Thursday, June 30, 2016

Brexit and the Markets

The surprising outcome of the British election over succession from the European Union rocked global financial markets on Friday. The selling continued into Monday, but markets quickly bounced back on Tuesday, Wednesday and Thursday. Now with Brexit a full week in the rear view mirror, most stock markets around the world have nearly or fully recovered their losses. But in bond markets, particularly in the US, the historic gains in prices (and drop in bond yields) remain largely intact. Moreover currency markets have also retained their post election gains (or losses).

Immediately following the large declines in world stock markets on Friday, investment advisors for major banks were all over the media advising investors of the bargains the stock market had provided. They cautioned investors that the markets were overreacting, throwing the proverbial baby out with the bathwater. Investment strategists were quick to point to beaten down US stocks, like Southwest Airlines with virtually no British of european exposure. The argument being, that these stocks were being unfairly punished by an indiscriminate market inclined to sell, sell, sell.

In reality, the market reaction to the Brexit vote had very little to do with the implications for corporate earnings or weakened economic activity in the UK. It had everything to do, first and foremost, with the excessive risk-on positioning of portfolio managers who were betting strongly on a remain vote. Many pointed to the odds at British bookie parlors, the "in the know" folks who were treating Brexit as a one in six probability. The torrid selling on Friday and into Monday was largely driven by fund managers scrambling to get back onside.

There is, however, a much more significant and lingering issue that underlies these moves. This, is the implication for currency markets. Friday saw the greatest one day selling of the Great Britain Pound (GBP) in history. While the Euro also sank, the US dollar rose. And, in far more dramatic fashion, the Japanese Yen soared.  

And herein lies the problem for US stock markets. The Bank of England announced earlier today that they will be likely adding to QE to stimulate the post-Brexit economy. As one might expect, the GBP is down another 1.5% against the dollar on the news. Further QE by the ECB would predictably have a similar reaction in currency markets. This being said, it is the Yen and the Chinese Yuan that pose the greatest risk to devaluation and the greatest implications for a further rise in the dollar, as these countries desperately struggle to invigorate their own exports. A stronger dollar would pressure sales and earnings of US multinational companies, already suffering not insignificant profit declines and poses a great challenge to US stock prices going forward.  

Thursday, June 23, 2016

The National Debt Problem

Despite what the title above may imply, there are many that do not see the dramatic rise in government debt as a problem. In fact, very few nations see their sovereign debt as an issue, despite the unprecedented rise in borrowings over the past several years. Most recently China, whose total debt has now risen to eye-popping levels, was quick to dismiss their levels of indebtedness as a reason for concern.

Let's put this in perspective for China. According to a recent study published by McKinsey & Co, in 2000, total China debt was roughly $2 trillion. By 2007, China debt had risen to $7 trillion and by 2014 to a whopping $28 trillion. In fourteen years, China's debt has grown by 600%. Yet, Chinese officials are eager to dispel any concern by claiming just earlier today that there is no problem with the debt, as long as GDP continues to grow.  

This has always been the rationale, hasn't it, or at least for the past ten years when debt in China, the US and around the world has exploded higher? The argument is supported by the primary metric for evaluating sovereign debt, the ratio of debt to GDP. China's total debt is currently 250% of GDP and, as shown from the chart to the rights, is expanding at an alarming rate. 

US debt, both total and US federal direct borrowing is also a key problem, however, and here's why. First, let's look at the US national debt and it's growth over the past ten years. Total US government debt in September 2015 was $18.1 trillion, according to official records of the US Treasury Department. In 2007, or eight years prior, the national debt was $9 trillion, representing growth of roughly 100% over this period. Eight years prior to this, or 1999, US government debt was $5.6 trillion, implying a growth rate of 60%. So clearly, the rate of growth is accelerating, in this case, by a factor of 2/3rd.  But let's leave this aside and return to the argument that it is only the ratio of debt to GDP that is relevant in quantifying the level of debt burden of the American people.

This ratio, as well, paints a fairly stark picture as can be seen from this graph of the Federal Reserve Bank of St. Louis.  But this chart shows Federal debt at just over 105%, a level that the government would argue is manageable given the breadth of the US economy. 

But is this metric of debt to GDP even meaningful? Let's remember that the government's ability to pay the interest (and principal) on the national debt is derived from tax revenue. Now while taxes are collected on economic activity, or GDP, it follows that the greater the GDP, the greater the tax revenue, etc.  But is this reasonable if US tax revenue represents a fairly small share of total US economic activity?

According to the Tax Policy Institute, total US tax revenue currently represents just 17% of GDP. With the national debt at $18 trillion and 2015 tax revenue of $3.2 trillion, the ratio of debt to tax revenue (or the portion of GDP that relates to the Federal government) was 562% at the end of last year! Now what other corporation or individual borrower in the United States has a debt to income ratio of 562%? Exxon, one of America's largest companies and with substantial capital investment, had total debt in 2015 of $20 billion. With annual revenues of $51 billion, however, a debt to income ratio of 562% would support debt of $286 billion (it would also make them insolvent to the tune of $116 billion). Perhaps the board of Exxon has considerably more common sense in its judicious use of debt than the US Congress, in its unwillingness to take cover in this questionable metric of debt burden.