A New Word
Readers of this article will encounter a new word to add to their lexicon — OmniBubble. Why OmniBubble? The word “omni” means “all” or “everywhere” and frequently connects in words like omnipotence. The inescapable conclusion is that we're encircled by a series of omnipotent financial bubbles that will ultimately suffocate the world economy.
The world economy is experiencing these bubbles due to the fear and loathing central bank wizards have towards deflation. In what can only be described as an irony of ironies, the Bank for International Settlements, the central bank of central banks, suggests:
Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive.
If the central banker’s central bank has this opinion, what’s motivating the Fed, the BoJ, and the ECB (just to name a few) to loathe the "D" word? Perhaps the independently-minded central banks are influenced by outside forces? Maybe it's a byproduct of questionable financial models?
While I'll let others debate these questions, why don't we focus on the components of the OmniBubble.
Real Estate Running Hot
Cast aside what you think home prices should be. In the aggregate, we should expect prices to reflect the earnings of working women and men. The graph below reveals something quite different.
This graph plots Average Hourly Earnings (red line) with Median Prices for New Homes (blue line). Both values were indexed to January 1, 1998 to show relative movement. During the period labeled “Housing Bubble 1.0,” it took about 4 years for housing prices to decouple from earnings and reach their peak. During the current bubble, “Housing Bubble 2.0,” it is closer to 6 years. The current bubble has been stronger and more persistent than the previous version. At a minimum, we should expect the blue line to converge with the red line, implying a noticeable fall in real estate prices. Of course, your local conditions will vary.
There are other factors (employment-population ratios, labor participation, birth rate, home ownership rate) also demonstrating that real estate prices have gotten ahead of where they should be or certainly might be in the future. But those fundamentals matter not for the OmniBubble.
Government Spending Gone Wild
In February of 2017, I penned this article on the fiscal state of affairs in the United States. The US government also contributed mightily to the OmniBubble as the chart below depicting the government debt-to-GDP ratio suggests.
During our last period of fiscal “restraint” in the mid-1990s, we had higher taxes and an increasing federal funds rate. The ratio stabilized and fell below the level set by the European Union for their member states. The post dot com recovery dissolved the temporary fiscal probity while the financial crisis made it a historic memory. The ratio increased so much so fast that it blew past the danger threshold (90%) established by academicians. While there are other economies that currently exceed the US ratio, it's uncharted territory for the world's largest economy and keeper of its reserve currency.
Lost in the morass that is RussiaGate, PornStarGate, and ___Gate is the projected treasury borrowing of $1 trillion. Keep in mind, this is with still muted, though rising, interest rates, low unemployment, rising GDP, and high corporate profits. Doesn't the Laffer Curve suggest this shouldn't be happening with lower tax rates?
The staunchest of Keynesians would argue that record treasury borrowing was necessary in 2008 due to the financial crisis. What argument would they have today? Lord Keynes is even squirming in his grave! If we’re at $1 trillion in treasury borrowing today, what happens when the next recession arrives?
Stock Market Relative To Economy
There’s no prescribed figure regarding what the stock market’s value should be relative to the overall economy. That said, strong deviations need careful consideration. The graphic below depicts the relationship between the overall stock market capitalization and the GDP of the United States.
From 1975 to 1982, the stock market was in persistent decline and its capitalization remained in line with GDP at the roughly 40% level. There were two recessions during this period. In 1982, the market began a historic run that continues. The ratio increased as well at a steady rate until 1994 at which time it shot up towards the historic top of 2000. After 2000, the ratio bottomed in 2009 before recently eclipsing its previous top.
Even at the Great Recession bottom in 2009, the ratio was nearly twice as high as during the early 1980s when the market was in the early stages of its historic rise. Consider this. If the market were to fall by one half with a constant GDP, it would still be at the ratio noted in the “Takeoff point” on the chart. Thus, it’s possible to have a robust stock market at a much lower ratio. Bubbles have a propensity to return to their origin, however. There can be no better indication of the financialization of the US economy than this graphic. An overly financialized economy can quickly succumb to a bearish sentiment.
This category includes revolving credit (credit cards) and non-revolving credit (installment contracts, auto debt, student debt). It’s instructive to understand the difference between self-liquidating debt and non-self-liquidating debt. The former is credit whose proceeds are used for the liquidation of the debt. For example, purchasing a new machine for a business suggests the machine’s output will be used to pay back the debt.
Non-self-liquidating debt relies on other sources for payback. For example, someone purchasing a pleasure boat relies on their income to service the loan. If the debt is associated with a consumer credit card, it’s more than likely non-self-liquidating.
One might argue that an auto loan or student loan could be self-liquidating since they’re transportation to secure an income or education for a future income. For the sake of this discussion, since neither is directly involved in a loan payback, I’ll place it in the “non” category.
Regardless of whether you agree with my definitions, revolving and non-revolving credit should not expand at a rate faster than economic growth. In the graphic below, I’ve excluded the economic growth line since it tracks roughly with revolving credit (red line).
The US consumer deleveraged revolving credit (red line) and it wasn’t until recently that they’ve breached levels witnessed a decade ago. The same cannot be said for non-revolving credit (green line), which has doubled in the last decade.
Student debt, which grew much faster, is more insidious than either of the two aforementioned. With revolving and non-revolving debt, there’s no deferment of loan servicing. With a student loan, the debt accumulation occurs during a four to six-year period without servicing. It can be deferred for several more years after graduation, becoming the elephant in the room. The abnormally low interest rate environment led to a very expensive "adult education" for students and a great deal for institutions of higher learning.
It’s beyond clear that both student loans and non-revolving credit (mostly automobiles) have decoupled from any economic reality.
This bubble has political implications. During the previous financial crisis, government programs like HARP and HAMP attempted to soften the blow dealt to residential homeowners. The Fed also assisted with purchases of mortgage-backed securities, lowering prevailing long-term rates. My sense is there’ll be less political appetite for such action next time.
Student loans are a different matter. I fully expect this to be a hot button issue in 2020 and beyond with calls for a debt jubilee. Who would bear the brunt of that jubilee? The US taxpayer.
The boardrooms of corporate America have been partying like it’s…. The chart below illustrates how corporate America restrained their debt issuance during the 2001 recession up until just prior to the financial crisis and Great Recession of 2008. Once rates lowered, they went on a borrowing binge.
There’s likely a strong correlation with this debt issuance and the stock market’s rise. Corporate optimism continues to fuel this rise with stock buybacks at an all-time record, eclipsing the levels of the 2007 stock market peak. Corporate America continues to purchase their own stock at ever-higher prices.
But wait you say. Corporate earnings are strong! According to David Stockman, in Deep State Classified, the after-tax interest expense for the S&P 500 was $55 per share just before the Great Recession. In 2017, it fell to $19 per share. Thus, 82% of the gain in earnings was due to falling interest expense. What’s going to happen as the Fed normalizes rates and investors, increasingly US and not foreign, demand higher rates for debt of all stripes?
The OmniBubble is all around us. The market pushes against its walls though they’re still pliable enough to move. You’ll surely feel its effects once it pops. What will make it pop?
In Escaping Oz: Navigating the Crisis, I used the metaphor of cones to explain how credit flows through the financial system. I suggested:
Cyclical influences in human behavior create speculation and bubbles but our flawed money system lays the foundation for excessive borrowing and bad investment.
The OmniBubble comes to an ignominious end when confidence erodes on the part of borrowers (credit hoarders) and lenders (credit suppliers). It ends when credit stops flowing through the various financial cones due to tighter monetary conditions caused by rising interest rates and defaults.
The OmniBubble was on its way to a full burst during the Great Recession, though our central bank wizards did not allow it — it's larger now. The popping of the bubble will be a historically painful event with significant political implications; of this I'm certain.
Is there a silver lining? Wealth inequality measures should return to historical norms — those with the greatest ownership of financial assets will see their values fall. My fear is politics conflating wealth and income inequality with some inherent flaw in capitalism. Financial intervention and manipulation have led us to the financial land of Oz, not capitalism. Regardless of the economic system, there’s the presence of both wealth and income inequality. An angry electorate may be persuaded to believe otherwise.
We can prosper economically on the other side of the OmniBubble. The intersection of politics and economics will define how we emerge. Let’s not, however, throw out the baby with the bathwater.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.