Borrowed Growth is Unsustainable
Personal and business failure can be attributed to one single four-letter word. If products don't sell, or strikes hit production, or fraudulent activity harms the balance sheet, there will be one overriding issue that leads to the collapse of a business. Similarly, if an individual loses his job, or sees his mortgage payments or rent rise, or suffers uninsured losses then he may face bankruptcy because of a single issue.
That single issue, for both businesses and individuals, is debt.
Now debt, per se, is not necessarily a bad thing. The wise use of debt enables companies to grow and take on new employees. Debt can help an economy to expand. Individuals increase their status and quality of life by taking on debt. Without a mortgage, there would be few that could afford to buy their own home and build wealth - or not, for those millions caught in the negative equity trap.
However, poor judgement in taking on debt, or the inability to service debt, will lead to financial hardship, and possibly the bankruptcy of businesses. This in turn will lead to loss of jobs, individual bankruptcies, non-payment of mortgages and other debts, and a downward spiral leading to economic recession, or even depression. When such a scenario threatens, governments step in, increase their borrowing and pump money into the economy. This is exactly what the US Government has been doing since 2009, issuing treasuries and initiating quantitative easing, and seeing interest rates fall through the floor.
Some would have it that the economy has been well managed and the Obama administration has steered a difficult course remarkably well.
Looking at the gross domestic product and gross debt figures over the last 30 years tells a different story, and one that shows successive US administrations have overseen false growth at the expense of the long term wealth of the nation.
1980 to 2000
Through this period gross domestic product grew from $2.78 trillion to $9.88 trillion, a rise of 255%. At the same time, as the government steered the economy through downturns and upswings, the gross debt of the nation increased from $0.91 trillion to $5.67 trillion, an increase of 523%. At this time, gross national debt had started to be paid down. From 1998 to 2001, the US ran budget surpluses with the surplus in 2000 being $236 billion.
Subtracting the increase in gdp from the increase in the gross national debt, it could be said that the US government added $2.34 trillion of borrowed money into the economy. In other words, a portion of the economic growth over the period was borrowed.
Of course, it could be argued that much of this debt was due to war. But it could be similarly argued that such spending adds into the economy anyway, as arms are bought and paid for, factories take on staff, and military personnel levels increase.
2000 to 2011
With the bursting of the tech bubble, the US Government began to increase spending to prop up the economy. Without the taxes to support this spending, borrowings increased. Through this period, gross national debt has increased to over 100% of gdp, from its 1980 level of 32% and its 200 level of 57%.
Gross domestic product grew from $9.88 trillion to $15.06 trillion, an increase of 52%. Gross national debt, meanwhile has ballooned to $15.17 trillion, a whopping 167% more than at the start of the century.
Overall, using the method of calculation above, the government has added in $4.32 trillion of spending into the economy, with borrowed money.
Paying for this debt
Much of this $15 trillion of debt is serviced with interest payments on treasury notes. In 1980, the interest rate on the 10-year treasuries was 12.84%. In 1990, this interest rate had fallen to 8.08%, and by 2000 had fallen further to 5.24%. It now stands at 1.98%. Interest payments on the debt alone stood at $454 billion last year.
What about the future?
The Congressional Budget Office (CBO) paints a rosy forecast for the future of the US economy. It expects real gdp growth of between 2.3% and 3.8% in each of the next 12 years. This will take the annual US gdp to $24 trillion in 2021. Over the same period, it is forecasting that the budget deficit will remain, though fall as low as $533 billion in 2014 before rising again to $763 billion in 2021. The net effect on gross national debt is that it will increase to £22.14 trillion by 2021, or 92% of gdp.
Risks to these forecasts
In making these forecasts, the CBO makes two key assumptions. Firstly it contends that interest rates will remain low: we already know that the Fed has indicated a 'zero interest rate policy' through to 2014. The CBO believes rates on 10-year treasuries will rise to 4.6% by the end of 2014.
Further, core inflation throughout the full period is expected to average around 2%.
I believe that these assumptions are too optimistic.
The oil price is high and will likely remain high, putting greater upward pressure on prices than currently assumed. Interest rates will rise accordingly - though the FOMC has stated its interest rate policy, there is dissenting voices among its members, six of whom believe interest rates will start moving up as early as 2012. One even thinks that rates will hit 2.75% by late 2013. Such a hike in rates would dampen an economy that is already living on borrowed money.
If economic growth does not match predictions, and with general interest rates rising, then treasuries rate may have to rise further and faster than assumed. This will add to the budget deficit still further.
Where does this leave equities?
US equity markets have doubled in value over the last three years. At current levels, I think that the optimism of the CBO and its forecasts has been fully taken on board. Any undershooting of economic growth, or overshooting of budget deficits will knock the market hard.
It is my view that much of the growth in the economy over the last 30 years has been 'borrowed' from the future. At some time, this debt will have to be repaid and growth will suffer. The longer it is left and added to, the higher the final payment and the worse the pain.
Clearly, with over $48,000 of national debt for every man woman and child in the USA, the medicine needed to correct this balance can not be taken in one spoonful. The repayment of the national debt will be a long, slow, and painful process.
The last time that US debt levels were as high as they are now in comparison with gdp was during World War II. For the next decade and more, the US prospered as rebuilding took place worldwide and American companies benefited. I see no such advantage this time around. Whilst it would appear that the economy has been well managed to prosperity, it is my contention that much of the economic growth over the last thirty years has been false and due to political greed, rather than for the good of the long-term wealth of the nation. If the US were a publicly quoted company, she would long ago have filed for Chapter 11.
Investors should be armed and ready for a move down in equity valuations toward the long term average price to earnings ratio of around 16 on the S&P 500 Index from its current multiple of 22.7. Such a re-rating, were it to occur today, would lead to a fall to around 1000 on the S&P 500 from current levels of 1370. When such a move will occur is difficult to predict, but may coincide with rising interest rates and further attempted cuts in government spending.
There is, of course, another scenario, which may be even more painful for equity investors. I believe that a long and sustained period of consolidation between current levels and those seen in 2009, with dividend payments the only real return, will prevail. Each upturn will be seen with renewed optimism that the end of the long-term bear market is in sight, with those hopes dashed as markets fall again. Market timing will be key to profitable investing.
Equity indices have marked time through the last ten years; they look likely to do so for some time to come.