Chart II

 

Source:  ISI Group

One wag estimates that all of this borrowing has left the nation in a negative net worth position when one includes our enormous entitlement liabilities:

          Household Net Worth                    $53.5 trillion

          U.S. Government Net Worth         $(11.5 trillion)

          Social Security and Medicare         $(45.9 trillion)

          Total Net Worth                                $(3.8 trillion)

Pretty ugly. Who would lend money to a credit like this?

Up until the last 2 years, consumers have been the most profligate borrowers.  The growth in consumer indebtedness was primarily driven by the real estate frenzy as everyone scrambled to own a piece of the action.  Residential real estate buyers bought into the notion that it was a one way trade.  Their optimism was increasingly affirmed by the price action in the market as overall prices rose at double digit rates during the last two years of the bubble.  Of course, prices rose 50% or more in many of the hottest markets—California, Nevada, Arizona and Florida.  There’s no need to point out all of the enablers of this fantasy, of which there were many.  However, clear-eyed observers would conclude that this period may have been the biggest misallocation of capital into residential real estate ever.

Chart III

Quite A Mortgage Boom

 

 

Source:  BCA Research

The aggregate corporate balance sheet is probably in the least impaired position of the three major sectors.  While borrowing has grown somewhat faster than GDP since 1980, corporations have built substantial liquidity cushions.  Aggregate liquid assets as a percent of short term liabilities is now 51.3%, the highest net liquidity position ever.

Chart IV

U.S. NONFIN CORP LIQUID ASSETS

% SHORT TERM LIABILITIES

2010:2Q  51.3%

 

 

Source:  ISI Group

Anyone that has followed the news over the past couple of chaotic years is very aware of the massive growth of the financial sector.  For most of the post-War period, total financial assets grew about in line with the overall economy.  Life was pretty simple as banks basically took in deposits and made loans and did very little of all their current esoteric activities.  It worked well as the 1950’s and 1960’s were years of solid growth.  All of that changed beginning in the early 1980’s.  This marked the onset of the golden era of financial assets, producing double digit returns for more than two decades.  Of course those that entered the financial business post-1980 became inured to those heady returns and then, increasingly, expected them to persist.  The business exploded over the next 25 years.  The amount of financial instruments, derivatives, securitized products, debt instruments, international investment vehicles, mutual funds, alternative products and industry employment proliferated.  This led to an explosion of total financial assets which grew twice as rapidly as the economy over that period from 500% of GDP to 1000% by 2007. 

Chart V

 

Source:  BCA Research

Since the end of 2008, Federal Government borrowing has increased by 60%.  As they say, you can’t make that stuff up.  Given the decline in tax revenues as a result of the deep recession and the explosion in spending, the Federal Government deficit is estimated to hit 10.4% in fiscal 2010. 

Chart VI

Federal Government Deficit

 

 

Source:  Ned Davis Research

The Congressional Budget Office projects the deficit as a percentage of GDP to decline over the next several years, but then it begins to rise again.  The CBO estimates that the deficit will still be a very problematic 5.6% in 2020.  If that were to happen, the growth in Federal Government indebtedness would explode to 90% of GDP from 40% in 2000 and 56% today.  Even more alarming, is that interest expenses as a percentage of GDP would almost triple to 13.8% from 5.3%.  If we look at that interest expense burden the way a creditor would, interest expense in 2020 would chew up 70% of tax revenues.  Once again, who would ever provide credit to a borrower whose debt servicing before principal repayment absorbed well over half of its revenues.  If we stay on this path, we’ll find out and at what price.

Chart VII

Type of Spending…..

Source:  Ned Davis Research

Fortunately, the world has an insatiable appetite for our Treasury offerings, at least for now.  While it’s generally believed that foreigners are buying the vast majority of our Federal Government debt, it’s not the case.  In fact our domestic banking industry bought over half of the Treasury’s offerings over the past dozen years.  As long as private sector lending remains subdued, it’s not an issue.  But when and if it revives, then the dreaded “crowding out” will become a concern. 

Chart VIII

 

Source:  UBS Research

State and local budgets are in total shambles.  The combined deficits of the 46 states not running a surplus is $112 billion.  Most states are required by law to balance their fiscal budgets (why the deficits are so high in the face of those laws is beyond us), so they have no choice but to balance them.  More on that later.

The Federal Reserve has leveraged up substantially as well.  Most of this increase is a result of quantitative easing, which is a consequence of its direct purchases of existing debt.  To the consternation of many, banking system reserves have doubled over the past year.  When and if bank lending revives, the Fed will have some very difficult choices.  Either foreign purchases of our debt increase, or interest rates rise.  Our guess is the latter is more likely.

Chart IX

Source:  Fed of St. Louis

We’re not the only profligate spenders and borrowers.  Federal Government deficits in most developed economies have spiked up over the last 10-to-20 years.  Japan’s government debt is now at a stratospheric 105% of GDP, or almost twice the level of that of the United States.  However, they enjoy the luxury of having a very high savings rate, so that most of it is purchased internally.  Borrowing has been growing more rapidly in Europe and the UK as well, and their debt ratios to GDP are about equal to ours. 

Chart X

Source:  BCA Research

Impressively at some level, the EU is now cutting deficits aggressively through spending reductions and tax increases.  As for the latter, VAT taxes have increased in the U.K., Greece, Spain, Portugal and Finland.  The United Kingdom has a very ambitious deficit reduction plan which includes a 25% cut in all “non-protected” government expenditures.  Amazingly, Greece will reduce its deficit by 39% over the next two years.   Japan has adopted a 10 year deficit reduction plan which represents quite a change from its fiscal policies over many years.  Maintaining the roster of EU countries will create tremendous strains for the weakest and biggest borrowers.  Historically, countries in huge deficit positions and whose debt is being downgraded to junk have always been able to solve part of their problem through currency devaluation.  Obviously, the PIIGS (Portugal, Italy, Ireland, Greece and Spain) don’t have that option since they are part of the euro bloc.  Consequently, their only choice is to adopt draconian deficit reductions, debt restructuring or in some cases, default.  These countries account for at least a quarter of European GDP and will impose a significant brake on its growth prospects for at least the next several years.

Collectively, the OECD economies will reduce their budget deficits relative to GDP by 1.6 percentage points next year, the most since the OECD began keeping records in 1970.  This might be too much, too fast and is obviously weighing on markets.

Over the last 60 years, it’s taken an increasing amount of borrowing to produce a given gain in U.S. GDP.  In each decade over that period, the ratio of the increase in debt to the increase in nominal Gross Domestic Product has risen.  During the decade of the 1950’s, it took a $1.36 of debt to generate a $1 of GDP.  In the first decade of this century, it required a whopping $5.56 of new borrowing to produce a $1

of GDP.  The implication of this is that the only way this country was able to achieve its strong growth rate over the past 60 years was to leverage up at an exponential rate.

Chart XI

Diminishing Returns On Borrowing

Source:  Ned Davis Research

The process of deleveraging is well under way in the private sector.  According to the Federal Reserve Flow of Funds data, U.S. household debt has declined in absolute terms for 5 consecutive quarters.  In the first quarter of this year (the last quarter for which data are available), consumer debt declined at a -2.4% annual rate.  Household debt is now 122% of Disposable Personal Income, down from 133% in 2007.  However, it’s still 30 percentage points above its 35 year median.

Business indebtedness was flat in the first quarter of this year after four quarters of decline. However, lots of corporate debt matures over the 2011-to-2014 period.  Given the risk aversion of lenders and the tightened capital requirements imposed upon banks from the new Financial Regulation bill, a number of these borrowers will not be able to refinance their loans.  Much of this debt will default which, in effect, will accelerate corporate de-leveraging.

The financial sector has been fading into the shadows as well.  Through mid-June, bank loans have declined year-over-year for 12 consecutive months, the weakest period since the Fed started collecting data in1947.  Total bank loans are off -1.7% over the past year, while commercial and industrial loans are down -15% and real estate lending -4.5%.  According to Stifel, Nicolaus, bank loans in the first nine months of this recovery through the first quarter of this year declined  -6.5% vs. an increase of +4.8% normally.

Chart XII

Financial Sector De-leveraging

Source:  BCA Research

The Financial Regulation Bill is rapidly approaching finality.  Whatever ultimately emerges, and we know most of it, it will surely force more de-leveraging on the financial sector.  Capital requirements will increase, proprietary trading will be restricted, alternative investments will be sharply curtailed and derivative activity will be limited, at least for U.S. institutions.

This is clearly unsustainable if one accepts that fact that we’re at the end of our borrowing rope.  And this has extremely important implications for global growth going forward as the developed world’s private and public sectors de-leverage.  There’s only one conclusion—slower growth in those economies.  They will become increasingly dependent on export markets to the developing world.  Those that are the most competitive will survive and perhaps thrive.  Those that aren’t won’t.

The long process of mortgage deleveraging is in its early stages.  Many individuals are saddled with a negative equity position in their homes.  The aggregate loan-to-value ratio for all residential mortgages is 60%, up from only 40% 10 years ago.   On the positive side, there is $6 trillion of unemcumbered equity in homes, but most of that is owned by our wealthiest citizens.  Meanwhile many homeowners that are upside down on their properties and whose incomes are insufficient to service the debt will be forced from their homes.  This defaulted debt, of course, will be extinguished forever, representing “forced deleveraging”.  And there will be a lot of it given the very large number of homes under water and the high and stubborn unemployment rate.  It will take at least 3-4 years of deleveraging, and a lot of it will be of the “forced” variety, to get the aggregate loan-to-value ratio back to normal.

Chart XIII

Source:  Portales

Through most of this past decade preceding the financial and economic meltdown, homeowners increasingly “monetized” the growing equity in their homes, primarily by taking out Home Equity Loans (HELOCs).  At the 2006 peak of the mortgage equity withdrawal (MEW) activity, consumers took out $500 billion, greatly adding to their spendable cash flow. These withdrawals were so common that they became known as the homeowners ATM. At its peak, this equity monetization was about 4% of GDP and significantly boosted consumption.  But that was then. Following the steep decline in residential real estate values, homeowners, in the first quarter of this year, actually repaid a net $10 billion, removing a substantial spending stimulus.

Chart XIV

Source:  Portales

Once the ability to borrow is impaired, as it is now, deleveraging starts with a vengeance. After years of spending and borrowing profligacy, the private sector has been forced to deleverage over the past 18 months.  The lethal combination of too much leverage and impaired cash flows has forced consumers and many corporations and private businesses to reduce debt either voluntarily or in a growing number of cases, through default.

It’s now the public sector’s turn. Federal, state and local governments are faced with the same predicament that the private sector has been forced to confront—massive indebtedness and impaired cash flows. The problem, particularly at the Federal level, is that many elected officials don’t recognize it or refuse to do so. But as we saw in the recent G-20 meetings in Toronto, the leaders of the rest of the developed nations have certainly gotten the message and are moving aggressively to reduce their large deficits.  Meanwhile, our leaders are admonishing them for their fiscal prudence and are pleading to either abandon those plans for the time being or to slow them down.  Of course, they are having no part of it and instead, are criticizing the United States for its ongoing fiscal profligacy.

To the extent that our current political leaders propose solutions to the yawning deficits, the emphasis is usually on tax increases rather than spending cuts.  History tells us that won’t work.  About 20 years ago, a Hoover Institute economist, W. Kurt Hauser, published a study demonstrating that over the previous 60 years it made no difference what the marginal tax rates were on income or capital.  Federal tax revenues never exceeded 20% of GDP.  This became known as “Hauser’s Law”.  Recently, H.C. Wainwright economist, David Ranson, updated the study and included the last 20 years.  In a Wall Street Journal op-ed piece, he came to the same conclusion as Hauser.  Over the past 80 years, changes in marginal tax rates don’t raise or lower the Federal revenues ratio to GDP, but recessions do.  We’ve witnessed that first hand as that ratio has dropped to 15% in the aftermath of the recent financial and economic meltdown.

Chart XV

Source:  Wall Source Journal

The reasons why it has been impossible for tax revenues to exceed 20% of GDP over the last 80 years are not difficult to comprehend.  Individuals respond to incentives—both positive and negative ones. 

And there’s nothing like higher tax rates on income and capital for incentivizing us to seek loopholes to legally avoid taxes.  The 70,000 page tax code provides ample cover for everyone to find ways to skirt higher rates.  The more taxpayers are encouraged to game the system as marginal rates are lifted, the less government will collect.  Also, many will choose leisure over labor and work less or even retire if they are financially secure.

The problem, of course, is that the current structural (in contrast to cyclical) Federal deficit is about 25% of GDP.  Hauser’s Law tells us that higher taxes won’t close the deficit.  So in the absence of spending cuts, this would leave us with a deficit of a very troublesome 5% of GDP.

But once again, history suggests that generating tax revenues at a sustainable rate of 20% of GDP is probably optimistic.  Over the past 50 years, Federal revenues have averaged 18.3% of economic activity.  They reached a level of just above 20% once, and that was in 2000 when realized capital gains soared at the tail end of the tech bubble.

Even more alarming are the recent Congressional Budget Office projections of a steady rise in Federal Government spending over the next 25 years if current policies remain in place.  They estimate that spending relative to GDP will increase to 35% by the year 2035, and that tax revenues won’t be any higher than 20% of economic output.  That’s totally unthinkable and will never happen.  We’ll get into that later.

However, if tax revenues do average 20% of GDP, and as we just pointed out that has never happened on a sustainable basis, and if spending isn’t cut to a level well below 25%, then it would still be fiscal suicide.  Deficits of 5% as far as the eye can see will propel us to unsustainable total debt levels and Federal interest payments.  So, what will change it?

Chart XVI

FEDERAL OUTLAYS AND RECEIPTS

Source:  ISI Group

There are three ways to reverse it.  First, the solution everyone would prefer—we grow our way out of it.  But that won’t happen during this long period of private sector de-leveraging which will obviously weigh on economic growth.  Second, the high class alternative—deficits are reduced by “voluntary” rational actions by our elected officials.  Of course, this will only happen if voters demand it.  Finally, the painful solution—the marketplace forces is it.  This is far and away the least attractive way to go about reducing deficits.  The fury of markets in reaction to ballooning Federal Government debt levels would raise havoc with our asset prices and currency.  Foreign central banks and sovereign wealth funds would increasingly diversify their holdings out of dollar denominated assets, sending prices sharply lower.  This would be ruinous for our standard of living.

We think there’s a very good chance that economic Armageddon can be avoided.  But it will only happen at the voting booths.  A recent WSJ/NBC poll cited that “the electorate is in a really ugly mood and is very unhappy with what’s going on in Washington.”  Only 35% feel that their representative deserves re-election, and 57% say let’s give someone else a chance.  The two most frequently mentioned issues relate to Federal Government activities.  Thirty-nine percent want to see Federal spending reduced while 28% want the new healthcare bill repealed.  A May AP poll found that 8 of 10 of those that were queried said that the Federal deficit was either an “extremely or very important” concern.

A Pew Research poll found that public trust in the Federal Government was at a record low of 22% of respondents.  Moreover, 58% believe that the Federal Government is intruding too much into State and Local affairs.  And 53% want major Federal Government reform and 50% want a smaller government with fewer services.  That’s hardly a ringing endorsement for Washington.

It’s difficult to tell whether all of this voter angst is having an impact on the administration’s plans to reduce the deficit. They still seem to be focused on increasing taxes rather than reversing the buildup in Federal Government spending.  We even heard of a Machiavellian  desire for a deficit scare-induced bond market meltdown which would heighten voter awareness of the deficit/debt issue (as if they aren’t scared and alarmed now?).  Such a panic, so the story goes, would grease the skids for major tax increases, including a VAT tax.  Strange—we’ve never heard of voters supporting tax increases except those that are imposed on others.  Hard to imagine among a populous that is increasingly unhappy with government at all levels and is now demanding less of it.

Importantly, it seems like the bipartisan Commission on Deficit Reduction is making some real progress.  They are strongly endorsing spending reductions over tax increases which the Hauser Law suggests would be far more effective.  Democratic co-chairman, Erskine Bowles, floated a long term goal of reducing spending to 21% of GDP.  While this would still leave us with a deficit, it would most likely stabilize our total Federal debt-to-GDP ratio at a level slightly above the 60% projected by year end.  Not ideal, but it would be a whole lot better than what is looming out there in the absence of dramatic changes in spending.  He, also, emphasized that significant cost reductions in Federal health spending and the other entitlement programs must be part of the solution.

All of this is very encouraging.  Those running for re-election and those opposing the incumbents take note.  The electorate is angry and is demanding change.  This will be interesting.

Reform at the state and local level has actually begun.  Steve Malanga of the Manhattan Institute recently said that “the tide turned in early 2010”.  There is a growing and vocal populist movement against government fiscal profligacy and is particularly directed at compensation.  Public sector wages have increased about 40% more than private sector compensation over the past three years and have reached levels that significantly exceed those of nongovernment workers.  Moreover, pension benefits are far more lucrative.  It is not our place to pass judgment on whether these differentials are justified or not and we won’t.  However, voters have become increasingly resentful of these differentials and are imposing their wrath and mandates for change on their elected officials—and it’s coming from both parties.  We expect to see more state and local governments emulating the policies of New Jersey’s governor, Chris Christie, seeking significant budget cuts including public workers’ compensation and retirement benefits.

We’re now back to where this letter began.  The world is deleveraging.  Consumers, corporations, state and local governments and the rest of the developed world are all pulling back.  They’re cutting spending and repaying debt, some voluntarily and some not.  All, except our Federal Government.  But as we indicated above, we think that will change.  Hopefully, voters force it before the market does.  We’ll see, but our guess it will come sooner rather than later.

Restoration of public and private balance sheets is good thing.  As we’ve said, there really is no choice anymore.  But this will not be over in a year or two.  Many individuals, businesses and governments will be forced into belt-tightening for years.  Consequently, debt growth in the developed world will be sluggish at best while its collective balance sheet is repaired.  We saw that it’s taken an increasing amount of new indebtedness to produce a $1 gain in GDP in each decade over the past 60 years.  And in the most recent decade, that dollar advance in GDP required $5.56 of new debt.

Now debt growth is going to slow substantially.  Consequently, it doesn’t take a whole lot of imagination to conclude that less borrowing means slower economic growth.  Slower economic growth will keep the unemployment rate much higher than we’d like for some time.  Slower growth creates a more challenging environment for business and will limit profit growth.  If profit growth is below its historical rate, and that’s our bet, the range of equity valuations will be lower as well.

Most of the current decision makers in the professional investment community were weaned during the great bull market for financial assets from 1982 to October 2007.  Economic growth in the ‘80’s and ‘90’s was exceptional.  Inflation and interest rates fell dramatically, profit growth and returns on equity were robust and valuations rose.  Now it seems that those strong tailwinds are now blowing squarely on our collective noses.  Yes, many will survive and thrive, but it will be tougher. 

The negative events of the second quarter have triggered a worldwide selloff in equities, including a decline in the S&P 500 which is approaching 15% as we write this letter.  All of the optimism that was so evident following the +75% cyclical bull market that began in early March last year, seems to have vaporized.  The issues we have described in this letter are well known and are weighing on investors’ confidence, or lack thereof.  The dispute seems to center on how long and how severe these issues will be.  We do not think the world is heading into a severe double dip, or even a double dip at all.  We do feel, as we’ve said, growth will be slower and making money will be more difficult.

The good news is that the pervasive pessimism has created opportunities in many individual equities and in some markets.  Currently, the S&P 500 is selling at about 12x a reasonable estimate of 2011 earnings.  And the cheapest sectors in the market seem to be concentrated in the highest quality companies.  This is an attractive opportunity for investors who can tune out all of the gloom and doom we see constantly on CNBC and in the press and take a longer term view.  There are many companies with terrific balance sheets, generating significant free cash flow and are exposed to the lucrative developing world markets that are selling at valuations  at the bottom of their historical range.  This is where our research if focused.  Happy summer!