October 29, 2021
By Steve Blumenthal

“Excessive indebtedness acts as a tax on future growth and it is also consistent with Hyman Minsky’s concept of ‘Ponzi finance,’ which is that the size and type of debt being added cannot generate a cash flow to repay principal and interest.

While the debt has not resulted in the sustained instability in financial markets envisioned by Minsky, the slow reduction in economic growth and the standard of living is more insidious.

While the debt was taken on with presumably good intentions, the result has been an increased wealth and income divide.”

― Dr. Lacy Hunt,
Executive Vice President, Hoisington Investment Management

I just finished reading my friend Dr. Lacy Hunt’s third quarter 2021 review and outlook letter titled, “Rising Debt Toll.” There is no better source than Lacy when it comes to understanding the dynamics of debt, what it means for the direction of interest rates, and ultimately, the economic impact on you and me.

Lacy has been talking about the consequences of debt for a long time. I believe we are on a slow-motion train ride that will lead to a debt restructuring of some form sometime within the current decade. Mauldin calls the debt and pension crisis end game “The Great Reset.” It’s what likely knocks my partner off his “Muddle Through” narrative. We are not there yet.

There is much you can read and study on this subject. For example, Ray Dalio (google him if you don’t recognize the name) writes about the challenges and consequences that present at the end of long-term debt cycles. We’ll get through the current cycle. Our job is to understand the dynamics and play the best hand we can as stewards of capital. Like it or not, too much debt is our most significant problem.

Today, I share with you a few charts and my notes from Lacy’s letter, along with a link to the piece itself.

Here we go (from Lacy):

Lacy talks about the “marginal revenue product from debt.” What does he mean by that? Numerous historical debt studies and our current data show that the use of debt capital has moved well beyond the productive phase. This is in accordance with the law of diminishing returns, a basic concept in economic theory.

The acceleration in debt relative to GDP has correlated closely with the sustained decline in the velocity of money, cutting it to nearly half of what it was in 1997. You can think of the velocity of money as the frequency with which one unit of currency is used to purchase domestically produced goods and services within a given time period. More money circulating means a stronger economy. The slower the velocity, the slower the growth in the economy. Note the drop in money velocity since 2000.

This is something that also shows up in the growth rate of a country. For example, from 1870 until 2000, U.S. real per-capita GDP rose by 2.2% per year. Since 2000, the growth has been 1.1% per year. The speed with which money moved through the system was cut in half since 1997, as was the growth rate of the economy. More debt hurt, rather than helped, economic growth.

Here’s a look at what could have happened had the U.S. economy continues on its prior 100+ year, 2.2% per year growth rate (blue line) vs. the actual growth rate per year:

In the day, we sweat it out on the streets
Of a runaway American dream
At night, we ride through mansions of glory
In suicide machines
Sprung from cages out on Highway 9
Chrome wheeled, fuel injected and steppin’ out over the line
Oh, baby this town rips the bones from your back
It’s a death trap, it’s a suicide rap
We gotta get out while we’re young
`Cause tramps like us, baby we were born to run

– Bruce Springsteen, “Born to Run”

I’ve shared this next chart with you in previous OMRs. It looks at total domestic debt by country. Shown is the growth in debt over the last 12 months and the last five years. But I want you to focus in on the “as a % of GDP” column. As you’ll see farther below, the debt death trap begins when the government debt-to-GDP ratio rises above 90–100%.

China, you ask? As of March 31, 2021 (latest available data), China’s private domestic non-financial debt as a percentage of GDP was 220.44%. In 2020, U.S. GDP was $20.94 trillion. With $80.5 trillion in debt, U.S. debt-to-GDP is currently 354.3%. China’s GDP was $14.72 trillion (USD) in 2020. I’m sure you are well aware of the real estate defaults in China. The global growth engine is in reverse.

Debt comparisons in the major global economies look like this:

The highways jammed with broken heroes
On a last change power drive
Everybody’s out on the run tonight
But there’s no place left to hide
… Come on with me, tramps like us
Baby, we were born to run

(Click here to play on YouTube)

 Lacy cites a handful of credible studies:

• In 2008–09, Carmen Reinhart and Ken Rogoff published research indicating that, based on an extensive quantitative analysis of highly indebted economies, their economic growth was significantly diminished once they become very over-indebted.
• Since 2010, Lacy has identified sixteen scholarly studies with findings consistent with the historical work of Irving Fisher, Charles Kindleberger and others. None of the studies were dependent on the Reinhart and Rogoff work.
• In 2011, Andreas Bergh and Magnus Henrekson substantiated the “significant negative correlation” between the size of government and economic growth in the Journal of Economic Surveys. Specifically, they wrote that “an increase in government size by 10 percentage points is associated with a 0.5% to 1% lower annual growth rate.” That insight suggests that, if spending increases, the government expenditure multiplier will become more negative over time.
• Checherita, now head of the fiscal affairs division of the ECB, and Dr. Rother, chief economist of the European Economic Community, found that a government debt-to-GDP ratio above 90–100% has a “deleterious” impact on long-term growth.
• In addition, they find that there is a non-linear impact of debt on growth beyond this turning point. A non-linear relationship means that, as the government debt rises to higher and higher levels, adverse growth consequences accelerate.

Take another glance at the debt-to-GDP chart above. It’s a death trap; it’s a suicide rap. And our kids are saying, “We gotta get out while we’re young.” And they are right.

Conclusion:

• Lacy believes that inflation is temporary, and conditions today are nothing like the inflationary tidal wave in the 1970s, which Paul Volker’s “whip inflation now” tough love ultimately solved.
• Ultimately, Lacy concludes, “Treasury bond yields could temporarily be pushed higher in response to inflation. These sporadic moves will not be maintained. The trend in longer yields remains downward.”

Here is the link to the Hoisington quarterly review and outlook letter.

Last month, I wrote “It’s Time to Hedge.” I believe we are moving into a global slowdown that will surprise analysts. A decline into mid-2022 with possible recession. Debt, demographics, and inflation pressures are the driving forces toward a slowdown. My best guess is we can count on the Fed and other central bankers for more of the same. They are not positioned that way right now, but they will be. Stuck between a rock and a hard place, as my father would say. But as Lacy is telling us, even more is less. A short-term sugar high in the system will ultimately result in an even larger long-term problem. More debt on top of too much debt is even worse’er (a technical term). The Great Reset awaits farther down the road.

Trade Signals is next. We’ll take a quick look at probable seven-year returns. Notable this week: Don’t Fight the Tape or the Fed moved to a 0 or neutral signal from a bullish +1. The overall weight of evidence continues to support a moderately bullish equity market outlook. The Zweig Bond Model is bullish on bonds again after spending a week in a sell signal. The 10-year Treasury intermediate-term MACD is bullish as well – signaling lower interest rates.

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Trade Signals – GMO’s 7-Year Asset Class Real Return Forecasts

October 27, 2021

Posted each Wednesday, Trade Signals looks at several of my favorite equity market, investor sentiment, fixed income, economic, recession, and gold market indicators.

For new readers – Trade Signals is organized into three sections:

• Market Commentary
• Trade Signals — Dashboard of Indicators
• Charts with Explanations

Market Commentary

Notable this week:

Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.

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Personal Note – Number 10

I’d like to give a hat tip to recent soccer retiree Carli Lloyd, #10!

Susan and I tuned in to watch the U.S. Women’s National Soccer Team play Korea. I was sad to learn that it was Lloyd’s last game. She retired after 17 years, 315 caps (appearances), and 134 goals for the U.S. Team.

@technefutbol asked @CarliLloyd about the keys to a long, successful career, and here is what she said:

Great advice.

I’ve got some more soccer updates for you from the Malvern Prep boys. They have won their last two games and are in the upper half of the standings heading into playoffs. Three wins in a row, which makes post-game IPAs with their Coach Sue (and my beautiful wife) much more enjoyable. As she tells her boys, “To be clear, we are playing to win.”

Today is another big one against Germantown Academy. The most talented team in the league. Malvern has a mix of good athletes and several players with a lot of soccer experience. The goalie is a 6’7” basketball player and he really stepping up. Going to need him today! Game time is at 3 pm. Rain and wind are in the forecast. Go Friars!

The rain is likely to continue into Saturday. That night, Penn State is playing Ohio State, and I’m hoping to wake up to a sunrise like the one below Sunday morning, as I’ve got plans to play golf with Matthew. This shot was taken from the first hole fairway at Stonewall the other morning. Hat tip to Ryan Lagergren for the photo. I’m checking in happy! And hope you are too.

Sunday is Halloween and I hope you are trick or treating with your little Spiderman, Ariel, Rocky from PAW Patrol, or Ted Lasso (great show!). If your children are too old for trick or treating, I hope you enjoy giving out lots of treats to your neighborhood trick-or-treaters!

Wishing you a fun week!

All the best,

Steve

Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.

Consider buying my newly published Forbes Book, described as follows:

With On My Radar, Stephen Blumenthal gives investors a game plan and the advice they need to develop a risk-minded and opportunity-based investment approach. It is about how to grow and defend your wealth.

If you are interested in the book, you can learn more here.

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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.

Click here to receive his free weekly e-letter.

Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.

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