HBO's epic fantasy TV series hit off its final season this past week, reminding viewers that through seven seasons of proclaiming that "Winter is Coming" despite no discernible signs of such change, winter has finally come. And with winter, which in the world of the story is a protracted season that could last a lifetime, comes an acute crisis — the zombie-like White Walkers breaching the wall keeping them at bay.
This serves as a reminder of a seasonal change in the real world, one that has been predicted for a long time but has, so far, shown few signs of its coming. I am referring to a relatively long period of economic "winter" — low growth and correspondingly low interest rates. Like in Game of Thrones, this seasonal change may result in an acute crisis at some point, or it may continue to unfold gradually.
The following is a thoroughgoing (i.e. long) report with many points and charts. If you prefer to just read a summary of the main points, skip to the last section at the end of this article.
Consequences of Exploding Debt
One of the finest think tanks on the issue of the federal budget is the non-partisan Committee for a Responsible Federal Budget (CRFB), which recently put out a report on why we should worry about the national debt. Like the camelskin-clad prophet crying out in the desert, CRFB proclaims a politically unpopular message — that the present path of the US federal budget is unsustainable and will ultimately prove self-destructive.
Never have deficits been this high when the economy was this strong – and they are growing. We project debt held by the public as a share of the economy will double by mid-century under current law, from 78 percent of Gross Domestic Product (GDP) today to over 150 percent by 2050.
A recent Bloomberg article labels the previous ten years since the Great Recession a "decade of debt," saying that after the horrible losses experienced in 2008-2010,
Prolonged and painful deleveraging seemed inevitable. Debt would have to be paid down or written off. Disputes over who should retrieve what from the wreckage would have to be resolved. Economic growth would be difficult if not impossible. Central bankers, trying to minimize the pain, cut interest rates to zero or below.
Behold the result of their labors: Leverage has increased. U.S. consumers and the Western banking system have cut back somewhat, but leverage has just moved elsewhere. Their retrenchment was far outstripped by a rise in borrowing by companies and particularly by governments.
CRFB asserts that there are consequences of an expanding debt burden at a time when debt levels are already high, such as:
- Slow income growth;
- Increase interest payments, crowding out other priorities;
- Push up interest rates;
- Dampen our ability to respond to the next recession or emergency;
- Place more burden on future generations; and
- Increase the risk of a fiscal crisis.
These are salient points of which investors should take note. When combined with market valuations and demographic realities (which we will address), the result is an inevitable slowdown of economic growth and continual suppression of interest rates.
Let us address each of the consequences of a high and growing national debt mentioned by CRFB as they apply to investors.
1. Higher debt leads to slowing growth by crowding out productive investment.
As explained by CRFB:
This slower growth occurs mainly due to the phenomenon known as “crowd out,” whereby investors purchase government debt at the expense of making productive investments in private capital. Less investment ultimately means fewer buildings, machinery, equipment, and software and even fewer new ventures or technologies. As a result, workers’ productivity growth will suffer, and ultimately income and wage growth will slow.
The CRFB concurs with the 2018-2028 Projection put out by the Congressional Budget Office (CBO), which also addresses the crowd-out phenomenon:
The agency estimates that greater federal borrowing ultimately reduces private investment below what it would have been without the additional borrowing.
When the government borrows, it borrows from households and businesses whose saving would otherwise be financing private investment. Although an increase in government borrowing strengthens people’s incentive to save, the additional saving by households and businesses is less than the increase in borrowing. The result is not only reduced private investment but also lower economic output and national saving (that is, total saving by all sectors of the economy). However, private investment generally falls less than national saving does because the higher interest rates that result from increased federal borrowing typically attract more foreign capital to the United States.
In CBO’s projections, the crowding out of private investment occurs gradually, as interest rates and the funds available for private investment adjust in response to increased federal deficits. In the longer term, the net decline in national saving would tend to reduce the stock of capital—and thus GDP—below what it would have been without the increased federal borrowing. Moreover, the additional net inflows of capital from abroad would cause more profits and interest payments to flow overseas, leading to a greater decline in gross national product (GNP) than in GDP.
This is not mere conjecture. One study from May 2018 examines data from both advanced and emerging economies and concludes that "the relationship between public debt and investment is likely to be causal and that public debt crowds out corporate investment by tightening credit constraints."
Another study looking at the impact of Chinese municipal governments found that "between 2006 and 2013 local public debt crowded out the investment of private firms by tightening their funding constraints, while leaving state-owned firms' investment unaffected." The authors explain that "in cities where public debt is high, private firms' investment is more sensitive to internal cash flow, also when cash-flow sensitivity is estimated jointly with the probability of being credit-constrained." In other words, those companies that are more dependent on tapping the credit markets for investment capital experienced greater crowding out than more self-funding companies.
Many will object that federal interest payments mainly go to others within the United States and therefore simply increase private savings. But this ignores a few facts. For one, it ignores the price paid for the right to receive those interest payments. If one thinks of Treasuries as an investment, one has to consider the relative price one must pay in order to enjoy that investment's income stream.
When debt levels are rising at the same time as interest rates are falling, more private capital is being poured into investments that are paying less. So if federal interest payments increase private savings, we have to consider how much private capital is being tied up for such little return.
We also must consider the ~30% of US national debt owned by foreign countries. When we make interest payments to them, our federal debt is not helping any American. The CBO estimated in a 2014 paper that each $1 of new borrowing reduces investment by $0.33 and shifts an additional $0.24 of investment from the US to foreign holders of US debt. International investors can and do use some of these dollars to purchase US real estate and equities, reducing the share of national income that can go to domestic investors.
The high price paid for such little return, in large part, explains why pensions are struggling with sizable gaps between assets and liabilities, with the latter outweighing the former by a growing margin.
National debt crowding out private investment negatively affects investors in two ways. First, it reduces the amount of capital that could have otherwise gone into the stock market, real estate, or other financial assets. Now, this one may be a head-scratcher for many readers. With financial asset prices across the board nearly at all-time highs, how could it be true that high national debt loads decrease investable capital available for other uses?
This analysis does not figure in several mitigating factors. One such factor is quantitative easing, which pushed trillions of dollars into the financial system in a relatively short period in the past decade. Up until recent years, the Fed absorbed much of the new supply of Treasuries, driving down Treasury yields and channeling investor capital into other financial assets such as the stock market.
Another factor is the massive influence of corporate share buybacks. This year, for instance, total 2019 corporate share buybacks are on pace to break the record of even the record-breaking 2018. These buybacks have been the primary driver of the strong rally this year, pushing stock prices up even as equity investors are exiting their positions in favor of bonds.
According to Bank of America Merrill Lynch, only two sectors of the stock market have seen inflows in recent months, while equity funds more broadly have seen outflows on net. Institutional and retail investors alike have been net sellers this year. In fact, as the chart below shows, investors have been net sellers of US equities since early 2017, which means that the Trump rally has been due almost entirely to tax cuts and buybacks.
All else being equal, there has been less private capital available for other financial assets, but this deficit has been more than made up for by buybacks.
The second way that the national debt crowding out private investment negatively affects investors over time pertains to most Americans' income. Since wage growth is closely tied with worker productivity, which is largely determined by business investment (in machines, equipment, software, employee training, etc.), less investment translates into less wage growth. Writes the CRFB team:
Over time, lower investment leads to slower income growth. In a recent analysis, CBO projected Gross National Product (GNP) per person – a rough proxy for average income per person – will total about $98,000 in 2048 in today’s dollars if debt is reduced to historical levels. Under current law, where debt rises to about 150 percent of GDP, average income per person will total $92,000.
This is per capita data. The future income loss is starker when considering a family of four, which typically has only one earner:
Source: Peter G. Peterson Foundation
Dampening income growth will, over time, suppress corporate revenue growth. The American consumer still accounts for some 70% of GDP and 60% of corporate revenues. Thus, the consumer's ability to spend directly impacts the sales growth of companies that investors own.
And this is on top of already weak real wage growth, which has been rising very tepidly since the late 1970s.
2. Increasing federal interest payments, especially in a low interest rate environment, also crowds out productive public investment.
CRFB writes that "interest payments already consume every dollar raised by the corporate income tax, the estate tax, gift taxes, and federal excise taxes. By the late 2040s, under current law interest costs will consume all payroll tax revenue."
They project interest payments as a percentage of GDP to quadruple from 1.6% as of 2018 to 6.3% by 2050. Their pessimistic scenario sees interest payments eating up 8.5% of GDP by 2050.
As mandatory spending (such as entitlements and interest payments) rapidly increase, taking up a larger and larger portion of total spending, they will inevitably force discretionary spending to grow slower and thereby shrink as a percentage of spending. The CBO projects discretionary spending — which includes all investments in the future such as education, infrastructure, and basic research — to fall from 30% of spending to 22% by 2029.
Source: Peter G. Peterson Foundation
By 2028, interest payments as a percentage of the federal budget are set to be higher than all combined federal spending on R&D, infrastructure, and education. By 2048, it is set to be twice as high as average spending on these categories.
Source: Peter G. Peterson Foundation
This does not bode well for economic growth, and what does not bode well for economic growth generally does not bode well for investors.
3. Interest rates: rising or falling from a heavier debt load?
On this point I somewhat part ways with the CRFB and CBO, which projects interest rates on the 10-year Treasury to rise to 3.8% by 2020 and 4.8% by 2048. (It currently sits at 2.56%.) I agree with former US Treasury economist Ernie Tedeschi who argues that deficits do, all else being equal, raise interest rates, but other factors are lowering them.
I have discussed elsewhere why, despite the logic behind the idea that higher debt levels lead to higher interest rates being fundamentally sound, other mechanisms are at play which turn this formula on its head.
The CBO estimates that each 1 percentage point increase in federal debt as a percentage of GDP increases interest rates by 2-3 basis points (a relatively minimal effect as it is). And yet, as federal debt has stacked up higher and higher over time, interest rates have fallen. Economist Lacy Hunt explains that the productivity of federal debt has steadily fallen and now produces a negative return in terms of GDP growth. Thus, increasing federal debt drags down the economy, leading to decreasing inflation and interest rates.
The government expenditure multiplier (the amount of GDP generated by a certain amount of additional government spending) is high when debt is low, according to Hunt, but as debt builds up, it gradually falls. And eventually, as we have seen, it turns negative. I would add that more wasteful and inefficient forms of government spending decrease the multiplier faster.
There seems to be a consensus among economists that, during recessions, when resources are idle, additional government spending can, in the short run, be stimulative in generating the economic activity necessary to put more resources to use. But in the long run, returns from incremental government spending diminish and then turn negative, thereby negating any stimulative effect.
One might expect that a sufficiently high debt load or sufficiently rapid increase in debt could overwhelm these mitigating factors and cause interest rates to rise. But the Federal Reserve could always ramp up quantitative easing to effectively reduce the supply of Treasuries and keep rates in check (as Japan has done). Alternatively, like Japan and several other countries, the Fed could pursue a negative interest rate policy to prevent Treasury yields from rising.
In sum, low interest rates are not a positive sign for investors. They are the sign of an economy too weak and indebted to let rates normalize.
4. Rising debt reduces the ability to fight the next recession.
The CRFB writes:
During economic recessions, as well as wars and other emergencies, it may be necessary or even desirable to run large deficits. Yet the higher deficits and debt are in advance of a recession or crisis, the less “fiscal space” a country will have to finance or combat that crisis.
They cite a recent study by Christina and David Romer which found that countries entering crises with higher debt levels tend to do less to combat the crises and recover slower. They argue that economic and political restraints to borrowing are higher during crises for already heavily indebted countries, making it more difficult to mitigate the negative effects of the crisis.
In my estimation, the only increased spending during recessions that is helpful is the "automatic stabilizer" or safety net sort of spending that temporarily treats the negative symptoms inflicted by the downturn. Increasing debt, especially when the government is already heavily indebted, in an attempt to artificially stimulate economic activity or job growth will end up sapping resources that would have been put to better use by the private sector.
In any case, whether increased government spending helps or hurts during recessions, going into one with a higher debt load leaves less optionality. Less fiscal optionality, for investors, means less of a safety net for financial assets.
5. Debt taken out for current consumption will end up being a burden on future generations.
Every child born today inherits roughly $50,000 of US national debt. This is not like inheriting a mortgaged rental property, which has debt that is financed with an income stream. This is more like inheriting a deceased parent's large credit card bill. The child will have to reduce his or her own saving and investment in order to pay for the parent's past consumption.
As I've said in the past, pointing out that most current federal spending basically funds a form of consumption — Social Security, Medicare, Medicaid, welfare, many forms of military spending, and, of course, interest payments — is not a judgement about the moral value of these programs. It is an attempt to give a clear-eyed view of spending and its consequences.
And like the child who has to take a chunk of his or her own paycheck to pay for the credit card bill inherited from the parent, younger and future generations will see their income grow less than it otherwise would because of the federal debt.
6. Elevated debt levels make our financial system more fragile.
The longer the nation's debt levels continue to rise without any sign of a decline at some point in the future, the greater risk there is of a fiscal crisis. There may be no national debt crisis looming in the near future right now, and there may never be an acute "crisis." But, says the CRFB, "if debt continues to rise and it becomes increasingly clear that trend will not reverse, the risk of a crisis will grow."
A US sovereign default or insolvency is highly unlikely due to our ability to print money in our own currency, an observation pointed out by proponents of Modern Monetary Theory (though the point is not exclusive to their school of thought). But that doesn't mean that a fiscal crisis is impossible.
If the economic strength of the United States ever erodes sufficiently to cause investors to lose some degree of faith in the American system, they would pull back their buying of Treasuries to wait for higher yields. With higher yields, interest payments would rise, spurring the need to either print more money or issue more debt. Says the CRFB:
While countries can often engage in modest monetary expansion or seigniorage without disruption, continuously expanding the money supply to chase ever-rising deficits is a recipe for hyperinflation. The implementation of new heterodox economic practices designed to facilitate such printing could itself spark this inflation by undermining price stability.
The intentional implementation of Modern Monetary Theory, which puts the power to set monetary policy into the hands of short-termist politicians, could be the spark that sets off a fiscal crisis.
For now, the risk of such a crisis is low, but the higher the national debt load becomes, the greater the risk becomes. Any fiscal crisis would, of course, be bad for investors.
Two More Factors at Play
So far, we've only covered the national debt situation, but that is not the only variable in the case for an economic "winter." One must also consider the current prices of financial assets as well as the American demographic profile.
Let's start with Tobin's Q ratio — the total price of the stock market divided by the replacement cost of its component companies. Currently, this valuation metric is around the same level it was at in 1929, and 1937 and higher than it was in 1969. It was only higher in the Dotcom bubble of the late 1990s and early 2000s.
Source: Advisor Perspectives
It took 29 years for the S&P 500 to again reach the highs set in 1929. It took 17 years for the S&P 500 to again reach the highs set in 1937. It took 24 years for the S&P 500 to again reach the highs set in 1968-1969. And it took 14 years for the S&P 500 to again reach the highs set in 2000.
As I pointed out in another article, corporate share buybacks are lowering the price-to-earnings (PE) ratio and making the market look cheaper than it really is. We get a truer picture by looking at the Shiller-CAPE ratio, which uses inflation-adjusted earnings over the previous ten years. The current Shiller-CAPE ratio for the S&P 500 is 30.62, compared to an average of 16.62 and median of 15.72 since 1870.
To risk beating a dead horse, what about Warren Buffett's favored market valuation metric, total stock market capitalization to GDP? Here again we find a market that is priced quite richly:
This measurement shows a market valued higher than in 2007 and nearly as high as 2000. GuruFocus rates our current market "significantly overvalued" by this indicator.
What about home prices? Here I'll use the Case-Shiller national home price index (as of January 2019) to gauge home valuations:
According to the index, aggregate US home prices surpassed their previous peak in the housing bubble of the mid-2000s in November 2016. When the housing bubble popped, home prices declined by 26%. Perhaps one piece of good news is that the run-up in home prices has not been as rapid or parabolic as it was from 2002 to 2007. It has rather been more steady, fueled today (as they were then) by low mortgage rates.
What about commercial real estate? Green Street Advisors maintains an index for commercial real estate values called the Commercial Property Price Index. It is indexed to 100 at the peak of commercial real estate values in 2007.
Source: Green Street Advisors
Here, again, we see that commercial real estate valuations have risen strongly. Low interest rates have fueled strong cap rate compression. As we can see, average prices for commercial real estate fell by around 37% from 2007 to 2009, although this calculation succumbs to the tyranny of averages. Some sectors fell much further than others.
Interest rates have steadily fallen, albeit with some spikes along the way, since the early 1980s. And since real estate is especially sensitive to changes in interest rates, it is unreasonable to assume that either home prices or commercial real estate prices will continue rising at the same clip as they have in the past 40 years of falling rates. This is definitely true in the face of rising or flat interest rates, but it is also true if the Fed lowers rates again, since there is very little room for rates to fall.
The demographic realities faced in the United States (and across the developed world) are inescapable. The Baby Boomer generation born in the prosperous decades following World War II are a significantly larger cohort of the population than the generations preceding and following them.
The Gen X generation were born in the more economically and politically troubled period of the 1960s and 1970s and, as such, are a smaller cohort. Millennials, on the other hand, were born in the prosperous decades starting in the 1980s and the 1990s and are a larger cohort — the largest in the US. The Gen Z cohort also came around during a time primarily marked by prosperity, though the birth rate has declined considerably.
For instance, 2018 saw the lowest population growth rate since 1937 at 0.6%. This is due to population shrinkage among seniors as well as a slowing birth rate.
With Baby Boomers retiring and the birth rate continuing to decline, we enter a period in which the senior population is taking up a larger and larger share of the total population.
Source: Senior Journal
The 65+ population is expected to take up a fifth of the US population by the 2030s. Though Boomers command the most wealth, consumer spending naturally changes and declines as people age. Healthcare starts to take up a much larger share of personal spending than anything else.
To finance healthcare costs, seniors will likely be selling at least some of their financial assets such as stocks, mutual funds, and real estate over time. This will be a headwind for asset prices going forward.
Summary: The Formula for a Low-Growth, Low-Rates Future
The federal government's own Congressional Budget Office projects that national debt to GDP will be the highest its ever been within 30 years, surpassing even the highs reached during WWII. If a sufficiently strong recession strikes in the near future, this peak will be reached much sooner.
The fundamental problem with continual federal debt growth is that it crowds out productive investment. Though additional federal spending is productive when debt levels are low and perhaps during recessions, the economic returns steadily diminish as debt levels rise.
Between 2008 and 2018, for instance, every $1 borrowed by the federal government resulted in only $0.44 of GDP growth. As debt continues to rise and new Treasury issuance soaks up a larger share of capital that could have found more productive uses, the economic returns from federal debt will continue to shrink.
Moreover, as measured by several ratios, financial assets across the board are quite richly valued. At these valuations, for instance, it has regularly taken decades for the S&P 500 to reach its highs again. And with interest rates hovering just above zero already, the boost to real estate prices from falling rates is unable to continue into the future as it has in the past four decades.
Finally, the demographic situation in the United States piles onto the previous issues. Baby Boomers, who control the most wealth among the generations, are entering retirement. Younger, less financially strong generations will have to partially finance their retirement benefits as the Social Security Trust fund runs permanent deficits into the future ($1.7 trillion over the next decade, for instance).
The birth rate, moreover, is falling — both a cause and a result of the relative financial weakness of the country. It is a cause of financial weakness because there will be fewer young workers to fund the retirement of the larger older generations. And it is a result of financial weakness as younger generations strapped with student debt and entering homeownership at slower rates are having fewer babies at later ages.
All of this can be formulated thusly:
High and Rising National Debt + Richly Valued Financial Assets + Unfavorable Demographic Realities = A Low-Growth & Low-Rates Future
Obviously, there will some good mixed in with the bad. New and exciting innovations will come along. And none of this dictates a severe market crash or Great Depression 2.0. But the overall picture is grim.
Investors can prepare for this future with a barbell strategy of Treasury funds, holding both ultra-short and ultra-long (20+ year) duration Treasuries. Extended duration Treasuries stand to be repriced upward if/when the Fed lowers rates again and restarts QE. And ultra-short Treasuries offer protection from volatility as well as an inflation-beating yield.
If/when rates are once again lowered and QE restarted, the chase for yield will likely resume coming out of the next recession, which will make moderate-to-high yield assets more valuable. Therefore, high quality dividend- or distribution-paying equities will likely be able to retain or regain their value in the foreseeable future.
If you think of any other implications for investors relevant to the preceding analysis, please mention them in the comments below!
Disclosure: I am/we are long EDV, NEAR, SHV. 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.