Interim Report - Financial Markets Disconnect 12/09/09
Since the latter part of March, 2009, we have managed client asset allocations to an underlying theme of global recovery. This view has led us to increase what we will call the risk asset portion of client investments – stocks, corporate bonds, gold and related precious metals – at the expense of cash-type holdings such as money market funds or short term treasuries. This strategy has been very profitable for client accounts through this date. Furthermore we believe, for the time being at least, maintaining near-maximum exposure to these risk assets is the correct course of action given the current posture of the Federal Reserve as the global recovery continues to unfold.
There is however, an unmistakable fear among investors that our government’s prodigious needs for cash now and over the next 10 years, or perhaps even longer, may at some point totally overwhelm our country’s and perhaps the world’s ability or willingness to finance this tsunami of ever-increasing debt. Where will the money come from to absorb our trillion dollar annual deficits and refinance the hundreds of billions of dollars of Treasury securities which mature each year?
It is obvious, the conventional wisdom tells us, that interest rates must rise in order to entice borrowers to lend money to any country that exhibits such “out-of-control spending”. Then, rising interest rates will snuff out any possibility of recovery in the housing market. Unemployment will not decline, thus adding to consumer fears causing spending to falter yet again and ultimately we will be back into recession. At that point we will need another stimulus package (already being discussed in Congress) which will cost even more money that we don’t have. Very roughly summarized, this is today’s conventional wisdom.
But wait a minute. Consider that the investment markets, where people place bets with real money have not been, and continue to not be concerned with this doomsday scenario. Investment markets collectively reflect future expectations. A decade of trillion-dollar deficits is acknowledged by all and, through the collective wisdom of all the world’s investors is already priced into risk assets to arrive at today’s asset price levels. However, perceived events of the next one-to-two years carry much more weight in the pricing formula than possible events beyond that time frame.
So why aren’t interest rates rising now? And why isn’t the stock market forecasting a double-dip recession? Why aren’t inflation expectations moving higher today? In short, how is it possible that investment markets are so totally out of sync with the impending end of the global monetary system as we know it? These questions lead us to one final question:
What if the collective common wisdom about funding our ballooning deficit is just plain wrong?
The financial markets’ message that the growing deficit is not a problem (yet) has been quite perplexing but we tend to place our faith in what markets are telling us as opposed to accepting all the opinions expressed in the media. Therefore, this research piece was undertaken simply to review current financing trends and to analyze underlying deficit statistics which in turn called for placing the U.S. situation into a global context. By doing so, our deficits appear much less alarming than the trillion dollar deficit figures in isolation seem to imply.
We offer the following observations regarding current financing trends.
There is simply no shortage of money available today to fund rapidly growing deficits. In fact, demand for Treasury securities has been rising all year. At the same time that the nation’s debt was increasing by $1.15 trillion this year, Treasury rates have continued their long term decline. Furthermore, increasing Treasury sales have been occurring at the same time that U.S. companies have raised a record $1.178 trillion from bond sales in 2009, according to Bloomberg news. “Crowding out”, the concern that the U.S. government will swamp the bond markets with its prodigious need for capital thereby making it more difficult for the private sector to raise money, simply has not occurred.
Bloomberg goes on to state that “For every $1 of debt sold by the Treasury this year, investors put in bids for $2.59, up from $2.19 of bids” for sales to this point in time in 2008. Foreign governments have also continued their strong participation in treasury sales with Japanese investors being among our biggest boosters. For example, through August, $105 billion of net debt was acquired by Japanese investors, boosting their total holdings by 17% to $731 billion according to Bloomberg News. The Japanese think U.S. Treasuries are a bargain, even with yields at their lowest levels in decades.
In spite of frequent grumbling, China, the largest foreign owner of treasuries, has continued to increase its holdings, and U.S. banks are providing a third source of very strong demand. Presently, domestic banks are improving their balance sheets by borrowing money at extremely low interest rates and re-investing the proceeds in “risk-free” treasury securities while simultaneously cutting back on loans to consumers and businesses. The Fed continues to reiterate that it will keep interest rates at current low levels for an extended period of time given ongoing weakness in the economy, thus allowing the banking system to increase its asset base at no economic risk.
Summing it all up, the current weak economic environment, trillion-dollar-plus annual government deficits and a powerful corporate borrowing trend have not created any stress in the bond markets this year. Money to continue funding the rising deficit over the near term remains readily available. But the Obama administration tells us that trillion dollar deficits are a fact of life for the next ten years. Where will all that money come from?
As noted above, we don’t believe financial markets assign much weight to events that may occur beyond a one-to-two year time frame given their increasingly tenuous nature. In a curious sort of way, widespread belief in an anemic, sub-par recovery may actually be aiding the Treasury’s voracious capital needs. Fear of recession, low consumer confidence and high unemployment all conspire to drive capital out of risky assets and into “safe” government securities. This capital flow, which helps the Fed keep yields low, was vividly illustrated just last December when fear of economic collapse caused a buying panic in the Treasury market. We recall at one point that Treasury bill yields actually were negative during that month.
Should the world experience back-to-back recessions, as many are predicting, it’s reasonable to assume that U.S. treasury markets would once again become the safe haven of choice for a great deal of that “excess liquidity” currently sloshing around the globe. In that event, demand for treasuries could overwhelm supply and interest rates could be expected to decline again, perhaps precipitously, even as Treasury sales continue to escalate.
A trillion here, a trillion there. . .
It is hard for anyone to grasp the meaning of trillion dollar deficits and so certain ratios can come in handy to put these mega numbers into perspective. For example, consider the ratio of government debt to GDP. The International Monetary Fund (IMF) calculates this information across many different countries creating a convenient means of comparison. Calculations for the U.S. show this ratio to be rising rapidly now with expectations of a continuing rise over at least the next five-to-ten years. But the same situation is true for the economies of the Euro area, Japan and the U.K. Simply put, nearly all developed countries are leveraging up at the same time. Only Canada stands out as a model of fiscal prudence over the next few years.
With our anticipated muted recovery and dramatic deficit spending, how large could our debt as a percent of GDP become before interest rates spike upward or worse, investors refuse to lend additional money? The chart below reflects the current projections of the IMF.
Debt as a % of GDP
Source: International Monetary Fund World Economic Outlook, October 2009
Japan stands out as an example of the extreme leverage which the world seems willing to tolerate from an economically advanced nation. Their debt to GDP ratio today and for at least the past 15 years has been greater than what ours may increase to by 2014. Furthermore, the Euro area’s leverage pretty much lines up with that of the U.S., indicating that we are not outrageously out on a limb, deficit wise, during this time frame. Greece’s fiscal situation presents another interesting point of comparison. The country’s sovereign debt has recently been downgrade to BBB+ by Fitch and is on Credit Watch with negative implications by S&P which presently rates the debt A-.
Italy is also relatively highly leveraged as illustrated in the table below.
Current Cost of Leverage
| |
2009 Debt
% GDP |
10-Year
Gov't Yield1 |
| Greece |
125.0 |
5.47% |
| Italy |
115.8 |
4.03% |
| United States |
84.8 |
3.48% |
1 Source-Bloomberg, December 10, 2020
Based upon these trends and the U.S.’s relative debt to GDP ratio, current hand wringing about the unaffordability of our future trillion dollar deficits maybe over done. Could this be what risk markets are telling us with their relative complacency in the face of accelerating deficits?
Funding the deficit
Our final thought on the subject relates to where the money could come from going forward to purchase new treasury issuance. Insights about this concern can be addressed by analyzing portions of the Federal Reserve’s Flow of Funds report for the Second Quarter, 2009.
Household wealth for the period ending June 30, 2020 is estimated at $67 trillion of which only $606 billion, or less than 1%, is invested in treasury securities. By comparison, $10 trillion is owned in the form of corporate stocks and mutual funds and an additional $10 trillion is held in corporate pension funds. Time and savings deposits and money market fund shares constitute in excess of an additional $7 trillion in household wealth. Adding up the numbers, the percent of household financial assets invested in treasury securities represents a miniscule 1.5%. Very small shifts in the composition of household wealth could easily absorb all of each year’s deficit short fall for years to come without any reliance on the assistance of foreigners!
In actuality, foreign purchasers have been increasing their ownership of treasuries during the past five years – both in dollars and percentage of treasuries outstanding.
Foreign Ownership of U.S. Treasuries
*through 6/30/09
Source: Federal Reserve Statistical Release Z.1, September 17, 2020
There are still other sources for purchase of treasury securities including the private banking system, Federal, State and local pension funds, brokerage firms and insurance companies. All of these financial entities have very low percentages of treasury securities within their investment portfolios at present. A trillion dollars is certainly a lot of money but relative to the total wealth of the U.S., or even just the value of all financial assets in the U.S., it is a relatively small sum.
The implications here for portfolio mangers are enormous. We are starting to read letters from managers who have badly underperformed their benchmarks this year because they misjudged how markets would react to the ten-year trillion dollar deficit theme. They “fought the tape” and so far, have come up short. In our view, the most significant risk to the low interest rate environment would be signs of a more rapid economic recovery here at home than is expected by the conventional wisdom. The surprising figures from last week’s greatly improved Labor Department reports illustrates the point perfectly, as the price of gold declined as did the price of longer-term Treasuries upon the signs of labor market stabilization.
To sum it all up, we think for now that risk assets remain appropriate and the time to shift to a defensive stance in our asset allocation has not yet arrived. The generally benign investment environment continues despite all the fears of future deficit funding at home and abroad.
Sincerely,
Sheffield Investment Management Inc.