Quarterly Reflections - July 2018

Rather go to bed without dinner than rise in debt. ~ Benjamin Franklin

On the economy

In the second quarter, our tariff tête-à-tête with the world moved from a game of chicken to full body combat. History has established that there will be losers on all sides and it would be foolish to consider that this episode will end any differently. At some point, world trade will begin to drop and world GDPs will shave off points. If 2017 was a Goldilocks year with employment, interest rates, inflation and global economic synchronization appearing “just right”, 2018 is starting to look “too soft”. It cannot be understated as to what a threat these tariffs are to world growth, at a time when interest rates and oil prices are also rising.

A problem also of our own making, and hopefully not of our undoing, is the current standing of our federal and corporate debt balances. Debt is not always bad. Government spending did pull us forward during long, fretful days when it seemed some new fresh hell opened up on every corner in 2007-8. But in the years since our government has missed every opportunity to balance the books.

Today U.S. debt stands at $21 trillion and will grow by $1 trillion annually under the current budget plan. Our outstanding debt is now more than our annual economic output for the first time since 1946. The IOUs of Social Security and Medicare/Medicaid are not even a part of that $21 trillion and could be another $50 trillion, according to the Congressional Budget Office. (On that note, the CBO also says that entitlement payments will consume all federal income within 18 years, leaving nothing left over for interest on our debt, military spending or anything else.) But countless economists have written blithely about how the debt is really no problem because, as you will remember, our federal government can borrow more to remedy the pain and mollify our creditors; investors love American bonds, especially if the rest of the world is struggling.

Those economists are wrong in their optimism. While the U.S. has yet to miss even a penny owed to a creditor, problems such as increasing interest rates (check) and disinterested bond buyers (China!) exist today. These exact same problems will eventually plague the corporate borrower although the household consumer has done somewhat better. One issue with business borrowing is that much of it has been done using short-term bank loans around 2 years. Without low rates locked in for the long-term, any refinancing will logically happen at much higher rates. Of course, some companies borrow only because it has been so very cheap; deleveraging for them will be relatively easy. Others borrow to survive. Per Moody’s, 37% of corporate debt is graded below-investment; to use another adjective, it is speculative.

The era of easy money will come to an end. For those who can, belts must tighten and budget diets must occur before the economic bull trips. For those who did not make hay while the sun shined, days are numbered.

On the markets

The markets have been a mixed bag thus far in 2018. The Dow has had the hardest time as the only major U.S. index to actually lose in the first six months of this year. The S&P 500 rose over 2% and the Nasdaq has gained over 9%. Money continued to pour out of global markets, after seeing record inflows at the start of the year. Volatility remained, European stocks lagged their U.S. counterparts, China’s market took a deep dive and emerging markets sunk 10% in the second quarter.

The U.S. economy continues to hum along thanks to the massive U.S. corporate tax cut. Businesses have also worked to keep employee wage costs from growing too much, providing lots of stimulus for profit margins and growth to remain solid. Earnings season predictions point to 20% growth in the second quarter, which begs the question as to whether this is only short-term stimulative event or if more can be made from the tax cuts to extend this expanding business cycle.

On the other side of the world, China’s Shanghei stock exchange entered a bear market, defined by a 20% drop from the high point. With a heavy reliance on exports, risky financing and debt, China is clearly more vulnerable to U.S. tariffs in these early days of the trade war.

In June, the Federal Reserve increased rates for the seventh time this cycle to 1.75%. As long as the labor market remains tight and inflation creeps up, bet on the Fed to continue rate bumps. At much concern among pundits is the bond yield curve, a reliable indicator of recession since 1955. Per the San Francisco Reserve, all nine recessions of the last 60 years have been preceded by an inverted yield curve. An inverted curve is defined by short-term yields exceeding longer-term yields, such as when the 2-year treasury rate is above the 10-year treasury rate. This signals low confidence in the near future. At this time the curve still has a positive slope relative to prior late business cycles.

Watch for the Fed to stick with their classic manual for tightening cycles, which means the Fed hikes rates until the yield curve inverts. Note that inversion does not tell when a recession will happen, just that it is extremely likely in the next 6 to 24 months. We shall be watching!

On personal finance

Millennials are having the hardest time of any generation since the Great Depression in getting their start in the world. The oldest of this group is roughly 35 years old and has struggled to enter the ranks of adulthood when it comes to family, career and wealth creation. The causes are many but tremendous student debt continues to play a large part. Secondary education tuition and fees have risen over 90% since the 1990s. Yet nothing has fundamentally changed to make a degree any greater in quality or value than previous generations received. Families have changed though; the devotion of every child to the goal of going to college has resulted in a willingness to pay, or borrow, more and more for that opportunity. Costs have risen in part based on strong demand and easy lending. If college tuition for a boomer was like buying a new car, college tuition for a millennial is like buying a home completely on credit. In fact, the only collateral considered is the parental unit’s ability to make money and repay the loan if the student does not.

No financial aid application is complete without parental cooperation and signature. About 16% of borrowers are in default but there is not data available on how many parents are making the payments because their student has defaulted! The concern is that as (former) students struggle to make payments, the burden to do so falls on their parents, who are already well behind in saving for their own futures. In fact, 29% of households over the age of 55 have nothing saved for retirement. How many of those same households hold some responsibility for college payments? Surely the overlap exists.

Like the debt problems facing the government and corporations, these are problems with accessible answers for those who are willing to think and plan ahead. For example, junior colleges are much more affordable; the College Board reports that the average annual cost of tuition and fees for a public 2-year college is $3,560 for in-district students. Compare that to $9,970 for an in-state 4-year university before adding in room and board costs.

As an aside, and not coincidentally, the largest asset on the Federal Reserve’s balance sheet is Student Loans at 45% of the total assets. Of course, it is a liability on millions of young people’s balance sheet.

To be a contemporary American is to have a house, have an education, go on vacations, both in our time zone and in zones well beyond. These are wonderful rewards for hard work and dedication. Yet we all need to consider the ramifications of easy money and excessive leverage.

It is our true pleasure to help with your investments and finances and we thank you!

For those who like numbers and puzzles, and want to see the data for themselves, check out the real-time running tallies on www.usdebtclock.org.

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