"[We] have population growth of 1.2%...real GDP growth of 3.8%...debt growth of about 11%, [and] central bank balance sheet growth of 16%...you just can't do this for long." – Kyle Bass, President of Hayman Capital
The opening quote is from a recent CNBC interview with Kyle Bass, one of our favorite hedge fund managers. For several years now Kyle has been preaching that the global economy is at a “Keynesian end point” meaning central banks can no longer stimulate the economy with cheap credit because the world is already awash in debt and interest rates are already at historic lows. In the opening quote, Kyle was referencing annual growth rates for four different global metrics over the past decade. The difference in growth of government debt and central bank balance sheets versus global population and GDP are alarming and unsustainable to say the least. We see the same trend when looking at similar metrics here in the US.
The difference in GDP versus population growth is understandable as innovation and productivity gains add to the GDP growth rate. What can’t be explained, at least as sustainable, is the growth rate of government debt and central bank balance sheet expansion (aka “money printing”) versus the population. In 2011 dollars, the government debt burden in 1994 was $27,855 per US citizen versus $49,752 at the end of last year. Similarly, there was $2,520 in assets (again adjusted for inflation) on the Fed’s balance sheet per US citizen in 1994 versus $9,350 today.
The current path of government debt and central bank balance sheet expansion is clearly unsustainable over the long haul. Everyone knows this and yet interest rates on US Treasuries are at historically low levels. How does one reconcile these two seemingly contradictory facts? Will there ever be a tipping point which changes the direction of interest rates, and if so what will be the catalyst and when will it happen? These are the questions that any investor with a long-term time horizon should be asking themselves today.
Like any question pertaining to finance and economics, the answer depends on a multitude of different factors. In general, interest rates on sovereign debt increase whenever investors fear increasing inflation or an increased probability of an outright default. In the now famous book This Time Is Different by Reinhart and Rogoff, the authors argue that these factors are in a way one and the same since extreme inflation produces the same end result as an outright default (e.g. the lender loses all the purchasing power of their investment). The book outlines historical examples of countries which crossed the “tipping point” of 90% debt-to-GDP ratios, at which point debt became a drag on growth and continued to grow until it was eventually written off through default or hyper-inflation.
Although we find this historical study fascinating, at the risk of arguing that “this time is different” we think that this simple rule-of-thumb does not necessarily apply to the United States today. The first major difference in today’s market place versus any other time in history is that the global economy is more intertwined than ever. The global nature of the world economy means that one nation’s liability is another nation’s asset. This is clearly seen in the relationship we have with China. The US buys cheap Chinese goods with US dollars. These dollars make their way to the central bank as local merchants convert the dollars they receive into Renminbi. The central bank then takes these dollars and invests in US dollar denominated assets. Historically this has been US Treasuries, although this trend has subsided over the past year. The takeaway being that international trade creates currency reserves which need to be invested in local denominated assets. This tailwind is further exacerbated by the fact that the US dollar is the world’s reserve currency. As the reserve currency, there is more demand for dollars since many international transactions, not even involving the US, are still done in US dollars. More dollar demand in turn means more demand for US dollar denominated “safe haven” assets. As long as US Treasuries continue to be viewed as a safe haven asset and US dollars are sloshing through the global economy, there will be plenty of demand for our debt which will keep interest rates low.
As of right now, global investors are still in effect signing off on the Fed’s quantitative easing program by continuing to buy US debt. They may be complaining about the Fed’s policies but their money is voting differently than their mouth. This is because there are no real alternatives to the US Treasuries and the dollar as the world’s safe haven asset and reserve currency. Developed nations with stronger fundamentals like Norway and Sweden don’t have currency markets big enough to handle the global demand of a reserve currency. Other major currencies like the Yen and the Euro have problems of their own that far exceed that of the US dollar. Of the emerging currencies, the only one that has any chance of being a reserve currency would be the Chinese Renminbi, but it is still pegged to the US dollar. So, to steal a phrase from Bill Gross at PIMCO, the US is “the cleanest dirty shirt” right now.
The favored status that the US enjoys in today’s global economy buys us more time to get our financial house in order. We need to be putting policies in place today that will put us on a sounder, fundamental footing in the future. If we don’t and politicians continue to pander by making decisions that will help them get re-elected versus what is in the best interest of the long-term future of our country, we will eventually run out of runway and lose our favored status. We are a privileged nation and we should not take that fact for granted. Eventually the music will stop once investors have a real alternative to the US dollar and they lose faith in our ability to make good on our debts. This would be a major tipping point for interest rates which we don’t see happening anytime soon, but if we continue down the path we are currently headed it will become a reality that we will be forced to address.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.