doesn’t quite have the same cache it did 30-years ago.

Also, why buy and hold investing, while it will make you money, won’t meet your financial goals in the future.


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VLOG – Are Markets Set To Soar Like 1992?

Clarity Financial Chief Financial Strategist Lance Roberts reviews the history of stock valuations, the CAPE, and how what happened in the early ’90’s is relevant to investors of the twenty-teens.

Orignal Article: Party Like It’s 1992


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VLOG – Why Smart Investors Should Fear An Inversion

Clarity Financial Chief Investment Strategist Lance Roberts shows why the danger of asset bubbles in every investment class is part of a recipe for reversal as the bond yield curves begin to invert…and what that means for your money.

Original Forbes Article By Jesse Colombo

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VLOG – Markets Diverge From The U.S.

Clarity Financial Chief Investment Strategist Lance Roberts examines the divergence of world markets to the U.S. and discusses the message they may be sending to investors.