Markets are all about flowsJan 3, 2019·Alasdair Macleod
This article looks at prospective supply and demand factors for financial assets in the New Year and beyond. Investors should take into account money flowing into and out of financial assets as well as stock flows, particularly escalating government bond issuance, which looks likely to accelerate significantly in the coming years. It adds up to the fundamental case for physical gold and silver.
At this time of year, the thoughtful soul considers prospects for markets. Pundits are laying out their forecasts, and they fall into two broad camps. There are brokers and fund managers who talk of value. Their income and assets under management depend on continually inflating prices. Then there are the pessimists, a ragbag of doom-mongers who sweepingly point to risks on a grand scale. The collapse of Italy, Deutsche Bank, China, Brexit… take your pick. Very few engage on the subject that really matters, and that is the underlying monetary flows into and out of financial markets.
We must assess the pace of monetary expansion relative to the demand for money and credit, and where that expansion goes. Early in the credit cycle, there is little demand from the non-financial sector for monetary expansion, so excess money and bank credit go into the financial sector, pushing up financial asset prices. As the cycle progresses, it begins to be demanded by the non-financial economy and money then flows from the financial sector to non-financials. This is why we have observed that just as business conditions in the real economy start improving, just as valuations begin to be vindicated, interest rates and bond yields start rising and shares enter a bear market.
It should be noted that while some shares are sure to rise reflecting specific corporate developments and investor focus, money draining from financial markets has the same effect as air draining from a leaking balloon. They deflate, and taken as a whole, prices of both bonds and equities persistently decline.
Interest rates begin to rise when the monetary expansion earlier in the cycle finds its way into the non-financial economy, inflating prices of goods and services instead of financial assets. More money ends up chasing the same quantity of manufactured goods and services, and their prices rise without an increase in demand. It is this effect which confuses those who can only equate rising prices with increased demand.
But for investors, the important effect of the evolving credit cycle is that it begins to limit the flow of new money into financials, relative to the money exiting into the non-financial economy. It is the balance of these flows which basically determines market values as a whole. The pessimists, many of whom will have been forecasting the imminent demise of stockmarkets through the whole bull run, at last have a chance of being right, because of the knock-on effects of falling financial asset values. And it must be borne in mind that in the absence of new money flowing to support financial asset prices, there are always marginal sellers who will drive prices lower.
The supply of government debt will increase
Besides the ebbing away of money supply from financials into the real economy, we must also consider the effect of stock flows on financial prices, the most significant being changes arising from the financing of government deficits. In a conventional Keynesian economic model, the government stimulates the economy by deliberately engineering a budget deficit early in the cycle. As economic activity recovers, tax revenues improve, and government finances return to a surplus. Therefore, according to Keynes’s theory, demand for capital evens out over the cycle as a balance is restored towards the end of it.
This idealised setup is no longer the case. The last US budget surplus was eighteen years ago in 2000. Since then the US economy has had a bust, followed by a boom, another bust and in 2017-18 was in its second boom. The accumulated budget deficits since 2000 total $12.454 trillion and government debt has increased from $5.674 trillion to $21.516 trillion.[i] Whatever one thinks of Keynesian interventionism, the abuse by the US Government of Keynes’s theory of the state’s management of the economy is truly staggering, and seems set to drive it into a debt trap that can only result in either a severe retrenchment of state spending or the eventual destruction of the state’s currency.
So far, investors have ignored this underlying trend. They have happily taken the combination of zero interest rates and monetary expansion and invested in financial assets, including all the government debt on offer. The money and credit have been issued for them to do this, but it cannot continue for ever. Monetary inflation has led to many governments adding to their debt obligations throughout the whole credit cycle, so the affordability to governments of future debt issues is bound to become an issue.
The rule of thumb employed by economists in the past has been to compare growth in GDP with the interest cost of government funding. This presupposes that GDP growth leads to higher tax revenues, and as long as the increase in tax revenues is expected to cover the interest cost of the increased debt, the debt is deemed affordable.
Governments have benefited from this relationship in recent credit cycles, not through increases in GDP, but through the suppression of interest rates. This is particularly dangerous, because a debt trap will almost certainly be sprung when that unnatural suppression comes to an end. It also assumes that economic growth continues with little variation. It cannot apply to countries heavily exposed to the volatility of commodity prices, particularly emerging economies, nor is it viable in the real world of increasingly destabilising credit cycles evident in consumer-driven welfare states.
The next two sections in this article will concentrate on the debt position of the US, on the basis that the dollar is the world’s reserve currency, and international markets reference prices in dollars. An acceleration of debt supply from the US Government is likely to dominate global investment flows and financial valuations in the next decade, so we should try to quantify them.
When considering the US Government’s debt, it must be noted that roughly one-third is held by the government itself in accounts such as the Social Security Trust Fund. However, they represent funding of external welfare obligations, so are external liabilities for the Federal Government. For the purposes of this debt analysis, they will be dealt with the same way as other public obligations, rather than as a purely technical internal government arrangement, which is the assumption of the Congressional Budget Office from which much of our information is drawn.
The threat of a US Government debt trap
The issuance of debt is normally subject to a contract that it will be repaid at the end of its term, along with the coupon interest. The exception is undated bonds, when only the interest contract must be fulfilled. In practice, governments and many corporations roll over debt into new bond obligations at the end of their terms, but at least bondholders have the opportunity to be repaid their capital. Therefore, the credibility of government debt is based on the assumption the issuer can afford to continue to roll it over rather than repay it.
However, the rolling over of old debts and the continual addition of new ones will almost certainly become a problem for governments everywhere. It is less of a problem when the debt is put to productive use, but that is rarely, if ever, the case with government finances. To judge whether the rolling over of debt is sustainable and at what cost, we need to rely on other metrics. The traditional method is to compare outstanding debt with GDP, and by using this approach two economists (Carmen Reinhart and Ken Rogoff) came up with a rule of thumb, that once a government’s debt to GDP ratio exceeded approximately 90%, economic growth becomes progressively impaired.[ii]
The Reinhart-Rogoff paper was empirically based, and loosely impresses upon us that the current situation for the US and other nations with higher debt to GDP ratios is unsustainable. Key to this reasoning is that rising debt levels divert savings from financing economic growth, and therefore a government’s ability to service it from rising taxes is undermined. At the Rubicon level of 90% and over, median growth rates in the countries sampled fell by 1%, and their average growth rates by “considerably more”. It is entirely logical that a government forced to tax its private sector excessively in order to pay debt interest will restrict economic potential overall.
This analysis was published in the wake of the Lehman crisis, when an unbudgeted acceleration in the rate of increase of government debt everywhere was a pressing concern. The signals from financial markets today indicate that we could be on the verge of a new credit crisis, in which case tax revenues will again fall below existing estimates, and welfare costs rise above them. Therefore, government debt will increase unexpectedly, as was the case that caused the Reinhart-Rogoff paper to be published in 2010.
To look at the increase of government debt between 2007 and 2009, as Reinhart-Rogoff did, was not, as it turned out, a long enough time-frame to fully reflect the consequences of the Lehman crisis on government debt. The increase recorded over 2007-09 was 32%, yet economists and others were still talking of austerity until only recently. The whole period between the Lehman crisis and the election of President Trump is perhaps a better time-frame, and we see that US Government debt between 2007 and 2016 increased by an astonishing 217%.
It turns out that the Reinhart-Rogoff report severely understated the problem by reporting early. Their 90% debt to GDP Rubicon has been left behind anyway, with government debt to GDP ratios around the world in excess of 100% becoming common. In the case of the US, total Federal debt, including intragovernmental holdings, is currently over 105% and rising. The Congressional Budget Office is forecasting substantial budget deficits out to 2028, adding an estimated further $4.776 trillion in deficits between fiscal 2019-23, or $9.446 trillion between fiscal 2019-28.[iii]
This assumes there is no credit crisis, so for those of us who know there will be one during the next ten years, these numbers are far too optimistic. Accordingly, we should look at two possible outcomes: first, a best case where price inflation continues to be successfully managed with a target rate of two per cent, and a second base case incorporating an estimate of the effects of the next credit cycle on government finances.
Best and base case outcomes
Our best-case outcome of controlled price inflation is essentially that forecast by the Congressional Budget Office. Working from the CBO’s own figures, by 2023 we can estimate accumulated debt including intragovernmental holdings will be $26.3 trillion[iv] including our estimated interest cost totalling $1.3 trillion[v].
That is our best case. Now let us assume the more likely outcome, our base case, which is where the effects of a credit cycle play a part. This will lead to a fall in Federal Government receipts and an increase in total expenditures. Taking the last two cycles (2000-07 and 2007-18) these led to increases in government debt of 59% and 239% respectively. Therefore, it is clear that borrowing has already been accelerating rapidly for a considerable time due in large measure to the destabilising effect of increasingly violent credit cycles. If the next credit cycle only matches the effects on government finances of the 2007-18 credit cycle, government debt including intragovernmental holdings can be expected to rise to $51.4 trillion by 2028. This compares with the CBO’s implied forecast of only $34 trillion of government debt over the same time-frame and makes no allowance for the cyclical effect on interest rates. More on interest rates later.
Because the underlying trend is for successive credit cycles to worsen, the $51.4 trillion figure for federal Government debt becomes a base figure from which to work. But there are still considerable uncertainties, particularly over the form it will take.
The character of the next credit cycle is unlikely to replicate the last one, which was a sudden financial and systemic shock. Today, the US banking system is better capitalised and off-balance sheet securitisation has been brought largely under control. There are however, uncertainties concerning the Eurozone banking system. There are also risks in global derivatives markets and the potential knock-on effects of counterparty failures on the US banks. Furthermore, there can be little doubt the sudden systemic shock of Lehman afforded a degree of protection for the purchasing power of the dollar, and therefore of the other mainstream currencies, despite the unprecedented monetary expansion.
However, it would be complacent to expect an outcome of relatively low price-inflation to be simply repeated at a time when government finances are even more dramatically spiralling out of control. Last time the threat was systemic to the banks, but next time the inflationary consequences of government finances is likely to be the dominant problem.
The explosion in the quantity of government debt that our analysis implies has many economic consequences. In the context of our rough analysis we should comment on the point made in the original Reinhart-Rogoff paper, which is that the reduction in GDP potential that results from an increase in the ratio of government debt to GDP is likely to be significant. The growth in Federal debt that replicates the post-Lehman experience will leave the US Government with a debt to GDP ratio of over 170%. The CBO assumes GDP will increase by 48% by 2028 to $29.803 trillion, whereas our cyclical case is for debt to rise to $51.4 trillion. While both these figures should be taken as purely indicative, clearly, US Government debt will increase at a faster pace than the growth in GDP and will strangle economic activity.
If the purchasing power of the dollar declines more rapidly than implied by the CBO’s assumed 2% price inflation target, interest payable on Federal debt will in turn be sharply higher than expected, compounding the debt problem. The Federal Government will face a potentially terminal debt trap from which there can be no escape.
Flows v purchasing power
On the face of it, bulls in financial markets will face an uphill struggle if they are to make money during the next credit cycle, given the prospect and consequences of an increasing supply of government debt. It is the diminishing flows into and increasing flows out of financial markets, together with the escalating demand for funding from governments that will decide the outcome.
When these parallel conditions developed in the UK between 1972-74, the FT 30 Index lost 73% of its value, or 80% allowing for price inflation. Collapsing asset values hit leveraged loans and a commercial property collapse ensued, taking out the secondary banks. A long-dated gilt (government bond) with a twenty-year maturity was issued with a coupon of 15.25% in 1976. That was great for the pension funds who loved the income stream, but ordinary investors were wiped out. The conditions today not only rhyme with this history on a global scale, but there is a worrying degree of replication becoming evident in US financial markets.
We have seen from the above analysis that demand for investors’ money from cash-strapped governments is almost certain to accelerate. The example taken of the US Government’s prospective finances is by no means the worst culprit. All major governments running welfare states are likely to increase their bond issuance in the next few years, particularly, as seems increasingly likely, if the investing world is on the verge of another credit crisis that threatens individual economies.
Members of the Eurozone particularly risk these destabilising difficulties. The ropy finances of Greece, Italy, Portugal and Spain have been well publicised. But we must include France, with her rapidly deteriorating finances as well.
There has always been the option for the central banks to open up the money supply tap. But to do that in addition to the post-Lehman monetary expansion still in the system risks undermining the purchasing power of their unbacked currencies. Price inflation is already no longer something that can be dismissed by hedonics, product-switching and repackaging goods into smaller quantities. Ordinary people and businesses will increasingly baulk at the low levels of time preference that do not take real price inflation adequately into account. Therefore, it is hard to see how central banks will be able to suppress interest rates in the way they have managed in the past. That was the hard lesson learned in the UK in the 1970s: The Bank of England had higher interest rates forced upon it by markets, eventually peaking at 17% in 1979.
It is challenging to see how governments can escape from their debt traps when interest rates rise above the levels currently assumed likely by both investors and government agencies. It will take, at a minimum, substantial cuts in government spending, which comes unnaturally to governments used to low-cost money being available on demand. The effect of high compounding interest will make government finances considerably worse than outlined in this article.
Investors faced with deteriorating prospects for government finances will therefore avoid financial assets, switching to tangibles. Top of the list are solid money in the form of gold, and also silver. Commodities might fall in price in real terms (i.e. priced in gold) but will rise priced in government currencies. Residential property will be hit by rising mortgage rates, but homeowners who survive the initial fall in prices are likely to be rescued by the bankruptcy of their lenders.
The ranking of hedges compared with deposits payable in bankrupt government currencies will become increasingly important to those trying to protect their savings. Worst case is a crack-up boom, but let’s leave that one for another time.
[i] All figures extracted from St Louis Fed’s FRED.
[ii] Growth in a Time of Debt Carmen Reinhart and Kenneth Rogoff, NBER Working Paper No. 15639, 2010. See https://www.nber.org/papers/w15639.pdf
[iii] See Table 2 at https://www.cbo.gov/system/files?file=2018-08/53884-apb2019.pdf
[iv] The CBO estimates of debt and debt interest are based on debt in public hands only. They exclude $5.8 trillion of debt held in intragovernmental accounts, which are included in debt ceiling calculations and my estimates.
[v] This includes estimated interest on intragovernmental debt, which is not in the CBO’s figures, and assumes an increase in average nominal funding costs of 3.25% by 2022, which is a real rate of 1.25% at 2% price inflation. This further assumes the deflator accurately captures the rate of price inflation, which it certainly does not.
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