December 16, 2022
By Steve Blumenthal

“What are the factors that gave rise to investors’ success over the last 40 years? We saw major contributions from (a) the economic growth and preeminence of the U.S.; (b) the incredible performance of our greatest companies; (c ) gains in technology, productivity and management techniques; and (d) the benefits of globalization. 

However, I’d be surprised if 40 years of declining interest rates didn’t play the greatest role of all.“

– Howard Marks, Oaktree Capital Management

The stock market is limping to the end of the year, with inflation, interest rates, and recession the major concerns. In the past few weeks, markets rallied on every small hope for a Fed slowdown, pause, or pivot in its current inflation fight. But in his Wednesday press conference, Fed Chairman Jerome Powell dashed those hopes: The Fed Funds Rate increased another 50 bps, up to 4.5%, with more increases to come in 2023.

The Fed (and the Government) created the issue for itself, and unfortunately, finding the exit is made far more challenging by the country’s insanely high level of debt. We’ll consider a number of the challenges facing the Fed in today’s missive, including inflation history.

There is a popular rule called “Three steps and a stumble,” which Edson Gould first illustrated, the legendary market technician from the 1930s through the 1970s. Ultimately the baton was passed from Gould to another legendary market analyst, the late great Marty Zweig, who incorporated the “rule” into his monetary policy indicator. The rule states that “whenever the Federal Reserve raises either the federal funds target rate, margin requirements, or reserve requirements three consecutive times without a decline, the stock market is likely to suffer a substantial, perhaps serious, setback.” This results from increased borrowing costs for companies and the increased attractiveness of money market funds, bonds, and CDs over stocks due to the higher interest rates.

From Jerome Powell, chair of the Federal Reserve this past week, “Historical experience cautions strongly against prematurely loosening policy. I wouldn’t see us considering rate cuts until the committee is confident that inflation is moving down to 2% in a sustained way.”

It’s important to note that the bear market bottoms have historically happened AFTER the first Fed interest rate cut. When it comes to inflation, we are in rare territory. A cut seems far off on the horizon.

As I wrote in Trade Signals this week (below), I believe we’ll experience a series of inflation waves in the coming years, much as we did in the 1970s. Right now, we’re on the back end of inflation wave #1.

Grab your coffee, find your favorite chair, and settle in. There’s a lot packed in this week. You may need to pause for a refill and take it one section at a time.

The World Cup concludes on Sunday morning. Messi’s Argentina vs. Mbappé’s France. Susan, the children, and I will be watching, rapt. Much of the world will be as well. I’m rooting for a beautiful game and looking forward to seeing the 35-year-old legend showing the 23-year-old rising star a thing to two—or vice versa. So much fun to watch.

There will be NO On My Radar post next week. I’m going to take Friday off, as will most of the CMG team. I’ll share my 2023 investment outlook with you the following week in the OMR edition on December 30. Until then, wishing you a warm and wonderful holiday season. All the best to you and yours!

(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)

Rising Costs of Financing U.S. Government Debt

Last week I shared the following chart with you in the Random Tweets section. Let’s take a deeper dive into this today.

Before I share with you highlights by Daniel Bergstresser from his research piece on government debt (Brandeis University, December 5, 2022), keep the following thought top of mind:

• The most recent data on this, as of Q3 2022, show that the effective interest rate on all of the Treasury’s debt is 2.40%.
• The Fed Funds rate is now 4.50%.
• The weighted average maturity of U.S. government debt is approximately five years. As bonds mature, they get refinanced at a higher rate.
• The longer rates stay high, the higher the interest costs the U.S. government must make on the debt it owes.
• To understand how rising interest rates stress the system, if the average U.S. government debt rate rises from 2.40% to 10.40%, the interest expense alone will take up close to 100% of the tax dollars the government currently collects. 10.40% on $31 trillion in debt is $3.22 trillion annually.
• In 2021, the total revenues of the U.S. government totaled around 4.03 trillion USD. Revenues include individual and corporate income taxes, payroll taxes, and other taxes.
• It’s estimated that the U.S. government spent $7 trillion in 2021 and $6 trillion in 2022. That shortfall is financed by more debt.
• You can see the problem. As we used to chant as kids during our baseball games, “We are slowly putting pressure on the pitcher and the catcher.”
• In this case, the pitcher is our U.S. government, and the catcher is the Fed.
• Bottom line: The Fed cannot afford to lose the battle to inflation. This is why I keep saying inflation is the kryptonite to Fed policy.

Hat tip toTom McClellan
Editor, The McClellan Market Report

McClellan shares one more chart. His point is we really can’t tax people any more than we are currently.

Source: Econfact.org

Let’s first jump to the conclusion:

Rising levels of debt service contribute to fiscal challenges that our country faces. The cost of debt service will depend on both the level of debt outstanding and the level of interest rates. Debt has risen to levels that are high by historical standards, but — until last year — that increase has coincided with very low interest rates that have kept the costs of debt service relatively low. However, the high levels of debt mean that increases in interest rates like those that we have seen in the past year will either have a large impact on our country’s budget deficits or will require increases in taxes or reductions in spending.

Most of the current government debt will mature within the next three years. New borrowing, and debt that must be rolled over, will pay current market interest rates.

The Facts:

• The government’s bill for its interest payments on debt reflects the size of the debt and the interest rates on the debt.
• Borrowing costs have been rising across the U.S. economy as the Federal Reserve has been raising interest rates in an effort to curb inflation.
  • The Fed funds rate has gone from 0% to 4.5%, and the 10-year Treasury yield has gone from under 1% to currently 3.55%. Interest rates on treasuries of different maturities had also risen: The 2-year went from 0.55 to 4.33%, and the 30-year bill went from 1.76% to 3.74% in the year ending on November 30.
• The Treasury does not decide how much to borrow, but how to borrow.
  • The U.S. Treasury considers the tradeoffs involved in selling debt of different maturities and whether to choose fixed or adjustable-rate bonds when deciding how to finance the current budget deficit and the rolling over of maturing debt.
• The interest payments on debt have varied over time with the level of debt and the interest rate.
  • Net interest payments rose from about 7 percent of total fiscal outlays in the mid-1970s to over 15 percent of fiscal outlays in the mid-1990s (see chart).
  • This was at a time when the overall debt held by the public as a percentage of GDP grew from 23 percent to 48 percent.
  • The reduction of debt payments from the mid-1990s to the mid-2010s reflects both lower interest rates and a lower level of debt.
  • Although the debt-to-GDP ratio rose between 2009 and 2017, net interest payments as a share of total federal outlays remained below 7 percent during this period, primarily because of low-interest rates.
  • Net interest payments on the debt as a percentage of total fiscal outlays have now started to rise with the increase in interest rates. (SB Here: Currently over 12% of total federal outlays.)
• Looking forward, the interest payments on debt will depend upon, among other factors, how much debt will come due in the next few years.
  • The U.S. Treasury issues debt with maturities as short as one month and as long as 30 years.
  • Thirty percent of this outstanding debt, amounting to $6.7 trillion, will mature and need to be refinanced during fiscal 2023.
  • An additional $300 billion in floating-rate debt, while not maturing during fiscal 2023, pays interest rates that will reset with market rates during that year.
  • An additional $2.5 trillion in debt maturing during 2023 will make coupon and principal payments that will be adjusted based on the inflation rate prevailing at that time.
• The maturity structure of debt matters for debt payments because interest rates on new and rolled-over debt may be different from interest rates in the past.
  • As an example, almost $7 trillion worth of debt held by the public will need to be refinanced during the 2023 fiscal year.
  • Each percentage point increase in interest rates on that refinanced debt will mean $70 billion per year more in net interest payments in that first year, or about 10 percent of the United States defense budget requested for 2023.
  • The most current forecast is that interest payments will reach and even exceed the percentages of the 1980s and at the turn of the century. This is partly due to an increase in the forecasts of Treasury bond yields of about 1.2 percentage points for 10-year yields and two percentage points for 3-month yields.
  • But market interest rates since the CBO’s mid-2022 forecast have come in much higher than they forecast then; they are now more than 1 full percentage point higher than forecast for bonds with 10 years to maturity and 2 full percentage points higher than forecast for 3-month Treasury bills.
• Although sometimes it is claimed that inflation reduces the burden of debt as a share of that GDP, that may not be the case now.
  • Increases in inflation raise nominal GDP, that is, GDP at current prices. For that reason, it is sometimes claimed that inflation may reduce the burden of debt as a share of GDP. But interest rates on new debt, on floating rate debt, on inflation-adjusted debt, and debt being rolled over will also rise with inflation.
  • Lenders will demand higher interest rates to compensate them for being paid back in dollars that are worth less in the future. The short maturity structure of outstanding debt means that much of the debt will be refinanced, and the interest rates will reflect current and expected inflation. Thus, research suggests that inflation itself is unlikely to contribute much to a reduction in the debt-to-GDP ratio.

You can find the full article here: Source: Econfact.org

Here is an up-to-date look at the problem:

It’s estimated that the federal government spent $6.27 trillion in FY 2022. This means federal spending was equal to 25% of the total gross domestic product (GDP), or economic activity, of the United States that year. $766 billion in interest expense equals 12.21% of the budget. Bottom line: It’s likely going higher.

In the words of Bruce Springsteen from “Born to Run”:

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 on Highway 9, chrome-wheeled, fuel-injected, and stepping out over the line
Whoah 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

Just having some fun with you…

We sit at the end of a very long-term debt accumulation cycle. The U.S. is rich in assets, but debt has become a drag on future growth. Inflation is the result of Government Fiscal policy and Fed policy. Inflation causes higher interest rates. Higher interest rates light the debt fuse. We will indeed reach a point when we decide to restructure the debt. As the kids used to say on long car rides, “Are we there yet?” You clench your teeth, breath deep, turn to them and say, “Almost…but NOT YET.”

It’s a debt trap, a suicide rap; we are really sticking it to the young.
Baby, with 60/40, there really is no place to run

I’m describing an inflationary picture, rising defaults, a slow economy… an inflationary recession. It’s a bad backdrop for traditional fixed income and buy-and-hold 60/40 stocks and bonds in general. Chin up. It doesn’t mean there aren’t opportunities. There are plenty. I believe you’ve got to play a different game.

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Random Tweets

Here is a bit more on debt from Dr. Doom, Nouriel Roubini. Ok, big problem. Click on the photo to read the full post.

Roubini concludes, “After years of ultra-loose fiscal, monetary, and credit policies and the onset of major negative supply shocks, stagflationary pressures are now putting the squeeze on a massive mountain of public- and private-sector debt. The mother of all economic crises looms, and there will be little that policymakers can do about it.’

“Just looking at explicit debts, the figures are staggering. Globally, total private- and public-sector debt as a share of GDP rose from 200% in 1999 to 350% in 2021. The ratio is now 420% across advanced economies, and 330% in China. In the United States, it is 420%, which is higher than during the Great Depression and after World War II.” Click HERE for the full article.

This next tweet is, in a word, painful. This is the game plan, folks. More to come…

More from the great Felix Zulauf. 

You can find Zulauf’s Barron’s full interview HERE or click on the above photo. As a quick aside, I’m a subscriber to Felix’s institutional research letter. I hope to have a CMG client call with Felix early next year. Stay tuned…

I can certainly understand the “Not In My Back Yard” thinking, but zoom out and know that we will need everyone to chip in to reduce our carbon footprint.  We have a ways to go.

Still bullish on Oil.

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Trade Signals: Tough Love

December 15, 2022
S&P 500 Index — 3,888

Markets move in cycles, and cycles will always exist. Trade Signals provides a weekly snapshot of current stock, bond, currency, and gold market trends. Trade Signals is a summary of technical indicators to help you identify where we sit in short-, intermediate-, and long-term cycles. We track important valuation metrics to help assess the probability of coming returns. Valuations can tell us a great deal about coming probable returns. Simply, where is opportunity best/least? This allows you to set targets strategically. I.e. More defense than offense or more offense than defense. Trade Signals also tracks select investor sentiment indicators with the objective of going against the crowd at points of extreme. “Be fearful when others are greedy, and greedy when others are fearful,” as Warren Buffett often reminds us.

Stay on top of the current trends with “Trade Signals.”

Market Commentary

Notable this week:

It’s All About the Fed

From Jerome Powell, chair of the Federal Reserve this past week, “I just don’t think anyone knows whether we’re going to have a recession or not — and if we do, whether it’s going to be a deep one or not. It’s just…It’s not knowable.” He added, “Historical experience cautions strongly against prematurely loosening policy. I wouldn’t see us considering rate cuts until the committee is confident that inflation is moving down to 2% in a sustained way.”

For the last 30+ years, we’ve had a combination of cheap labor (expanding globalization/supply chains… most notably China), cheap energy, and cheap credit (low inflation and low-interest rates.  All three of these are reversing. Labor costs are increasing due to de-globalization. Energy costs are rising due to war and the realization that we need oil and gas to get us to a point where nuclear, solar, wind, and other cleaner energy sources become more viable.

The era of low-interest rates and cheap credit is likely behind us.

Inflation

Here’s a look at the 1970s inflationary cycle. Note the three waves. If I had to guess, I believe we are on the declining end of wave #1 (1972-73 in the chart).

The Dashboard of Indicators follows next. A lot of red across the board. Bottom line: More defense than offense!

Click HERE to see the Dashboard of Indicators and all the updated charts in this week’s Trade Signals post.

Not a recommendation for you to buy or sell any security.  For information purposes only.  Please talk with your advisor about needs, goals, time horizons, and risk tolerances. TRADE SIGNALS SUBSCRIPTION ACKNOWLEDGEMENT / IMPORTANT DISCLOSURES 

Personal Note: Fusion Energy Breakthrough

If you heard the good news in science this week, I’ve got a bit more for you, coming from my Camp Kotok fishing friend, Philippa Dunne, and her partner Doug Henwood. This excerpt, in particular, caught my eye…

The Financial Times first reported on a fusion breakthrough at Lawrence Livermore National Laboratory, and we’ve added a bit of history to the story. 

Scientists at National Ignition Facility (NIF), part of the Lawrence Livermore National Laboratory (LLNL) in California, have succeeded, after 70 years of effort, in producing a net energy gain in a fusion reaction.

The process known as inertial confinement fusion, ICF, was first taken on by LLNL in 1957 when, following meetings with Edward Teller, physicist John Nuckolls began thinking about exploding small hydrogen bombs in large caverns to produce electricity. He wondered how small those bombs could be.

The recent experiment bombarded a “tiny pellet” of hydrogen using the world’s “most energetic” laser, capable of producing temperatures found in the cores of stars and giant planets. And it was the first time the reaction produced energy, 2.5 megajoules, that exceeded the energy that went in, 2.1 MJ. That 120% of input far outstripped past experiments’ 70%.

That was a surprise large enough to damage some of the diagnostic equipment, good trouble.

The analysis is still in process, the US department of energy will be announcing a “major breakthrough” on Tuesday, and the reality remains likely decades away. Plasma physicist Arthur Turrell calls it a “moment in history,” if confirmed, that smashes a “decades-old goal.”  

The NIF was built to test nuclear weapons, and this success underscores the wide applications of pure science work, whether aligned or misaligned with our own personal goals. It’s a lot easier to love the goal of clean technology than nuclear bombs of incomprehensible power, if not the outcome.

And it even proved a politician’s words to be true! When announcing the launch of a new White House strategy this year, chairman of the fusion energy caucus, Don Beyer, called this technology the “holy grail,” capable of lifting more world citizens out of poverty than the “invention of fire.”

We’re not sure fire was really “invented,” but we’ll take what we can get.

­­– Philippa Dunne & Doug Henwood

Christmas Holiday and Snowbird, Utah

The kids are flying and driving home; we’ll all be together, gratefully. I’ll be taking next Friday off to enjoy the long holiday weekend. I hope you, too, can find some downtime with the people you love most.

We’ve got a ski trip to Snowbird, Utah, coming up soon as well. I’ve gone to Snowbird at least once a year since age 18. Dad took me, and I thought I was a hotshot East Coast skier. I quickly learned, however, that I wasn’t very good. Picture big hair, jeans (yes, jeans), and a tee shirt. It was a warm early morning April day, and after a few quick turns, I found myself sliding head-first down a slick, steep run that gifted me a pretty good blood-red brush burn. Mountain 1, knucklehead 18-year old 0.

After college, in 1983, I worked in Colorado for three months before moving to Phila to start my career. The season’s first big storm came in early December, and one of my college teammates took me into the Back Bowls at Vail. It was the first time the Back Bowls opened for the season, and the entire area was untracked powder. The rule is, there are no friends on a powder day, and I soon understood why. Once my buddy took off, I never saw him again. I attempted to follow but quickly found myself way out over my skis (literally). First turn, second turn—faceplant. I dug myself out and tried again. Same outcome. But “fail, fix, try again” is the best recipe for almost everything, and within a few weeks, I learned how to ski powder. It really is a different dance. And, oh, what a wonderful dance it is.

Five of our six kids will be with Susan and me in Utah, and we can’t wait!

Wishing you and your family a warm and joy-filled holiday season!

Steve

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

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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.

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