I Was Told There Would Be NO Math.
October 24, 2022
“One-legged Man in an Ass-Kicking Contest” Illustration by my 7-year-old daughter
The apple doesn’t fall far from the tree!
There is an old Saturday Night Live sketch of a presidential debate where Chevy Chase portraying President Gerald Ford was asked a question regarding budgetary figures. Instead of answering the question about his administration's economic policies, he responded "it was my understanding that there would be no math." The retort is both humorous and fitting for our own present experience. It seems like government officials both domestic and global would rather invoke "I was told there would be no math," rather than face the troublesome reality.
Charlie Munger once quipped “without numerical fluency, you are like a one-legged man in an ass-kicking contest.” I am continually surprised at how few people on Wall Street and important Government positions fail to have a sound grasp of arithmetic. Since the start of the year, I have been monitoring a few issues that have me scratching my head and concerned. A few months back in my letter The Beatings Will Continue Until Morale Improves, I discussed a few "Fundamental Laws of Physics for Investing.” There I explained that investing and economics have general rules that hold over long periods of time but do not have to hold over shorter periods of time. Here we are three quarters of the way through 2022 facing the worst market correction since the 2000 tech bubble and we are still out of equilibrium. I remain defensively positioned but have begun questioning for how much longer.
What Happened… Introducing the Short-Term Debt Cycle
If we rewind to 2021, the economy was rebounding strongly from the COVID-19 shutdown and trillions of dollars of economic stimulus provided by central governments and central banks globally. If we break the economy down to its most basic elements, it is nothing more than the sum of all the transactions that occur. And a transaction is created every time we spend money or use credit. It should be noted that the use of credit is far more important to the economy because it greatly exceeds the actual cash available. If we view the economy through this lens, we can create a simple equation to understand our current situation.
The most important part of understanding what is going on in the economy is a simple truth. One person's spending and debt is EQUAL to another person's income and assets.
Since governments globally have added trillions of dollars into the economy and productivity (quantity sold) has remained relatively stagnant or moved lower from supply chain issues, prices have climbed significantly.
The central bank's role is to control the amount of money and credit that is available in the economy. When economic activity declines like it did with the forced shut down during the early days of the COVID-19 pandemic, the central bank stimulated the economy by lowering interest rates which increased demand for credit and printed money to purchase financial assets (mostly government debt and mortgages). Cheap credit fueled consumer demand and central bank purchasing of financial assets forced investors into riskier markets driving stock prices higher.
Low interest rates and a greater availability of money allows people to spend more than the productive capacity of the economy can handle in the short run. For example, if a person earns $100,000 a year and can borrow 10% of his income, he can spend $110,000. This means another person is earning $110,000 in income and she can borrow and spend $121,000. This dynamic results in the economy getting overheated and over extended. Ultimately these borrowers are spending their future income today and will eventually have to spend less than they earn to settle their debts.
Inflation starts rising in this situation which causes the central bank to increase interest rates to slow down the economy. Higher rates increase the cost of borrowing leaving consumers with less to spend and total spending declines.
What I have just explained is called the short-term debt cycle. It is human nature to go through periods of excess and correction. That leaves us with the question of, “where are we today?” We are roughly six months into a period of restrictive monetary policy from the central bank. Rising interest rates are causing total spending to decline which should eventually bring down inflation. My description of the economy and credit cycle make it seem like it acts in a mechanical nature. IT DOESN'T. Humans drive the process and typically adjust gradually and then suddenly. Which drives boom and bust behavior. The central banks have made it clear the restrictive policy will remain in place until inflation declines to the desired 2% level.
How Much Longer Will Central Banks Remain Restrictive?
Officials at the Federal Reserve have been clear that they intend to remain restrictive until it is clear inflation is on a path back to its desired 2% level. I found a comment by Jamie Dimon, the CEO of JPMorgan Chase, as particularly helpful in gauging how much longer we may be enduring restrictive monetary policy. I would argue JPMorgan Chase has better data than the US government regarding the status of the economy. As the largest retail and investment bank in the United States, they have unique insight into the health of both the Consumer and US businesses.
"You've got a very strong consumer. However, it's rather predictable if you look at how they're spending and inflation… That extra money they have in their checking accounts will deplete sometime by midyear next year. And then of course, you have inflation, higher taxes, higher mortgages, higher oil, volatility and war." "So those things are out there, and that is not a crack in current numbers. It's quite predictable. It will strain future numbers."
In short, he is suggesting that the economy hasn't felt much pain to date because of the excess savings accumulated over the past two years. However, those excess savings will be exhausted by mid-2023. This means the higher interest rates implemented by the Federal Reserve have not made their full impact and will not until the excess savings have been spent. It is my fear that more trouble lies ahead and will continue for most if not all next year.
The US Government has a funding problem
What adds another wrinkle into what looks like a normal economic cycle is an issue of who will purchase US Government debt to fund the budget deficit. The $23.7 trillion US government debt market is one of the largest most liquid investment options available. The US Federal Reserve Bank holds $9 trillion (38%) of the US Government debt and has purchased nearly all the incremental debt issuance over the past two years to aid the Federal deficit. However, as I just discussed the Federal Reserve bank must drain cash and credit out of the economy to reduce inflation which means it can no longer purchase Government debt. In fact, they plan to reduce their holdings by $650 billion per year. Banks hold an estimated $4.8 trillion of US Government debt (20% of total). However, as Mr. Dimon mentioned above consumers are draining their savings which means banks in turn must reduce their holdings of US Government bonds. These two buyers account for 58% of the total US Government debt market. While these two buyers are reducing their ownership, the US Government must also find new buyers for its estimated $1.4 trillion budget deficit. This means individual savers, pension funds and foreign governments will need to step up and purchase >$2 trillion of US government bonds in order to avoid a liquidity problem.
The smart question to ask in response to this looming problem is "and then what?" After all every seller needs a buyer. To entice other buyers to purchase the new debt, the Federal Government will likely have to offer higher interest rates. This will in turn continue to put pressure on all other financial assets as the interest rate on US Government debt is the standard by which all other assets are priced. It is important for the Federal Reserve and Federal Government to work in concert with each other. If there aren’t enough buyers of Government bonds to fill the $2 trillion funding gap, the Federal Reserve also known as the ‘lender of last resort’ will have to step in. If required to do so, their ability to fight inflation will be impaired.
Thoughts on the Market
- Asset prices rise after a period of pessimism
- Greed grows as fear of losing money is replaced by fear of missing out
- Risk aversion and caution disappear as investors assume things will get better forever
- Eventually company fundamentals disappoint the market's lofty expectations
- Prices decline and adjust towards fair value
- Pessimism drives prices below fair value; a few investors realize things will get better
- Everyone realizes things are getting better and prices rise
- Rinse and repeat
I introduced the market cycle above in my May letter The Beatings Will Continue Until Morale Improves and at the time felt we were in stage 4 or 5 of the cycle. At this point, I think we have moved into stage 5. Prices have adjusted in an orderly manner lower, but it is difficult for me to make the case they are significantly below fair value that would signify stage 6. I must qualify this assessment, there is no guarantee that the market will follow the precise path of the cycle drawn above. It could dip briefly into stage 6 for a couple days and exit, last for an extended period of time or I could be wrong in my assessment of valuations and stage 6 already occurred. Pessimism is present in the market today, but not at the levels of despair I have seen in past market corrections, when I think economic conditions were better than they are presently.
This letter has a somber assessment of what I think we may face with the road ahead. However, we need to bear in mind that all of this has happened before, and it will happen again. The headlines will continue to be scary as they always have. But most major companies will set new profit records down the road. The American economic system works. We must remind ourselves as investors that we are part owners of great businesses, and they will surely suffer hiccups along the way. Remember over the long run business results converge with the financial results of the companies we invest in. A better future still lies ahead.
Cautions Investing,
To The Front
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Cautious Investing,
To The Front
This commentary is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market result is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.
