Making Hay Monday - July 31st, 2023
Thank you, Hoisington!
Charts of the Week
Both of the “Charts of the Week” for this Making Hay Monday edition are related to remarkable interest rate developments. What’s astounding about the image below is that interest rates on credit card balances are now over 20%. Even more incredible is that this exceeds the peak seen in 1981 when Paul Volcker had driven the fed funds rate also to that level. In case you haven’t been closely tracking it, the Fed’s key cost of money setting is currently roughly 5 1/2%. We are constantly reminded about the healthy condition of U.S. consumers, and yet they owe $1 trillion on their plastic. That combined with 20%+ rates means this is costing American households over $200 billion/year. Clearly, there is a considerable number of folks out there whose finances are painfully stretched.
Our second Chart of the Week is every bit as surprising but, in this case, on the positive side of the ledger. The pundit who created this is well-known perma-bear Albert Edwards. He admitted his shock when he first saw this and asked for confirmation from his research team at SocGen. They assured him it was accurate. It does look superficially odd that corporate net-interest costs should be falling sharply at a time when the Fed has been elevating rates at the fastest clip in over 40 years. The fact that many companies used the Covid-era collapse in the cost of money to wisely lock-in cheap rates is no doubt a factor. Further, the strongest entities have substantial cash holdings. These have gone from earning next to nothing a year ago to 5% plus today.
For the Microsofts and Apples of this world, that is an undiluted blessing. One thing that struck me, though, as I carefully studied the below chart, is that this situation can persist for a while and then it appears that the rate hikes bite. This apparently causes corporate net interest costs to eventually spike. 2018 was an exception, possibly because the hiking phase was both mild and short. That is certainly not the case in the late innings of Jay Powell’s second — and, likely, last — tightening campaign of his Fed career.
To learn more about Evergreen Gavekal, where the Haymaker himself serves as Co-CIO, click below.
“A Soft Landing In Sight For U.S. Economy” The Wall Street Journal, July 29th, 2023, frontpage headline
“Soft Landing Optimism Is Everywhere. That’s Happened Before. People are often sure that the economy is going to settle down gently right before it plunges into recession, a reason for caution and humility.” The New York Times, July 27th, Business Section, front page
Occupational Laggards
One approach I often attempt in our Haymaker editions is to come up with new angles on popular financial or economic beliefs. Naturally, these need to be based on facts, even (or especially) if they are obscure and/or underappreciated.
An example of this was the June 12th edition, How Narrow Was My Rally. In it, I challenged the prevailing perception that the stock market was unhealthy due to the reality that only a handful of stocks had generated all of the S&P 500’s return through May. In a way, I was challenging my own thinking because I had often cited that narrowness of leadership. My contention back then was that perhaps the laggards would catch up with the leaders rather than the latter catching down with the former. As I noted at the time, that was already happening, and has continued over the subsequent six weeks.
Another example of a potential misinterpretation or, at least, inadequate understanding, is the widespread acknowledgement that monetary policy works with long and variable lags — those who set that policy are often hazarded by this phenomenon, hence today’s title. This means that when the Fed has been materially tightening financial conditions — like by raising rates and selling its vast U.S. government bond holdings, as it has since early 2022 — it takes time for these measures to kick in. The same is true when it is easing, though it does seem like financial markets more rapidly react to easy money than they do to tightening.
There’s nothing wrong with this belief; it is undeniably true, despite that no one really knows how long and variable the lags are. We are seeing that today, where the consensus view, as expressed in the above-mentioned Wall Street Journal article, is that there has been little damage done to the economy despite one of the most intense Fed-tightening programs of all time. The dominant assumption appears to be that the worst of the liquidity draining damage is behind us, and, accordingly, the coast is clear for the economy.
But the other lag is way off the radar of even most professional economic observers. It is the key theme of this Guest Making Hay Monday edition: the lagged impact of immense fiscal stimulus. (For newer readers, we typically run an external expert at least once a month.) The highlighted individual in this issue is the legendary Dr. Lacy Hunt. In addition to being one of America’s foremost economists, he’s also crafted an enviable long-term track record managing bond portfolios with his partner of many years, Van Hoisington. Previously, Lacy was the Senior Economist for the Federal Reserve Bank of Dallas.
His Quarterly Reviews and Outlooks are must-reads and, in my opinion, his most recent version is among his very best. This is in no small part due to his highly contrarian take on fiscal stimulus. In simple terms, this means federal government deficit spending. The fact that this is running at 7% to 8% of GDP is shocking when unemployment is near a record low. But as horrific as it is for the long-term financial health of the country, it is viewed as near-term bullish for both the economy and the stock market. (It’s also incredible that S&P 500 profits are already in recession; generally, mammoth government deficits lead to soaring corporate earnings.)
Yet, as Lacy persuasively argues, over time a torrent of federal red ink is actually a growth retardant. If you doubt this, consider that U.S. economic growth has slowed dramatically since 2000, notwithstanding the explosion of outstanding Treasury debt this century. In less than 25 years’ time, total U.S. government debt has risen from $5.6 trillion to around $32 trillion today. In other words, extremely rapid debt and deficit increases have led to a substantial decline in economic growth. To be specific, it’s decelerated from the long-term per capita increase of 2.2% to 1.3%. This growth deterioration started in 1971, when Richard Nixon took America off the gold standard, but it barreled off the cliff around 2001, which is also when deficit spending went postal.
Unsurprisingly, I don’t always see eye-to-eye with Lacy. For instance, I was repeatedly on record from late 2020 into 2022 that the effective implementation of Modern Monetary Theory (MMT) — essentially, full-blown debt monetization of the government’s deficits by the Fed that was occurring during and after the pandemic — would create a serious inflation problem. Lacy disagreed, but now concedes he underestimated the degree to which the Fed was financing the many trillions of deficit spending back then.
Presently, he’s much more optimistic than I am about the outlook for long-term Treasury bonds. Part of our opinion divergence is that I believe it’s merely a matter of time — and, likely, not that much time — before the Fed is forced to once again fund the federal government’s gargantuan spending. (My belief is also that Jay Powell won’t go along with this ploy and will be replaced by a more politically pliable Fed-head.) But I certainly agree that interest rates will be falling at some point next year, likely steeply, on three-to-five-year Treasurys. Additionally, I’ll concede some powerful rallies on longer T-notes and -bonds are likely, but I believe you’ll need to be very nimble to capitalize on those.
The fact that the Fed continues to execute a double-tightening — raising rates and shrinking its balance sheet (quantitative tightening) — is scary enough. However, if Lacy’s right, and I think he is, then it’s truly a triple tightening, with the drag from fiscal de-stimulus soon to be felt. That’s why he and I both have a hard time believing in the Goldilocks fairytale of the economic porridge being just right. (He believes the delay from heavy fiscal stimulus to when it exerts a drag on economic activity is about six quarters.)
Below I’ve greatly condensed his latest Review and Outlook, but if you’d like to access this in its entirety, we’ve included a link to it at the end. (Note: The ellipses indicate where I’ve cut out sections.) Hoisington freely shares these every quarter as a public service. In my view, it’s a great service indeed.
Hoisington content below:
Monetary and fiscal indicators continued to tighten significantly in the second quarter pointing towards a material slowdown in the U.S. economy. Negative money growth, increasing fiscal deficit, rising real interest rates, and central banking guidance of higher short term interest rates are creating a classic ‘credit crunch.’
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While money supply and real interest rates reflect a traditional tightening financial cycle, as is the case now, a contraction in real bank credit is unprecedented when real GDP is rising. Money supply leads bank credit. In previous cycles, real bank credit did not turn negative on a one-year basis until the economy was already in recession. Even in the GFC recession, the 12-month change in real bank credit did not decrease until the end of the recession.
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As the second quarter ended, the contraction in bank credit showed the markings of an old-fashioned credit crunch.
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The U.S. Government budget deficit has taken a serious turn for the worse this year. The Inflation Reduction Act (IRA) and CHIPS and Science Act of 2022, as enacted, add over $1 trillion to the deficit over the next several years. The Penn Wharton Budget Model, however, indicates that due to the way instructions were written, the cost of the IRA is running three times greater than the amount appropriated by Congress.
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Current year federal tax revenues have also fallen considerably below a year ago. This is consistent with real gross domestic income (GDI) which fell in three of the last four quarters.* Even after excluding the Fed’s losses, real GDI was negative in three quarters and flat in another. Consequently, the deficit as a percent of GDP for 2023 is likely to be much worse than 5.5% in 2022 and 4.6% in pre-pandemic 2019.
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After taking into consideration the benefits of the deficit spending, the lagged negative multiplier effects and the way in which debt is being financed, the upcoming deficits are likely to have a negligible, if not contractionary, impact on economic growth this year and next. Increased interest payments and a short fall in tax revenues both add to the deficit, but they do not boost economic activity. Neither produce a new job, a new road, or a new dollar of research and development. More importantly, the lagged effects of the huge budget deficits of FY 2020-21 are likely to be negative due to the government expenditure multiplier.
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Ethan Ilzetzki, London School of Economics; Enrique Mendoza, University of Pennsylvania; and Carlos Vegh, University of Maryland found that the multiplier is “sharply negative” in highly indebted industrialized countries (“How Big (Small?) are Fiscal Multipliers?”, Journal of Monetary Economics, March 2013).
*Haymaker note: historically, this has only happened in the lead up to full-blown recessions.
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Two different rigorous studies, one completed in 2011 and the other in 2012, each using different methodologies, both concluded government fiscal policy actions that either increase the size of government relative to GDP or increase the government debt relative to GDP significantly weaken the trend rate of economic growth. The evidence, from more than a decade since this research was published, confirms those findings and indicates that the government multiplier is becoming increasingly negative.*
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Increases in government size means that more of the economy is being shifted away from the high positive multiplier private sector into the negative multiplier government sector.
When President Nixon closed the Gold Window, the 20-year moving average of the ratio of government size relative to GDP was 25.2% while the real per capita GDP/GDI average growth rate was 2.2%, which coincided with the average real per capita GDP growth rate since 1870. Based on the comparable numbers in early 2023, government size was a considerably higher 34.3%, and the growth in the real per capita GDP/GDI average was a much slower 1.3%. Thus, government size increased 9.1 percentage points and the real per capita GDP/GDI average growth lost 0.9% per year (Chart 3).
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Productivity, or output per hour in the nonfarm sector, declined by a record pace over the past ten quarters. Neither a rising standard of living nor increasing corporate profitability are achievable over time without higher productivity. For the eleven quarters since the pandemic/recession ended, real average hourly earnings (which cover 119 million full time wage and salaried workers) fell at a 2.9% annual rate. This is the largest decline registered in any economic expansion of comparable length since the earnings series originated. While firms continued to add employees, the rate of increase in wages have lagged inflation.
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To restore productivity, firms will need to rationalize their workforce, which will simultaneously reduce labor costs, inflation and household purchasing power.
The continued tightening of financial cycle conditions with lower inflation and poor economic performance will mean that long dated U.S. Treasury yields will continue to trend lower.
*Haymaker note again: a negative multiplier means that each incremental dollar of federal spending produces less than $1 of economic growth; i.e., this process is economically contractionary.
Hope you enjoyed that abbreviated version of the Hoisington review. Ironically, my new friend Adam Taggart also picked up on the significance of Hoisington’s latest missive; his podcast with Lacy, available on Wealthion’s website, is superb. For those of you who plan to watch that or read the full Hoisington piece, Lacy heavily focuses on Other Deposit Liabilities, ODL. He believes this is a more timely and accurate way of tracking the money supply. Like me, he’s worried about the falling velocity of money, which he refers to as ODLV
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Nine quarters of productivity decline does no auger well for the future of the economy. How much of this is the decarbonization/increase in energy costs effect, one might ask? How much is the big government effect? Declining gross national income and the skewing of what remains to the rich? Looks like 1929 to me and I am pretty sure that JK Galbraith would agree if he were around to comment. Banks pushing credit card interest rates above 20% looks like desperation or is it simply opportunity and greed.
China Calling.