The Investor June 2019

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By Richard Cluver

On a list of the five questions we are most asked, inevitably one is “How much money do I need in order to be able to retire?”

If you want a snap answer I will say R12-million. But of course the true answer is dependent upon so many variables that this amount will range from the patently ridiculous to the patently ridiculous. It is either unimaginably large or grossly inadequate depending upon individual circumstances.

Ask an investment professional and you will be told about the 80 percent rule which argues that a retiree should be able to live of approximately 80 percent of the salary he was earning in his last year of employment. Add to that the observation that the JSE Overall Index has risen in value by compound 12.5 percent a year over the past 20 years minus a 5 percent inflation rate average over the same period and they will tell you that in order to keep your retirement capital intact you should accordingly not draw down more than 7.5 percent of the Total Return of your portfolio.

Total Return is, of course, defined as the sum of all dividends and interest received from the portfolio together with the aggregate capital growth rate that it achieves over time and so, provided you do not draw down more that 7.5 percent you can reasonably ensure that the original capital sum will remain intact so that it can be bequeathed to your heirs or to some favourite charity.

Beneficiaries of retirement annuities and pension funds are subject to yet another calculation which is based upon an actuarial prediction of your likely life-span which is in turn dependent upon another host of observations about your racial origins, level of education, life style and so forth. If your pension fund has a sufficiently large membership its fund managers can usually make a fairly accurate assumption about your average life expectancy and in turn be able to divide up your available retirement capital into an appropriate number of proportions which, together with, as the capital shrinks over time, an ever-dwindling amount of interest, will be able to ensure that at your death the entire capital sum will have been used up. And because they are insuring the retirement years of a very large sample of people, those who die earlier than their allotted years will then subsidise those who live longer.

With such known assumptions it is then easy to build in refinements like allowing you to receive annual inflation adjustments etc so that the recipient should be adequately provided for throughout the so called “golden years.”

The only problem with all of this is that the fund managers do not seem able to achieve market-related capital growth as I illustrated recently in my commentary about South Africa’s Morningstar awards analysis. Add in the fact that so many folk simply do not or cannot make provision for their old age and we understandably come to the well known fact that over 90 percent of South Africans head into retirement grossly unprepared and their welfare thus becomes the responsibility of the State and their children. This statistic is partly explained by our social demographics which note that if you are unable to find secure employment for most of your adult life it is a no-brainer that you will be unable to accumulate any wealth at all.

I would challenge this latter view with the argument that there is always something one can do to put bread on the table even if it is begging on a street corner and, provided you elect to save a tenth of this income, you can make yourself financially independent within a decade or so. But I cannot nevertheless ignore the fact that 90 percent do not retire with any sense of financial security.

So how much does one really need to aim for and how can you quickly calculate it? Well recently I came across a novel rule of thumb that seems to work very well. It argues that you should start with the market value of your home and multiply by 0.3. That is the income you need in retirement. Next, take that number, and divide by .04. That will give you the assets you need to retire with.

Let’s do an example.

Let’s say you are reasonably well-to-do, and live in a house whose market value is R1.4 million. Not what you paid for it—the current market value. So take R1.4 million, and multiply by 0.3 which gives you R420,000. That is the income you are going to need in retirement.

You probably think that number is high, and that you can get by on less than R420,000. Let me tell you why you can’t.

First of all, R1.4 million houses are expensive to maintain. It will cost you, on average, 1-2% every year: 0% some years, and 5-6% other years. But that is the least of your problems.

If you live in a R1.4 million house, you live in a good South African neighbourhood. Those houses have good cars in their garages and so will yours. Maybe you think you will have an old rust bucket sitting in yours. Then you will be that guy.

If you are living in a R1.4 million house, your wife will not be buying her clothes at Mr Price and chances are she will send you to Woolworths to pick up the salads whenever you are hosting a braai.

All of this stuff adds up. Your lifestyle, and all the money you spend, comes from the house that you live in. And just in case you plan to sell up on retirement and move to a golfing estate, just note how your living costs there will reflect that lifestyle.

Wait—it gets even better.

The 4% Rule

You have probably heard of the 4% rule. It says you can safely withdraw 4% from your retirement savings annually during retirement. So if you have R1 million, you can take out R40,000 a year. Simple enough.

Let’s go back to the example above. You live in a R1.4 million house and you need R420,000 to live on in retirement. How much savings do you need?

R420,000 divided by .04 = R10,500,000.

You will need over ten million in savings. That’s pretty close to my R12-million which I constantly argue is needed in South Africa today.

Why R12-million? Well I start with the simple fact of 12 months in the year so if you have savings of R12-million you will have R1-million working for you every month and the average dividend yield of a Blue Chip share is 2.5 percent.

Thus R12-million will give you R25 000 a month off a blue Chip portfolio and guarantee you a capital growth rate of around 17.6 percent a year which will more than take care of inflation and your rising costs of medical care as you age!

Banks and the next Financial Crisis

By Brian Kantor

I recently read Mervyn King’s The End of Alchemy: Money, Banking and the Future of the Global Economy, (2016 and 2017) with some concern. The alchemy of which the former governor of the Bank of England is much concerned is the money multiplier, that bank deposits that serve as money are a multiple of the cash supplied to the banks by their Central Banks. This shibboleth, that banks have some dangerous magical power to create deposits, that is money, has long been disabused.

It was argued by Tobin and others in the sixties that banks are a particular kind of saving intermediary that funds its lending by supplying an attractive payments facility. The willingness of banks to supply this costly service depends on their profitability. Without income from lending – funded by deposits – the banks might not have been able to supply the costly payments system on the scale they have done. And the economy would have had to rely much more on receiving and delivering cash- a very costly alternative.

That is unless the banks could have charged fees to cover the full costs of managing the payments system. However such fees might have discouraged the demand for deposits and increased the demand for cash. Hence the banks in effect cross-subsided the transactions depositors would make with the revenue earned from their lending activities. The profitability of banks  depends in part on managing their cash reserves, keeping them as small as possible – and by holding no more than prudent reserves of equity capital to cover non-performing loans and improve the return on shareholder’s capital. In other words from leveraging their balance sheets.

It is not the deposit multiplier but the leverage of the banks that exposes their shareholders (and the broader economy that depends upon sound banks) to the danger that non-performing loans may exceed the equity of the bank – hence bankruptcy or the necessity to raise more equity or debt capital. However it is not only the deposits (liabilities of the banks and assets of depositors) that may be destroyed by the failure of a banking system. Of greater importance is that the payments system, of which deposits are an essential part, can go down with the banks, with truly catastrophic effect for any modern highly specialised economy.

Perfect safety can only come with deposits fully backed by cash issued by the central bank. Banks as we know them however would not have been able to supply transaction balances and be profitable enough to survive- without taking on leverage. Leaving banks to make the trade-off between risk and return, has worked well enough most, but not all of the time. The Global Financial Crisis of 2008 demonstrated why it is very important to be able to deal with a banking crisis – should banks or more specifically, the payments system delivered by banks be threatened with failure. The solution to any run on the banking system is for the central bank to supply more than enough cash to stop the run. Or to prevent it in the first place should it be recognised that the banking system is indeed too important to be allowed to fail

As the responses (on the fly) to the GFC proved it is not beyond the wit of man to preserve the payments system from failing should such a melt-down threaten? It is moreover not beyond our wit to develop bankruptcy laws for banks that will always in all possible circumstances preserve the payments system. Such a fail-safe system does not have to allow bankers and their governors to escape the consequences of failure.

That is the known fear of failure and its consequences will be enough to focus the minds of bank lending officers on the trade-off between reward and risk – enough to reduce the threat of banking failures in the first instance. But there can be no guarantee of permanently responsible behaviour- of too much rather than too little leverage and bank lending. Too little bank lending is another danger to an economy as the European banks may be demonstrating today.

What should be guaranteed by the government is the survival of a payments system that is indeed too big to fail and might have to be taken over in a severe emergency via a predictable, legitimated process that would forestall any panic by depositors that they would not have access to their deposits to make payments with.

Perhaps modern information technology will in due course allow a 100 percent, central bank deposit backed, fee collecting payments providers to survive and compete with the deposit taking banks. And so eventually take over the responsibility of the payments system from private banks- if the fee structure is attractive enough to compete with the banks for the transactions balances of households and firms.  If so deposit taking banks, supplying a bundled service of payments with the aid of leverage may fade away to be replaced by other forms of financial intermediation- with leverage – but without responsibility for making payments.

 

This brave or rather more cautious new world may be the next wave in the evolution of a financial system. One that would provide for the separation of the payments system from the dangers of leverage.  Wisdom would be to let a profit seeking competitive financial system evolve in response to the preferences of lenders and borrowers and for regulators to stay out of the way. Other than to design a predictable rescue operation- that could be called upon in extremis – and be expected to save the payments system – but not lenders or borrowers from the consequences of their own follies.

US Pensions under threat!

By John Mauldin

I can remember writing a decade ago that public pension funds were $2 trillion underfunded and getting worse. More than one person told me that couldn’t be right. They were correct: It was actually much worse. (See, I’m an optimist!)

Two years ago I wrote that Disappearing Pensions are The Crisis We Can’t Muddle Through. Nothing since then has changed my mind. In fact, failure at all levels to even begin solving the problem is making it worse. The latest estimates, as we will see, suggest that it has gotten $2 trillion or more worse in just a few years.

Note we are talking here about a specific kind of pension: defined benefit plans, usually those sponsored by state and local governments, labour unions, and a dwindling number of private businesses. Many sponsors haven’t set aside the assets needed to pay the benefits they’ve promised to current and future retirees. They can delay the inevitable for a long time but not forever. And “forever” is just around the corner.

As we will see below, the numbers are large enough to make this a problem for everyone, even those without affected pensions. The problem is “solvable”… but the solutions will be problems in themselves.

Underfunded Future

Let’s begin with the enormity of the pension funding gap. As with the federal budget deficit, the large numbers are hard for our minds to process. They are also inherently uncertain. Let me explain.

A defined benefit pension plan for, say, a city’s police department, knows it owes a certain number of retirees certain monthly benefits for life. Their lifespans are fairly predictable when the pool is large enough. (I think new biotechnologies will change this soon, but that’s another topic.)

From that, it’s simple math to calculate how much money the plan should have right now in order to pay those benefits when they are due. But then the assumptions start. The plan must presume a future rate of return on the invested portfolio, an inflation rate, and in some cases future health care costs (medical benefits are part of many plans).

So, when we say a plan is “fully funded,” it may not be so if the assumptions are wrong. The amount a plan is underfunded could be much larger than the sponsor and auditors say. In theory, it could be smaller, too, but I have never seen that happen. The accounting rules that govern all this allow (some would say encourage) the sponsoring cities, counties, and states to understate their liabilities. This lets them avoid hard decisions like raising taxes, cutting benefits, or reducing other needed services.

Here’s a Wharton School note to place this huge number in context.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_1_20190510_TFTF.png

Sanitation workers, firefighters, teachers and other state and local government employees have performed their duties in the public sector for decades with the understanding that their often lacklustre salaries were propped up by excellent benefits, including an ironclad pension. But Moody’s Investors Service recently estimated that public pensions are underfunded by $4.4 trillion. That amount, which is equivalent to the economy of Germany, accounts for one-fifth of national debt. It’s a significant concern for public employees who were banking on a fully funded retirement to get them through their golden years. The true number could be much higher. Whatever it is, filling it will be painful for somebody. Pensioners will receive lower-than-expected benefits, taxpayers will get higher-than-expected tax bills, or citizens will see government services cut. Or maybe all the above.

Then again, if you make more realistic assumptions on future returns the unfunded liability becomes $6 trillion according to the American Legislative Exchange Council. Total state and local annual revenues are only $3.1 trillion. Total property taxes are roughly $590 billion.

Here’s more grim news from The Heritage Foundation.

Overall, the American Legislative Exchange Council estimates that pension plans have only about a third of the funds on hand—33.7 percent—that they need to pay promised benefits. Some states have significantly lower funding levels, which means they are at risk of running out of funds in the near future.

Once a state or local pension plan runs out of money, taxpa

yers have to fund the pension benefits of retirees as well as the contributions of current employees.

Connecticut, Kentucky, and Illinois have the lowest funding ratios, at 20 percent, 21 percent, and 23 percent respectively.

Already, Illinois spends as much on pensions as it does on welfare and public protection (that is, police and firefighters) combined, and nearly half of its education appropriations go toward teacher pensions. If the state’s pension plans reach insolvency, pensions could become its single biggest cost.

These unfunded liability estimates are high because plan assumptions are too optimistic. Almost all public pension funds assume investment returns somewhere around 7% (and some as high as 8%+). A more conservative and realistic approach would force the state and local governments to fund those pension plans at a much higher level by either raising taxes or reducing services. What local politician will volunteer to do that? Better to find a consultant to tell you what you want to hear. There are plenty of them that will, for a reasonable fee, billed to the taxpayers.

The following graphic shows how your state is ranked on a per capita funding basis. You can see the absolute numbers in the following table.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_2A_20190510_TFTF.png
Source: Valuewalk

A further complication is that the taxpayers who might have to cover these amounts are mobile. They can move to other states with lower tax burdens, leaving behind those who, for whatever reason, can’t leave their states.

And to make it even more interesting, the beneficiaries often no longer live in the states that pay them. Retired public employees from the Northeast might live in Florida now, for instance. They can’t even vote for the people who govern their incomes.

The broader point: As with the federal debt, some portion of this unfunded pension debt is going to get liquidated in some manner. Any way we do it will hurt either the pensioners or taxpayers.

Thirty years ago Frisco, Texas, had fewer than 20,000 residents. Today its population is well over 180,000. Corporations from all over America are moving there. Tax revenues are booming. Frisco is the happy exception that simply grew faster than its pension liabilities.

Not so Dallas, whose Police and Fire Pension System was advertised as solvent just a few years ago. Now it is so deep in the hole that the mayor says plugging the gap would take almost a doubling of city taxes. (I bought my Dallas apartment after that news was announced but such an increase would have still made my taxes cost more than my mortgage. Can you say taxpayer revolt? It wasn’t the main reason, but it did factor in to my move.) Texas Monthly recently noted:

For those of us in Texas, with our gloriously high credit ratings and fervent allegiance to low taxes, restrained spending and conservative oversight of a robust Rainy Day Fund, the news that certain big cities around the country were in a heap of trouble might have elicited nothing more than a collective, if somewhat condescending, shrug. Except for one thing: Texas’s four biggest cities were all high on the list [of the worst 15 cities]. Dallas, which came in second, is on the hook for $7.6 billion, about five times the amount of its total operating revenues. Houston was fourth, with a $10 billion shortfall—equal to four times its operating revenues. Austin, at number nine, has $2.7 billion in liabilities, and San Antonio, ranked number twelve, is $2.3 billion short. That seems like very bad news for just about any Texan. Particularly since the vast majority of Texans now live in urban areas. How can a state known for fiscal responsibility have so many cities with empty pockets?

Will Frisco residents want to pay for the Dallas pension funding problems? Is The Woodlands going to want to pay for Houston’s problems? Is Indiana ready to pay for Illinois? Of course not. How much of a crisis will we need in order to recognize we are all in this together? Probably a lot bigger than you imagine.

Make the Children Pay

While arguments progress at the national level, state and local leaders must simultaneously pay their pension benefits, provide public services, and keep taxes to a level that doesn’t sweep them out of office or drive top taxpayers away. Not to mention keep the markets happy enough to sell future bond offerings, until such time as the Fed steps in as buyer-of-last resort. A tall order.

Given those choices, the usual answer seems to be “cut services and hope no one notices.” It is happening nationwide but California is in the vanguard, thanks to its massive pension debt. This is from a recent Brookings Institution note.

Pension and health-benefit costs are bending education finances in California to their will. The sheer magnitude of the rising costs is staggering. Large numbers of school board officials who participated in our survey indicate that the rising costs are meaningfully affecting educational services. For example, many report making cost-saving changes to district budgets that include deferred maintenance, larger class sizes, and fewer enrichment opportunities for students in response to rising pension and health benefit costs.

So in effect, today’s students are paying to keep benefits flowing to retired teachers and administrators.

Meanwhile, the Berkeley city council is taking criticism for prioritizing pension payments ahead of public works projects. Voters approved bond issues supposedly dedicated to infrastructure but the city is apparently not doing the work.

Nor is it just California. In a recent study, Bank of America analysts found an inverse relationship between infrastructure investment and pension fund contributions. Each additional $1 billion in plan contributions subtracts about $2.5 billion from state and local government investment.

We have multiple parties fighting over pieces of the same pie, all hoping that Uncle Sam will step in and save them. Uncle Sam may well do it, too, but it won’t remove the pain. It will just redistribute the burden, perhaps more widely, but the aggregate amount won’t change.

In my view, this leads to some kind of Japan-like deflationary recession. If we’re lucky, it will be mild and long. It won’t be fun but the alternatives would be worse.

Towards income equality

Reproduced from The New Yorker March 2014

By John Cassidy

Fifteen or twenty years ago, debates about inequality tended to be cast in terms of clever but complicated statistics, such as the coefficient and the Theil entropy index, which attempted to reduce the entire income distribution to a single number.

 One thing that Piketty and his colleagues Emmanuel Saez and Anthony Atkinson have done is to popularize the use of simple charts that are easier to understand. In particular, they present pictures showing the shares of over-all income and wealth taken by various groups over time, including the top decile of the income distribution and the top percentile (respectively, the top ten per cent and those we call “the one per cent”).

The Piketty group didn’t invent this way of looking at things. Other economists, such as Ed Wolff, of New York University, and Jared Bernstein and Larry Mishel, the creators of the invaluable State of Working America series, have long used similar charts and tables in their publications. But partly by using new sources of data, such as individual tax records, and partly by expanding the research to other countries, Piketty and his colleagues have deployed their charts to reshape the entire inequality debate.

For a long time, that debate was almost entirely focussed on what was happening to median incomes. That inevitably led to discussions of globalization, skill-biased technical change, and policies focussed on education and retraining. Now, thanks to Piketty et al., the remarkable gains of those at the very top can’t be avoided. And this means that the issues of politics and redistribution can’t be avoided either.

The next chart is a simple one, and it concerns the United States alone. It tracks the share of over-all income taken by the top ten per cent of households from 1910 to 2010. Broadly speaking, it’s cantered on a U shape. Inequality climbed steeply in the Roaring Twenties, and then fell sharply in the decade and a half following the Great Crash of October, 1929. From the mid-forties to the mid-seventies, it stayed pretty stable, and then it took off, eventually topping the 1928 level in 2007. (The chart shows the share of the top decile falling back a bit after the financial crisis of 2007 to 2008. New figures for 2012 from Saez, which came out too late to be included in Piketty’s book, show the line hitting another new high, of more than fifty per cent.)

https://media.newyorker.com/photos/590951552179605b11ad2f98/master/w_727,c_limit/chart-01.jpg

The second chart shows the share of income taken by the one per cent over the same period, and the teal line, which includes income of all kinds, has the same U shape. (Once again, the 2012 figures, which aren’t included, show another step up.) The top percentile hasn’t taken such a large share of over-all income since 1928. Interestingly, the recent rise in its share is a bit less dramatic when the analysis is confined to wage income. The difference between the bottom line (wage income) and the top line (total income) is accounted for by income from capital—dividends, interest payments, and capital gains. Because they own a lot of wealth, the one-percenters receive a lot of their income in this form.

https://media.newyorker.com/photos/590951552179605b11ad2f9c/master/w_727,c_limit/chart-02.jpg

Chart Three expands the analysis to what Piketty calls other “Anglo-Saxon countries”— Australia, Canada, and the United Kingdom—and it confirms that rising inequality is a global phenomenon. Since 1980, the share of over-all income going to the one per cent has risen sharply in those three nations, too. However, the United States still comes out as the winner of the inequality race.

That’s perhaps not too surprising: we tend to think of the United States as a very unequal country, but it’s worth noting that this perception wasn’t always accurate. The chart shows that, ninety years ago, the United States and Canada had roughly the same amount of inequality, according to this measure, while the United Kingdom was a markedly less equitable place.

Today, though, the U.S. has few challengers. Even in terms of income generated by work, Piketty notes, the level of inequality in the United States is “probably higher than in any other society at any time in the past, anywhere in the world.”

https://media.newyorker.com/photos/59095148c14b3c606c103770/master/w_727,c_limit/chart-03.jpg

Chart Four shows what’s been happening in six developing countries: Argentina, China, Colombia, India, Indonesia, and South Africa. Once again, we see the familiar U shape: during the past few decades, more and more income has been accumulating at the top. In most of these countries, however, the share taken by the one per cent is quite a bit lower than it is in the United States. The one exception is Colombia, where the figures are broadly comparable. (Compare Chart Four to Chart Two.) It barely needs noting that Argentina, Indonesia, and South Africa are highly stratified and grossly inequitable nations. But, according to this measure, anyway, they have less inequality than the United States does. Despite the recent growth of a big-spending nouveau-riche class, the same is true of China.

https://media.newyorker.com/photos/59095148c14b3c606c103775/master/w_727,c_limit/chart-04.jpg

The fifth chart switches the attention from income to wealth, and it takes a long-term perspective. For much of the nineteenth and twentieth centuries, the class-bound societies of Western Europe were dominated by a landed and monied elite that owned much of the land and the wealth. The United States had rich and poor, too, but the wealth was still spread around a bit more widely. In 1910, for example, the one per cent in Europe owned about sixty-five per cent of all wealth; in the United States, the figure was forty-five per cent.

In recent decades, the roles have been reversed. The U.S. monied elite has outstripped its counterpart on the other side of the Atlantic, and wealth has become even more concentrated in the United States than it is in Europe. In 2010, the American one per cent owned about a third of all the wealth: the European one per cent owned about a quarter. Citing figures like these, Piketty warns that “the New World may be on the verge of becoming the Old Europe of the twenty-first century’s globalized economy.”

https://media.newyorker.com/photos/590951492179605b11ad2f69/master/w_727,c_limit/chart-05.jpg

The last chart is a bit different. It concerns Piketty’s theory that capitalism has a “central contradiction”: when the rate of return on capital exceeds the rate of economic growth, inequality tends to rise. (That’s because profits and other types of income from capital tend to grow faster than wage income, which is what most people rely on.) The purple line shows Piketty’s estimate of the rate of return on capital at the world level going back to antiquity and forward to 2100. The yellow line shows his estimate of the global growth rate over the same period.

The important point to note is this: setting aside the period from the late nineteenth century to the early twenty-first century, which is roughly what we would call modernity, the growth rate has been below the rate of return, implying steadily rising inequality. The twentieth century, far from representing normality, was a historic exception that is unlikely to be repeated, Piketty argues. In the coming decades, he says, the growth rate will most likely fall back below the rate of return, and the “consequences for the long-term dynamics of the wealth distribution are potentially terrifying.”

https://media.newyorker.com/photos/5909514a019dfc3494e9d98e/master/w_727,c_limit/chart-06.jpg

Piketty’s projection is only guesswork, of course. (In my magazine piece, I suggest a couple of ways it could be turn out to be wrong.) But it’s based on some serious arguments, and it’s got a lot of people talking. Just like the rest of the book.

Charts adapted from the originals in Thomas Piketty’s “Capital in the Twenty-first Century.”

John Cassidy has been a staff writer at The New Yorker since 1995.

How I learned to love the Debt

By John Mauldin

The US, Europe, and most of the developed world on are the road to Japanification. We will see financial repression, ever increasing deficits, slower growth, etc. Essentially, the rest of us will begin to look like Japan with its astronomical deficits and ultra-dovish monetary policy.

This is not the end of the world. It’s not the best world, either, but we’ve gone too far to come back now. There is no significant constituency for any of the things it would take for the US government to balance its budget. Neither party wants to reduce the deficit, and the MMT fans want to make it even bigger.

That means the rules of investing we have come to know over the last 50 years are likely—as in very, very likely—to change. But we should generally do fine as long as we change our own investment strategies accordingly.

Ben Hunt over at Epsilon Theory recently riffed on Stanley Kubrick’s 1964 masterpiece, Dr. Strangelove or: How I Learned to Stop Worrying and Love the Bomb. He did a great parody with it called, Modern Monetary Theory: How I Learned to Stop Worrying and Love the National Debt.

Could we actually see Modern Monetary Theory in the US? Lacy Hunt in his latest quarterly explains how it is theoretically possible for the Treasury Department to issue zero maturity, zero interest bonds to the Fed, which would then deposit dollars into the Treasury bank account. This would, at a minimum, create inflation and possibly hyperinflation. To say it would be destructive is like comparing an ocean breeze to a category five hurricane. It would in fact be a financial disaster of biblical proportions.

I don’t believe it will happen that way. We will instead run up debt the old-fashioned way: Japanification and massive amounts of quantitative easing. Let’s look at how that might play out.

 The Financial Times has a very helpful graph using Congressional Budget Office data showing the deficit as a percentage of GDP, both in the past and forecast for the next 10 years.https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_2_20190426_TFTF.png

When you realize that the GDP is well over $20 trillion now, and the CBO projects the GDP to grow, this chart visually understates the reality of growing deficits. Let’s look at another helpful chart, which actually shows the dollar amount of the projected deficits.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_3_20190426_TFTF.png
Source: CBO

Basically, the projection is an average annual deficit of $1.2 trillion per year for the next 10 years. But there are a few caveats.

First, let’s assume away the real world. To give the CBO their due, they only assume 2.3% GDP growth, very mild unemployment growth, and roughly 2% inflation.

But here’s the kicker. Well, actually there’s two. They assume no recession and they make no allowance for the roughly $400 billion per year in off-budget expenditures.


The off-budget expenditures mean that, even without a recession, the debt will rise $1.6 trillion per year for the next decade. That means the national debt will be $40 trillion by 2029.

If, as I expect, there is a recession, we will reach that $40 trillion number sooner, sometime in 2026 through 2028. The deficit in a recession will be a minimum of $2 trillion per year and maybe much higher than those suggested above.

There will be some token movement to reduce spending, but it won’t make much difference because “mandatory” spending (a euphemism for Medicare, Social Security, and other entitlement programs plus interest on the debt) plus defense spending overwhelms so-called “discretionary” spending. Here’s the CBO chart (again in terms of GDP because the absolute numbers would scare you).

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_4_20190426_TFTF.png
Source: CBO

Even if we could cut some discretionary spending, the deficits would still be huge as there is no constituency for cutting entitlement programs. We will talk about why growth will actually slow under such a scenario in a later letter. Today’s question is, where will we get the money to pay for this spending?

Answer: The Treasury Department will sell bonds and run up the debt. That’s a given. Then there will be a recession, as there always is, and then the Federal Reserve will take interest rates down to the zero boundary (otherwise known as financial repression and the devastation of savers), followed by unprecedented amounts of quantitative easing… just like Japan has done.

Again, this isn’t the end of the world, at least if we pursue it that way. Full-on MMT would be much, much worse, and if I seriously expected it, I would be preparing to ride out a hyperinflation scenario. But I do not think that will happen.

Is it possible? Sure. The most dangerous thing for investors is to not imagine what could go wrong with their basic thesis. Right now, my base case is for a more or less deflationary world.

Monetary Hockey Stick

Now let’s think how we got here. The response to the last crisis setup the next one. A lot happened in 2007–2009, during which we endured a recession that left little chance for reflection. Now we have that chance.

Those in authority back then faced enormous pressure to “do something.” Letting nature take its course may well have been the best strategy, but it couldn’t happen that way in our political system. They had to act.

(Sidebar historical note: there was a Crash/Depression in 1920–1921. You never read about it. President Warren Harding simply did nothing and let prices and markets clear. It was all over by mid-1921, and we got the Roaring 20s. No Fed or government intervention, except the Fed did raise interest rates to 7% after inflation World War I, so they get a share of the blame. And there was the gold standard, so no QE was available. Back to our world…)

In 2008–2009, we got things like TARP—the Troubled Asset Relief Program that used $431 billion of your money to buy loans that banks no longer wanted on their books. The government eventually sold most of them, as well as equity warrants received from participating banks, so the net cost came out much lower. But that wasn’t a sure thing.

What we now forget is that TARP helped banks that weren’t even banks before that point. Goldman Sachs, Morgan Stanley, and numerous other broker-dealers and insurers hurriedly got bank charters specifically so they could be part of TARP. The government welcomed it, too. But these fiscal and regulatory surprises pale in comparison to the Federal Reserve’s unprecedented monetary actions.

Rate cuts were only part of it and not the most important, but they were huge. In August 2007, they cut Fed Funds a quarter-point from 5.25% where it had stayed for some time. A year later, it was down to 2%, and soon was effectively zero. Compare that to the current cycle, which spent four years raising the rate from that effectively zero level to the present 2.5%.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_5_20190426_TFTF.png
Chart: St. Louis Fed

The Fed is perfectly capable of moving rates far more aggressively than we have seen recently, and in either direction. But the bigger and even more aggressive policy move was in asset purchases, which included but weren’t limited to quantitative easing.

When the crisis hit, the Fed by law could only buy certain kinds of assets: Treasury securities, bank debt, federally-backed mortgage securities, and the like. They didn’t change the rules but instead stretched them far beyond what anyone envisioned could ever happen.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_6_20190426_TFTF.png
Chart: St. Louis Fed

That hockey-stick jump in the Fed’s balance sheet assets wasn’t on anyone’s radar, but it happened. The Fed then added several more rounds before finally topping out and recently beginning to exit.

Was any of this the end of the world? No. The markets absorbed it all and even performed well. In fact, markets performed well because they absorbed all this craziness. In that lies the seed of our next cycle.

Killer Debt

Recently I sent Over My Shoulder members a Swiss newspaper interview with my friend William White. Bill is former chief economist with the Bank for International Settlements and my favourite central banker. He speaks with unusual candour. In discussing the current move to loosen policy, the reporter asked, “How did we end up in the debt trap?” Bill’s answer:

“We were encouraged to do this. Just think what we have been doing since 2007. Monetary easing is an invitation to take on more private sector debt. And fiscal expansion is by definition an increase of government debt. Both instruments carry the risk of higher debt levels that eventually will kill you.

In the Great Recession, we had both fiscal easing (TARP, expanded safety net programs, etc) and monetary easing (lower rates, asset purchases, QE). The result, exactly as Bill said, was sharply more government debt and private sector debt.

That may seem counterintuitive, since recessions supposedly bring deleveraging. That happened, but not uniformly. Some deleveraged while others added more, and the latter group was much larger. And the Fed’s vast liquidity injections enabled it.

Bill went on to explain that debt problems are about solvency, but central banks provide liquidity. A fractional reserve banking system has a lender of last resort in order to avoid collapse in a bank run. Bailing out borrowers who can’t repay is not its mission or its talent.

Nonetheless, under pressure to act, the Fed and its peers did what they could: throw money in all directions, hoping some of it would stick. Some of it did, too. The new liquidity found its way into assets whose prices then rose, enabling more borrowing, driving asset prices higher again, and here we are.

 According to the Institute for International Finance, global debt was $244 trillion as of Q3 2018. More than half of it was financial and non-financial corporate debt. About 27% ($65 trillion) was government debt (not counting unfunded liabilities, which are huge).https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_7_20190426_TFTF.png


Source: Bloomberghttps://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_8_20190426_TFTF.png

Household debt was the small category and hasn’t grown that much in the US. Here’s a closer look via the New York Fed’s quarterly survey.

You can see in the chart how US households retrenched in the recession, then began slowly adding more debt in 2013 and after. Mortgage debt is still slightly below its pre-crisis peak.

Corporations did not limit themselves like families did. Here’s nonfinancial corporate debt growth for that same period (2003–2018).

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_9_20190426_TFTF.png
Source: St. Louis Fed

The recession (shaded area) had almost no effect on corporate debt growth, which continued merrily higher. Note that this is only securitized debt; much more exists on private books. You could argue that the added debt is not so dramatic as a percentage of GDP, which also grew in this period. That’s true, but it’s also riskier debt. The proportion of bonds at junk or near-junk status has grown significantly.

I’ve quoted several times now my friend Peter Boockvar’s statement, “We no longer have business cycles, we have credit cycles.” His point: Falling asset prices won’t be a result of the next recession; they will cause the next recession. And asset prices will fall when the free-flowing credit that pushed them so high recedes, which it is doing right now thanks to the Fed’s two-factor experiment of simultaneously hiking interest rates and reversing QE. The Fed is now at least pausing that experiment and appears set to reverse it later this year.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_10_20190426_TFTF.png I fear they are acting too late. The latest corporate earnings news and lots of other data suggests the cyclical weakening has begun. The next marker will be some high-profile debt defaults, probably among lower-rated issuers. I don’t know who: WeWork, Tesla, name your favourite. But somebody is going to run out of cash and find themselves unable to refinance for the 97th time. And then the real fun will begin.

Dominoes Dropping

Years ago, I started calling Japan a “bug in search of a windshield.” I was certain their economy would go splat as they ran huge government deficits, cratered their own currency, and had the Bank of Japan buy every financial asset that wasn’t nailed down.

Well, the Japanese have enthusiastically implemented all those policies. I’m not going to say it worked… but the bug hasn’t yet hit the windshield. Other governments and central banks have noticed, too.

Here’s what they observe. Japan has spent decades with zero or negative rates, engaged in massive QE and boondoggle spending, gone in and out of recession, and somehow stayed on its feet. An economic boom it is not, but the country avoided the worst nightmares. That’s a “win” in the way central bankers think.

Meanwhile, Mario Draghi’s European Central Bank tried a similar strategy to the extent it could, given that the Eurozone lacks a unified fiscal authority. It seemed to be working well enough that the ECB decided last year to end some of the extraordinary measures. But simply talking about it appears to have put the Eurozone economy into a mild flu. So now they are back on a Japan-like course.

Italy alone has so much debt it could easily become another Greece, but far larger and more difficult for the rest of Europe to rescue. Italy is already in recession, albeit a mild one (so far), but its debt load is still rising. At some point, it becomes a systemic risk to the Eurozone and EU.

And the US? As I’ve said, the Fed waited too long to start exiting from crisis-era measures. They gave the economy time to go from “dependence” on easy money to outright “addiction.” And as we all know, addictions are very, very hard to break. So now the Fed has cold feet, too. Further tightening appears unlikely. They will try to cut rates as the weakness grows more obvious, but it won’t help, and they will start digging through the toolbox for something else to try.

Whatever they do will probably surprise and alarm us. It will not have the desired effects, at least not as fast as they want. But it also won’t kill us if we prepare for it.

The dominoes are starting to drop as expected. To review…

  • The entire world is up to its ears in debt, thanks to a decade of central bank action.
  • We are late in a growth cycle that is going to end, possibly soon.
  • Whenever it does, US government borrowing needs will skyrocket higher from already astronomical levels.
  • The Federal Reserve will end up monetizing this new debt.

Working off that debt will take years, possibly decades. Hence the long, slow Japanization I’ve described. I don’t think we will endure it for 30 years like Japan has. We will instead force a worldwide default, which I’ve dubbed the Great Reset.

Beyond that lie better times. But we’ll go through hell first.


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