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Despite the optimistic noise on financial television, at the water cooler, or elsewhere in your life — the equity markets are not an accurate or complete representation of the reality of the United States economy.
The health of the economy should not be measured by one individual component; nor should anyone attribute the health of an economy to a bull or a bear market in stocks. Throughout history, we have had bull markets in weak economies and bear markets in thriving economies. While there is usually an obvious correlation, speculation in equities is not a barometer for economic health.
We are told that we’re nine years into an economic “expansion,” after having survived the worst recession since the Great Depression, and that this expansion can continue, ad infinitum.
Almost nobody is warning or even discussing the possibility of a recession, shrugging off many reports of negative economic news. We are told that the steps that were implemented after the last recession — massive taxpayer bailouts, quantitative easing, lowering interest rates to zero, etc. — completely saved our economy.
If all of that is true, why does it often seem like the American economy has never actually recovered, never really normalized? Why does it feel more like an extended depression than a booming recovery?
Despite creating trillions of dollars here in America, and many more trillions of euros, yen, etc., overseas, despite massive bond buying and despite allowing zero percent interest rates for nearly a decade (negative in many other areas of the globe), our economy is still subdued and still consistently growing at sub 3%.
The massive and unprecedented steps taken after 2008 haven’t seemed to generate much of anything besides, of course, massive financial bubbles, the expansion of yet-larger amounts of unfathomable debt, and the propping up of “zombie corporations,” which now account for over 10% of all American corporations.
What is a zombie corporation?
The Walking Dead, Inc.
The Bank of International Settlements defines a zombie corporation as a company, 10 years or older, wherein the ratio of EBIT (earnings before interest and taxes) to interest expense is lower than one.
In sum and substance, it’s a corporation that is surviving only because of the constant refinancing of debt. Additionally, despite the constant re-structuring and historically low interest rates, these corporations cannot cover their interest payments with their operational profits.
The assumption, post-2008, was that sustained easy money and zero-percent interest rate policy (ZIRP) would create a “wealth effect” that would make Americans feel rich and thereby more willing to spend and consume.
That consumption would lead to economic growth, growth would lead to jobs, more jobs to higher incomes, and yes, of course more spending. This was little more than an experiment — one that many think failed, miserably. The real legacy of these polices is record-breaking debt, and asset bubbles, some of which have already begun to burst.
Nearly 60% of Americans cannot come up with $500 in an emergency without taking on debt, over 20% of Americans have a negative net worth, and we are again reaching record levels of household, credit card, student and auto loan debt — topping $13.5 trillion as of February, 2018. With the exception of certain months in 2005, Americans’ personal savings rate is at an all-time low, and has been in a downward trend since the mid-1970s.
Does this sound like wealth to you?
Quantitative easing and ZIRP did not create real wealth for the vast majority of the American population, and it didn’t cause any psychological “wealth effect” either. In contrast, it created massive sovereign, corporate and household debt, it sustained zombie corporations and it inflated asset and housing prices to virtual unaffordability.
It seems as though those days have come to an end....
The Federal Reserve has missed opportunities to normalize both their $4.5 trillion balance sheet and interest rates over the last nine years, especially in 2010 when the economy was at least a little stronger. As of 2014-2015 the Fed began to tighten monetary conditions by finally raising interest rates and ending the quantitative easing programs. This tightening cycle began six years, and very late, into an “expansion” due to the obvious weakness all throughout.
Tightening monetary policy into such obvious weakness is not a common practice, and the last time this was attempted was 1937.
Anyone who pays attention to business cycles knows that a normal recession, with or without a financial crisis, is coming sooner than later. But even a typical recession would create huge issues today.
Consider that, according to conventional wisdom, interest rates need to be cut around 3%-4% (300-400 bps) during a recession to gain any stimulus in economic activity, encourage borrowing, spending, etc.
There have been several rate hikes since 2015, but because of the obvious weakness in the economy, the Fed has only raised rates 25 bps at a time to get to a total of 1.50%-1.75% as of March, 2018. That’s a far cry from the 3%-4% needed to provide any economic stimulus.
To make matters more concerning, the Fed began to reduce its $4.5 trillion balance sheet in October, 2017. The announced plan was to reduce the balance sheet by $10 billion per month in the third quarter of 2017, then accelerate each quarter thereafter. By October of 2018, the Fed plans to shrink $50 billion per month (~$600 billion per year) and continue on until they decide the balance sheet has normalized. For context, prior to 2008, the balance sheet was around $800 billion, in total. The hope is to accomplish these hikes and normalization without creating the recession they are rapidly preparing for.
It’s a classic Catch 22 — tighten too quickly and cause a recession, tighten too slowly and be unprepared to fight a recession.
This plan is concerning for a few reasons:
1) The economy cannot seem to handle these interest rate hikes, even after the nine-year “expansion,” as there is too much personal, corporate and sovereign debt.
2) The Fed is tightening into a progressively weaker economy.
3) The combination of the recently-passed Omnibus budget, the tax cuts and quantitative tightening project to eliminate ~$3 trillion from the financial markets by 2020-2021.
Consider the implications. Quantitative easing was monetary alcohol for drunken financial assets, stocks and housing — quantitative tightening will be the awful hangover and alcohol withdrawal. In recent weeks, only a minuscule amount of tightening and the expectation of rising real interest rates helped usher in the return of fear and volatility to the markets. There have been over 10% drops in certain indices, and over 20% drops in individual stocks.
So why does this matter?
Simply put, the Fed is destroying liquidity, and at the same time making the borrowing of capital more expensive.
This will create a precarious situation for financial assets, the housing market and debt holders who are impacted by the rising rates — not to mention the zombie corporations that can barely survive as it is. The act of tightening monetary policy into an already weak, and progressively weaker, economy may only hasten and provide the catalyst for the recession they are trying to prepare for.
To make financial matters more concerning, the large tax cut which was just passed, in addition to the quantitative tightening and interest rate hikes, will cause a massive annual budget deficit projected at $1 trillion or more.
Tax cuts are a good thing for the economy, but they are concerning when government spending isn’t correspondingly reduced. They are much more concerning when spending is actually increased.
If the government spends the same amount (or more), but takes in less revenue, it must borrow the remainder to fund its spending. It’s akin to paying your Visa credit card with your MasterCard.
So how do debt, deficits and tightening lead to eventual inflation?
An Unexpected Recipe For Inflation
Our economy is weak, and has been weak for the entirety of the recovery.
At some point the quantitative tightening, interest rate hikes and budget deficits are going to seriously spook the financial markets, and the markets will begin to correct to fair value. As the markets drop, and a recession is more apparent, the Fed will have little choice but to reverse course on the tightening plan at some point.
Depending on how much tightening was actually accomplished, there is a good chance that the Fed will still have an enormous, abnormal balance sheet as they move to again drop rates to zero, or God forbid, below zero, and attempt a fourth round of quantitative easing.
While this may re-inflate the bursting bubbles, it could also lead to a major loss of confidence in the dollar currency itself, and subsequent massive price inflation as people trade devaluing dollars for other assets. Confidence is really the only thing that gives any currency any value; if it’s lost it can be very hard to regain.
While this scenario seems “worst case,” consider the following:
1) The Fed has barely begun to unwind its balance sheet and we’ve already seen negative reactions to it.
2) Real interest rates are extremely low — if not still negative — but even these small hikes were still enough to return fear to the market.
3) We are nine years into a bull market and economic expansion — far longer than average — and a normal recession will come sooner than later.
Throughout history, gold has proven that it can maintain its purchasing power in both deflationary and inflationary environments.
If/when the Fed eventually reverses course, printing massive amounts of money in a new iteration of quantitative easing and dropping interest rates to zero or beyond, gold may perform as it did in the inflationary 1970s and more recently in 2008-2011 time period.
The dollar price of gold is simply a measure of how many U.S. dollars it takes to exchange for an ounce of the metal. Gold itself doesn’t go up or down, or really change much in real value, maintaining similar purchasing power over millennia.
Since the dollar/gold link was broken in 1971, and since gold became legal for Americans to invest and own in the mid-1970s, the gold price has measured a steady decline in the value of the U.S. dollar. A dollar to gold in 1971 was 1/40 and now is around 1/1,350.
Gold is the constant. So if we experience a major inflationary period it will account for the extra dollars circulating in the economy, and its price will adjust accordingly.
Note: A 34-year-old private investor from Long Island, N.Y., Frank A Jurs II is a part-time author and avid student of macro-economics. You can find him on Twitter as @OccupyWisdom.
(Nothing whatsoever in the above article should be construed, interpreted, or used as investment advice. The above content is the opinion of the author and is not meant in any way to advise anyone on investment decisions, or be interpreted as advice on any strategy, investment product or plan).
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