David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).
A few thousand miles of flying gives one a chance to catch up on some research reports. In this case the stack was about the debt-to-GDP ratio and what it means.
It is clear that the United States is on a borrowing binge. And also clear that the Nancy Pelosi-led US Congress has no will to restore any discipline to its spending habits.
Now we all know that borrowing at increasing rates cannot go on forever. And we also know that it can go on for a long time. And history shows that the adjustment process is non-linear. In other words, there is a period when the increased borrowing in order to finance consumption seems to be painless. We are in that period now.
This usually is followed by a shock. What triggers the shock? When does it occur? These are the types of questions we wrestle with each day as a money manager. And these are exactly the questions without easy answers. A bunch of research reports has proven that to these tired eyes.
Here is what we do know. The total of all government debt in the US has now breached the 100% of GDP level. We get this number courtesy of Ned Davis and by tallying up all the debt of the federal, state and local governments. This ratio has not been this high since World War II. It is climbing in a vertical fashion and can be projected to set a new record each and every foreseeable month.
Unlike World War II, the US debt explosion is not due to military and interest expense. Ned Davis has calculated the spending to GDP ratio without interest payments or defense. Again we are at an all-time high in the post World War II period. We cannot blame the spending spree on the army.
Total credit market debt to GDP in the US is a record 373% as of June 30th. In the UK it is 233%. In Japan it is 225%. We have become the most profligate borrower of the large countries in the world.
Private sector and household debt is not the problem. In the last two months the household debt declined by a huge $37 billion. Non-financial corporate debt is also not the problem. It is barely increasing.
The problem simply is government. It is borrowing at all levels and without restraint.
From Japan we learned that increasing borrowing can continue for a very long time. And that we can get it without much inflation and with persistent very low interest rates. The reason is that borrowing is a way of loading a debt burden on the economy. The larger the debt burden the slower the economy will grow. This is especially true when the borrowing is for consumption purposes. That is the current condition of the United States.
We borrow from ourselves when we have savings. That is the case today as the savings rate has risen due to an after shock of the financial crisis.
We borrow from others when they are willing to lend to us or when they are motivated by other than economic returns. The Chinese loan to us because that is the way they can maintain their currency peg. They need to do that in order to keep their export prices very low. We buy the stuff cheaply and trade our debt to them in return for their cheaply produced goods.
They are motivated by internal politics. They have an estimated 50 million workers making stuff to sell to us and the rest of the world. (Source: China online) It is better to have those workers earning some income than it is to have them idle and looking to foment civil unrest. We have about 500,000 workers making stuff we sell to China. Our stupid protectionist policies will not change this. Bashing China or placing tariffs on their goods will not create any new jobs in the US. Politicians who tell that to us knowingly lie to us.
China is motivated by internal politics. So they finance us in an unprecedented way. We may as well enjoy it for as long as it continues.
All this debt has a deflationary characteristic. That is a serious worry for the economy. It also means that longer maturity bonds are still worthwhile investments. They have rallied meaningfully and still have more to go in some of the sectors. This is not true for Treasury bonds. It is true for spread product. Those are the bonds that are performing well and will continue to do so until the spreads return to some new level of normalcy. We do not know what the new normal will look like. But we have every reason to believe it will be narrower spreads and not wider ones.
My friend and Brandeis professor Catherine Mann uses metaphors to characterize the interdependence surrounding the China-US debt relationship. I once heard her describe it as similar to the relationship between the alcoholic and the liquor store. They need each other. They can sustain the relationship for a long time. It only ends when the drunk runs out of money or when the liquor store runs out of inventory. In this case the drunk is getting credit and the liquor store is booking the sales on the accrual method and carrying a big receivable. Some day it will have to be paid.
When I think more about this I listen to the advice or sage Art Cashin. It is time to stop for the day and wet some ice cubes with a night cap. We’re back after four flights, 8000 miles, 4 hotel nights, two rental cars, etc. And, we must admit, we did it all on credit. Good night.
David R. Kotok, Chairman and Chief Investment Officer, email: firstname.lastname@example.org