Deficit Spending Gone Wild

For the fiscal year ended September 30, 2013, the US recorded the smallest fiscal deficit in five years. At just over $1 trillion, statesmen and economists from across the nation congratulate themselves on a job well done. The sequester and rising tax rates aside, this feat is universally attributed to economic growth (and the resulting tax take on that growth), the Keynesian "prescription" for economic recovery that has kept Paul Krugman's bearded face affixed to a regular column over at the New York Times. Those proclaiming victory over recession quickly point to a reduction in the ratio of deficit to GDP, now falling for the US to a modest 6.55%.  A further sign of our progress in righting the ship.  

From the nosebleed seats at which we climbed to watch prior years' deficits spiral up to $1.4 trillion, this new level of spending beyond our means has to appear humble, noble, if not awe inspiring. Of course, not a moment has been wasted by those in Washington seeking to claim credit for this accomplishment, eager to compare our new economic prudence to those unprincipled nations of peripheral Europe, still wracked by deficit spending. While the US deficits still exhaust more global capital than the next 7 major industrial nations combined, this must all be taken in context, you see.

The US, they are quick to caution, has carefully managed its fiscal deficit down to a rate below that of many third world nations, the UK and of course the European periphery, where in recent years the much maligned Spain and Greece have flagrantly floated deficits of 13.3% and 24.23% of GDP, respectively.

But this has us thinking. Where exactly is it written that government deficits should be measured in relation to gross domestic product (of all sectors of the economy) in order to weigh their significance to an economy (or the prudent management of governmental budgets)? Well, yes, in the treaties creating the EU, where all participating nations pledged to limit deficit spending to under 3% of GDP. But no one paid attention to that, with literally every nation in the EU (including Germany) breaking this promise, often repeatedly. Is GDP the appropriate measure to judge how modest or excessive deficits have become? Or is the measure of deficits to governmental revenue a more appropriate measure of the extent to which a government is leveraging its tax base?

And that's the thing about the trillion dollar plus deficits that the US has racked up in each of the past five fiscal years. It's the amount that the deficit exceeds the revenue base that to us, is so startling. It implies that all things being equal, tax rates would have to increase by nearly 50% to balance the budget. Measured in this light, even the most recent US fiscal deficit of $1.09 trillion places us second only to Greece in quantifying our flagrant mis-management of the Federal budget.

What's at Stake with the Debt Ceiling and Fed Tapering

The media these days is feasting on the political posturing in Washington over the debt ceiling. Fueling hysteria is, of course, something of a preoccupation of the American media. The public, always eager to line up on the left or right of any issue, has its opinions of who's to blame for the crisis and what should be done to resolve it.  But what's really at stake?  And how does the Fed's decision to taper its QE program fit into this?

Few would argue that taking the country to the brink of default over the debt ceiling makes sense. Truthfully, this is highly unlikely.  The debt limit debate is something of a sideshow for political junkies only. There is little likelihood of an actual default on the debt.  Despite the impending debt ceiling of Oct 17, the Treasury has the existing authority to refinance maturing notes.  While the gov't is shutdown and even if the cap isn't lifted, which it will be, the Treasury will continue to take in $250 b a month in revenue which can easily be prioritized to pay the $30 b or so for interest. Political theater. Good for ad revenue, bad for just about everything else.

But this controversy does raise the question of what our national debt looks like currently and, given the massive deficits financed over the past five years, how fast and far it has grown. Here's a picture of where we are now. Yes, it's the slope that matters and as you can see, it has steepened considerably in recent times.

But many believe the national debt is not a serious problem for the country and point to the interest on the national debt to make their point. As can be seen from our next chart, total interest has actually been falling as a percentage of total US government expenditures. In fact, interest on the national debt now comprises the smallest portion of the Federal Budget the country has seen in the past twenty years!

Here's another take on the US debt burden, showing total net interest in dollars compared to total Federal spending over the past twenty years. Again, it's hard to see what all the fuss is about (the source for all of this data, by the way is the Federal Reserve Bank of St.. Louis).

But here's the rub.  Look at what has happened to the rate of interest accrual on the debt or the net cost of capital for the US government over the past twenty years.  By taking the total net interest payable by the US each year and dividing by the total debt outstanding, we can calculate the implied average cost of that debt.

So now we begin to have a much clearer picture of what's going on. The decline in interest rates over the past five years resulting from the Federal Reserve Bank's unprecedented policies of zero interest rates and quantitative easing have greatly reduced the cost of funding the national debt. We can refer to this as the "Benanke Bequest". In fact, as we now know, the Fed has suppressed interest rates to where they are below the rate of inflation, such that "real" or inflation-adjusted rates of return on US Treasury securities are negative. Economists have referred to negative real rates as "financial repression" to imply a significant and, again, nearly unprecedented repression of the assets and wealth of savers in the US.

This fundamental issue of the effects of financial repression on savers, senior citizens and young families, aside, concern also rises in terms of what the US debt burden will look like when interest rates in the economy are normalized.  For this, we look to the following chart.  If we recompute total interest expense for the US over the past twenty years using the historical average rate of 5.5% (twenty year average) we see the very significant difference between actual and normalized interest expense for the US, as a percentage of total spending. Quite a different picture!

Lastly, we can plot this differential separately for the period 2008 - 2013, to give us a sense of how much added interest expense we avoided, due to the Bernanke Bequest, and what we very well may soon be looking at funding in the years ahead.  Note the scale is in billions of US dollars.  At 25% of total government spending, the interest on the national debt suddenly appears unsustainable.

In our view, this consern is what is causing the Fed to hesitate on tapering its purchases of Treasury securities under QE. The fact that the mere mention of tapering sent the debt markets into a downward spiral this past June-July has frightened the heck out of the Federal Reserve. Because, more than anything, the Fed is well aware of the role the Bernanke Bequest has made in allowing the US to shoulder the crushing additional debt load of the past five years. At the same time, the Fed is equally aware of the effects of continued monetary printing on debasing the currency. The Fed has thus painted itself into a corner. Taper and risk unsustainable levels of interest on the national debt (and also likely crashing stock and bond markets). Continue QE indefinitely and risk a currency crisis. Don't look to Washington to figure this one out.

A New Gilded Age

The period of the late 19th century, following the end of the civil war and before the arrival of WWI is now regarded as the Gilded Age, a period in American history where fortunes of previously unheard of levels were now being made by the likes of John Rockefeller in oil, Andrew Carnegie in steel and the railroad "robber barons" Vanderbilt and Stanford, as they became known.  The Gilded Age, its growing industry and unprecedented wealth soon attracted numerous European immigrants, with the greatest wave of these reaching American shores by the early 20th century.  Amidst all these riches, however, Wikipedia cites the Gilded Age to be one of equally, or perhaps unequally, great poverty in America with the average income of most families below $380 per year.

Social scientists and economists are now drawing parallels of the vast and growing income inequality of America today to that of the late 19th century.  Some have called it the second Gilded Age.  Without question income and wealth inequality is on the rise.  This fact was most recently pointed out in a number of articles that site the fact that just under 20% of the total income in America in 2012 went to the top 1%.  This is the highest share since 1928.  The top 10% earned a whopping 48% of total earnings last year. Perhaps more staggering, since the beginning of the economic recovery in 2009, 95% of income gains have gone to the top 1% of the population.  

At the same time, median household income has fallen for the fifth straight year for a cumulative loss of 8.7% (versus 2007).  Median family income is now the lowest, on an inflation adjusted basis, since 1995.   

Some have blamed Obama, some the culmination of prior administration policies.  Truth be known, Congress has very little direct control over income (other than by confiscating it through taxes) and the White House, even less.  Nonetheless, the evidence of inequality is irrefutable.  So if not administrative policy, what has changed over the past five years that might contribute to such growing income inequality? Monetary policy.

Since the onset of the Great Recession, the Fed has relied on two tools of monetary policy.  Short term interest rates, anchored by the Fed Funds Rate and Discount Rate, were dropped abruptly by the Fed in 2008.  Next Chairman Bernanke deployed a series of unconventional policy tools, known as QE or Quantitative Easing, the purchase of US Treasury and Mortgage Securities by the Federal Reserve.

Today, the Fed's balance sheet has swelled to $3.5 trillion of these securities, with new purchases added at the rate of $85 billion per month.  The recent talk of "tapering" is designed to gauge the level of reduction in the rate of monthly purchases, a phenomena the capital markets regard as tightening of policy.

Aside from the dubious benefits or market-related effects of QE, several things are clear as it regards our topic of income inequality.  First, the Fed's zero discount rate policy or ZIRP has simultaneously dropped the cost of funds of banks on deposits to zero (or near zero) while also lowering the rate of return to investors on bank deposits to this same rate. Economists have called this "greatest transfer of wealth from savers to the banking system in US history".  The banks have been substantially recapitalized through this process, at the expense of savers.  

Bank stocks have rallied, with the Fed shoveling cheap cash their way, which the banks have been all to eager to invest in the rising stock market.  It then should come as no surprise to anyone that the dominant US banking capital of New York has the worst inequality (or highest GINI coefficient) of any state in the country.  The top 1% of New Yokers earn 35% of total income.  The bottom 50%, just 9%.

Second, because the rate of interest on savings deposits, short term US treasury bonds and other fixed income securities, has been less than the rate of inflation, economists have referred to this negative real interest rate phenomenon as "financial repression".  Financial repression favors the issuers of debt, like the US government, and punishes investors in that debt who see their rate of interest turn negative when adjusted for inflation.

Lastly, QE was designed in part to lower mortgage rates in the economy, but also to promote a wealth effect by boosting the value of financial assets, principally stocks.  Given that stocks are disproportionately held by the wealthy, however, these capital gains have been disproportionately owned by the wealthy.  Now, also by surprise, we find growing income inequality among this very same group.

So let's recap what Fed policy has promoted over the past five years.  First, it has favored banks through low interest rates, at the expense of savers.  Second, it has favored the wealthy, as disproportionately large owners of stocks, from those of lesser means.  Lastly, it has punished retirees, young families, non-profit organizations and others seeking short term savings investments through low rates of return.  While we grouse about growing income inequality, the fact remains that the Fed today, more than that of the current or past administration is the party most directly responsible for this outcome.

Earnings, Multiples and the Stuff We Overlook at Market Tops

The new record highs for the S&P and DJIA indices has spurred a great deal of discussion about what's driving the market to new highs.  The doubters look to the Fed and the Bernanke Put as setting a floor under equity prices.  The bulls look to relentless corporate earnings and fattening balance sheets to justify valuations.

Thus as it's always been, a battle of bulls and bears providing equilibrium to the markets.  With the macro data once again turning negative (for the fourth straight spring cycle), Asia weakening and Europe part in recession and part in full-scale depression, we are compelled to dive deeper into the puzzle of US corporate earnings for answers.  After all, when the US economy stalled in 2010 as stocks steadily advanced, the bulls educated us all on the percentage of US multi-national sales that came from a then healthy EU and a roaring Germany.  When these markets faltered, they redirected us to Asia.  These same voices are now advising we look inward to corporate balance sheets.

And, no doubt, balance sheets are in great shape (at least for large companies) thanks to the Fed greatly reducing refinancing costs and boosting stock prices.  But balance sheets bolster corporate solvency and credit-worthiness not earnings.  It's peculiar testimony to the uncertain operating environment corporations face that their highest and best use for cash is to recycle it to shareholders. The accelerated use of share repurchases may be driving stock prices higher, but shrinking the balance sheet is not a formula for organic growth in any textbook we've seen. 

Earnings, however, are different.  They are clearly a sign of growth, purpose and value, even if you overlook the lack of top line revenue from which they derive.  But earnings growth is also slowing and valuation metrics are increasingly stretched.

Goldman's Chief Equity Strategist David Kostin today released an uber-bullish call on US equities.  The essence of his model is that a forecast 2013 earnings growth rate of 11.3%, accompanied by further multiple expansion, must lead to higher share prices.  Well, that's simply arithmetic, isn't it?  Assuming you accept the assumptions.

Kostin cites the current market p/e multiple as a forward multiple of foretasted earnings, as is increasingly the common practice, rather than price over trailing twelve month earnings (TTM) as until fairly recently was accepted market convention.  This is undeniably what tends to happen at market tops when valuations get stretched:  people create new and improved metrics.  Those of us who lived through the tech boom/bust of the late 1990s, early 2000s will recall how during the boom cycle p/e ratios were upgraded to p/e/g ratios, arguing that p/e ratios must be adjusted by the growth rate of earnings to properly value modern high tech companies against stodgy old makers of laundry soap and toothpaste.  No one seemed to mention p/e/g ratios beyond 2001.

Kostin references the current S&P market p/e as 13.3 on its way to 15 by 2013 and 16 by 2015.  Hmm.  Well, these are first and foremost forwardly looking p/e ratios, because the TTM on the S&P as of today is a hearty 19.2 (for the Russell 2000, by the way, it's a juicy 35.66).  But this phenomena of overstating future earnings, only to downwardly revise throughout the year, has been the pattern of the last two years.  So now Kostin advises that we approach 2013 with a forecast for earnings that may be 10% too high (relative to what we may actually realize) and then slap a greater multiple on those earnings that will undoubtedly bring the p/e TTM measure into nose bleed territory.

Add to this the practice of borrowing to fund share repurchases and corporations easily meet higher EPS targets not through growth in operating earnings, but through a lower share base.  As the p/e is commonly calculated by simply taking the price per share and dividing by earnings per share, an inflated EPS (as a result of share repurchase) will artificially lower the p/e.  These are the kind of things we overlook when trying to convince ourselves that we're operating within reason at market tops.