Jeremy Strickler
jeremy@wwmgreenville.com
Paradigm Shift
Happy Spring! At least it’s spring in Greenville, SC where 3 of the last 5 years, winter ended in mid- February. In 12 days, the sun will set at 7:34 and it will be dark at 8 pm.
The start to the year has been good. Most economists and financial pundits in 2022 expected we would be in recession by now. But rather than that, the job market is holding up quite well with unemployment near 3.4% and modest growth in labor force participation rate. Some people are actually going back to work.
The economic situation in the US is far from dire. We have full employment, energy resources to tap, good credit, a reasonably good government, a strong military. In other words, we have the means of solving our problems.
US Indebtedness
However, there are cracks showing. The system has accumulated too much debt, that debt is being priced higher. A sign of the times: a growing percentage of car buyers are falling behind on payments on cars that are worth a good bit less than they paid. No, cars are not appreciating assets, unless they’re rare and excellent. But this is just one way of seeing that the US consumer is getting stretched.
We’re in a big transition from the previous era. A paradigm shift. Inflation and higher interest rates are effects from the previous conditions, not the causes. If it cost more to buy a car or a home, this is a parallel story to the fact that the US national debt is larger than the Gross Domestic Product of the country. In other words, it’s time for everyone to take stock of spending and get the house in order.
Despite the fact that there will be a debt ceiling debate, the US is not in crisis. We are not in a recession. We are not in a financial crisis. However, we are at a point where we must take stock of the situation and stop perpetuating some negative trends. There will be some tough decisions if we want to alter the future in a meaningful way.
According to the US Treasury, the national debt is over $31 trillion. We don’t have to pay off the national debt. But we do need to quit growing it faster than the economy grows. In 2007, the national debt was around $9 trillion—or about 62% of GDP. Let’s say (back in 2007) we ran a 4% budget deficit, adding to the national debt. If the economy grew at 3%, the economic output could still outgrow the debt and debt service.
But not now. US debt is 124% of GDP.
Most likely, we cannot run sizeable budget deficits and outgrow the debt. The debt will likely grow faster than the economy.
Secondly, the cost of carrying the debt is rising. At 1% interest rates, $31 trillion costs about $310 billion in interest each year. What about if interest rates rose to 5% (they have) and stayed there awhile. The cost of floating that debt could rise to $1.5 trillion each year. Total tax receipts were about $4.9 trillion last year (up meaningfully in a couple years without significant tax hikes), and government spending was $6.27 trillion. So, a few years of higher interest rates could mean that interest costs eat up more than 30% of the tax revenue.
Most likely, the heavy inertia of this problem will slow down the economy and pull interest rates down from their peaks in the coming years. But we have not reached the peak in rates yet, and we shouldn’t expect rates to decline in the near term.
Looking to the future
Given the debt situation, debates about the debt ceiling and the future of entitlement programs cannot be avoided.
What does it mean to carry this much debt? It means that money that could have been used for investment or improved standards of living will be used to pay interest on the debt. You understand this within household finances, and there is a parallel in the national finances.
We are in a bit of a paradox: the fed wants to control rising costs, and the only tools they have either stimulate or slow economic activity. But in order to find longer term solutions, we actually need a cycle of investment, rather than disinvestment—which is what higher interest rates contribute. Higher interest rates are a form of or cause of de-leveraging and disinvestment.
The inputs are not that complicated:
- We need more workers, so we need more legal immigration. How likely are we to see higher birth rates? How long would that take to make an impact? Immigration is the answer- about 2 million new people per year. Also- perhaps more Americans will go back to work because they need the money in an inflationary environment. We need more people working than not working.
- Home prices are too high. So we raised interest rates? That’s a temporary fix. We need more homes. A big homebuilding cycle would balance out the relationship between home prices and incomes in time. We need investments in housing, not dis-investment. One of the sneaky benefits of the 2008-2009 financial crisis (when housing was over-built) is that housing was very affordable in 2010 at about 10% of household incomes. Now we don’t have enough houses. So, that market is not likely to collapse, but also, housing costs are too high a percentage of household incomes. That means money can’t be spent elsewhere.
- We cannot reasonably cut defense spending under the circumstances. And we are not overspending on Ukraine. What do you think the almost $1 trillion defense budget is for? Exactly this. It’s a necessary and good investment in our future. The Pax Americana had an important feature: you don’t get to attack your neighbors and annex their country! That shouldn’t change now. If it does, it undermines the proposition of an international order with the United States driving global governance. We are not spending too much on this conflict. It’s unavoidable. We need to win it.
- In order to change the setup for the future, we have to look at entitlement spending. Conservatives are right about this. After 2031, social security payments will begin to eat into other tax revenues.
- We need to think about non-inflationary ways to grow the economy. More productivity. Better relationships around the world. I think perhaps some people don’t make the connection to globalization: free trade lowers costs. Trade wars are inflationary. A protracted and hostile cold war with China is not desirable or necessary. It’s bad for the global economy if the two largest economies can’t collaborate.
The best inputs for our future are immigration, affordable housing, freer markets with more internal competition, and a peaceful geopolitical situation. We have to live up to the traditional American proposition. Free trade. Social mobility. Human rights. Civil society.
What do we do now?
I’m interested in what answers will emerge from this situation. Many answers arise when you get into serious problems, but not before. I would not bet against America or Americans to solve our problems.
Some opportunistic a-holes are selling doom and gloom, playing to people’s fears, bearing false witness, making people paranoid.
Look, Americans are tough and smart. We’re not all corrupt. We’re not lazy. But now we are in the tough phase of hammering out the answers. Nobody yet knows the rules of this transitional phase or of the new paradigm.
We know we have higher interest rates. We believe those rates should put pressure on asset prices until inflation comes in a bit lower. That process isn’t over.
In the meantime, investment markets offer much more attractive interest rates to savers. Not all the answers are that complicated. It probably makes sense for a lot of investors to hold more bonds and cash equivalents and somewhat lower stock exposure. Most likely stocks should trade cheaper than 18x forward earnings expectations.
But will it be a disaster? It hasn’t been so far. Just an uncomfortable adjustment to the new realities. In my experience, a little pain now is preferable to denial, compounding problems and future crisis.
It’s time to roll up our sleeves and get to work, personally, politically, and socially. You can’t build the future we’re talking about inside your house, inside of a walled country.
You can’t build it out of paranoia and jingoism. It can be built if there’s a vision for the future, courage to connect, a will to collaborate and the strength to insist on fair play.
Jeremy L. Strickler, CFP®
Portfolio Manager
*This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.
