Debt Dependence – April 2010
April 20, 2010
Dow Jones Average: 11,092
S & P 500 Index: 1,198
Economic growth in the United States over the past thirty years was fueled in large measure by a sharp increase in debt relative to national income. The ratio of debt to gross domestic product reached a record high shortly before the financial crisis hit in 2008. Much of the debt was supported or collateralized by real estate. When the real estate price bubble broke the foundation carrying the debt load was severely undermined. The failure of leading financial institutions, combined with the realization that many homes were not worth as much as the mortgage, caused a general panic. For the first time in decades many people started to pay down credit card balances and put some savings aside. While debt reduction is a good thing for an individual or family, a national economy powered by borrowing cannot handle a sudden contraction in debt. The US economy had become addicted to easy credit and the consumer spending that was made possible by the use of borrowed funds.
Government policy makers were quite certain that a sudden decline in aggregate debt (the total debts held by individuals, corporations, and government) would cause systemic collapse. It would have been the equivalent of pulling an addict off a drug, cold turkey. As individuals and businesses curtailed their use of credit, or wrote off debts entirely through foreclosure and default, the government put in place an array of strategies, designed to keep the total amount of capital deployed in the system at a steady level. Consequently, the massive, aggregate debt burden in the U.S. has not gone down. Part of the debt burden has simply been shifted from the private to the public sector.
Economic advisors to Presidents Bush and Obama generally agreed that a steep increase in government borrowing and deficits was necessary to avoid a possible depression. Piling up government debt to save a fragile economy drowning in too much privately held debt is a counterintuitive strategy. If going more deeply into debt were a long-term solution to the problem, there would be no problem in the first place. It’s the equivalent of downing a shot of whiskey to remedy a hangover. Even though the infusion of government funds appears to have stabilized the economy, increasing national debt by 1.5 trillion dollars per year is a short-term fix at best. President Obama has said that government deficit reduction will start as soon as the economy is on firmer footing. Deciding when that time has come and actually taking support away from a debt dependent economy is likely to be a formidable challenge.
The U.S. Government’s ability to borrow more than a trillion dollars annually at extremely low interest rates is impressive, but the situation may change as the debt burden mounts. Even though the U.S. continues to attract bond investors there is a limit to any nation’s borrowing capacity. If national debt grows too large relative to national income, the burden of repayment can strangle a nation’s economy. Outright default on sovereign debt is rare, but happened several years ago in Argentina. In recent months Greece and Iceland had to seek emergency funds or guarantees from wealthier countries to avoid default. The alternative to default is currency devaluation. Paying foreign lenders back with a sharply devalued currency is a form of partial default. Several legendary investors believe that the U.S. will print money and debase the U.S. Dollar when repayment of debt becomes politically unpalatable. It is no surprise that countries carrying less debt (Canada, China, among others) also have strong currencies. A strong currency means less inflation, lower interest rates, and a happier citizenry. Economic policymakers in the U.S., Japan, the UK, and other heavily indebted countries, hope that economic growth will soon outpace growth in government debt. If economic growth stalls, currency devaluation and inflation may be the only way out of the debt vise.
Stock prices have risen for more than a year without a single pullback of ten percent or more in the broad market indices. An uninterrupted run of this length is highly unusual as stocks typically retrace a portion, often fifty percent, of a major move. In our opinion, stock prices now reflect investor expectation for a strong economy and much higher corporate earnings. It remains to be seen whether stock prices have moved too far, too fast in anticipation of results that have not yet been achieved. There is no margin of safety for investors committing funds at current prices. We are somewhat surprised to see most stocks so fully valued in a macro economic environment that continues to be very problematic.
When the market makes a major move higher we tend to be active on the sell side. In recent months we have sold a few positions entirely and cut other holdings in half. We are taking gains in a disciplined fashion as price targets are attained or exceeded, undeterred by the fact that proceeds will go temporarily into money market funds producing no yield.
We are searching for new stock buys, but are not coming up with much right now. This is one of the more frustrating environments for new purchases that we have encountered in thirty years. Experience has taught us to be patient when waiting for better buys to materialize. Market trends seem to shift just as our frustration level reaches maximum intensity. An increase in global interest rates, a sharp slowdown in the over-heated Chinese economy, and the upcoming U.S. elections are a few wildcards that could alter the current tranquility in the markets. When stock prices inevitably retreat we will be active buyers again, just as we were after the crash of 2008 and other periods of market weakness.
Interest rates are starting to rise, but are not yet at levels that we find appealing. The ten-year U.S. Treasury bond, which was priced to yield two and a half percent about a year ago, now yields closer to four percent. Investors who bought the bond when yields were low are carrying a big capital loss on those purchases. While four percent is a better return for investors, it is not high enough in our opinion, given the Federal Government’s financing needs and inflationary policies. Interest rates are rising in China, Australia, India, and may soon be going up in other regions. We will either buy foreign bonds, as we did with Canada, or wait for rates in the U.S. to reach a normalized level.Return to Archive