Chair of the United States Federal Reserve, Janet Yellen, has delivered her last semiannual testimony (formerly the “Humphrey-Hawkins” reports for us old timers) before Congress. She’s had a good run at the Fed, absent her being CEO of the Federal Bank of San Francisco during the second-worst financial crisis in U.S. financial history and a voting member of the FOMC in 2009. She took on the role of Vice Chair in 2010 and in 2014 took over for Ben Bernanke as Chair, so in those two positions she likely enjoyed the fairly spectacular moves higher in global financial asset prices.
During the question and answer period, there were hints that her comments may become less guarded as she approaches the end of her term (February 2018). In other words, she seemed a little more “off the cuff” to me. For example, in response to a question concerning the implementation of potential triggers (if the tax reforms don’t provide the expected economic growth and tax revenues, then the triggers would automatically increase taxes), Chair Yellen opened up a bit about her views on the country’s debt levels.
Specifically, she said (about one hour and eight minutes into Wednesday’s hearing), “Well, I will say my understanding is the idea of triggers is motivated by a concern that some have over the picture we have of debt sustainability now and into the future, and I would simply say that I am very worried about the sustainability of the US debt trajectory. Our current debt-to-GDP ratio of about 75% is not frightening, but it’s also not low. But when you look at, for example, CBO’s long-term budget projections, it’s the type of thing that should keep people awake at night. And it shows a picture in which, as our population ages, expenditures on Medicare, Medicaid, and Social Security grow more rapidly than tax revenues, and the debt-to-GDP ratio moves up, and this should be a very significant concern. So exactly what is the right way to address this, I think, is a matter for you to decide. My understanding is the trigger discussion is motivated by that, and I just say it’s right to be focused on that problem, and I would urge you to remain focused on it.”
In other words, the train is coming, but no one knows when it will get here. We agree, Using a long-cycle indicator like debt levels to time the markets is counterproductive. However, using this kind of information can identify whether risks are higher due to financial imbalances. And when the risks continue to compound, risk management becomes even more important.
We’ve featured charts showing the massive debt levels before, like the first chart below, which illustrates the latest cycle debt binge from around 2009 through now. Currently, publically held debt as a percentage of GDP is 83.4%. The second chart below shows that the annual run rate for the budget deficit is -3.6%, meaning that even with what many are calling a healthy economy, our country continues to spend more than it takes in.
We’re thinking about debt in light of the tax plans being floated by the House and Senate (who knows what the final product will look like). While a corporate tax cut would certainly benefit U.S. business, and individual tax cuts would likely spur some spending, we’re not convinced our legislators have yet figured out the key to what ails us: spending!
I’ll try to tackle U.S. spending, off-balance sheet spending/borrowing and other items in another report. However, I do think it is important to know what our government is basing their assumptions on, and the table below is an eye-opener (I’ve been featuring these tables since the year 2000 and they never cease to amaze me.)
The table illustrates the economic assumptions made by the Office of Management and Budget (OMB) and was featured in the publication for the Budget of the U.S. Government for 2018 (link: https://www.whitehouse.gov/sites/whitehouse.gov/files/omb/budget/fy2018/budget.pdf).
Take a look at the line item “Real GDP, percent change, year/year.” This shows the baseline economic growth assumptions that the OMB is making when “analyzing” (and I use the term loosely) future expectations. As you’ve probably already noticed, the disturbing problem with this table is that the OMB fully expects U.S. GDP growth to take off and never look back for the next ten years, without so much as a hiccup. No slowdown, no recession, no problems whatsoever. It is this kind of thinking that causes our representatives to be caught off guard and unprepared when something does actually hit the fan.
Just for fun, the next table illustrates the 2006 CBO’s report’s baseline assumptions. This report shows that the Congressional Budget Office expected budget surpluses from 2012 on and that Debt Held by the Public as a Percentage of GDP would be 20.1% by 2017, not the 83.4% we had shown earlier! Clearly, 2017’s reality is far different.
Our view is that the growth in the U.S. economy and globally, while below-trend, has been enough to preclude any significant rough patches. The advance Q3 GDP report was good, but if you look at the growth rate since 2015, there’s not a lot to get excited about. We’re watching closely to see if the last couple of quarters are the beginning of a new trend.
Also, it can be argued that central banks providing huge doses of monetary stimulus (low interest rates, asset purchases, open market purchases of equities, etc.) have underpinned the global economic growth. With this in mind, the chart below struck us as interesting (attribution is unavailable). In the top clip we show U.S. Gross Domestic Product (GDP) in dollars. The bottom clip of the chart shows GDP minus Fed borrowing. The concept is that GDP includes government spending and government investment. If part of the government’s dollars is being created out of thin air (ex-nihilo), then maybe those dollars shouldn’t be considered as “hard dollar” economic output.
Our view is that macro risks remain relevant concerns. Overall, our investment models continue to portray the message that a mildly bullish stance is appropriate–which means “invest wisely and don’t throw caution to the wind.” We continue to seek value and opportunity, and as our quantitative, unemotional models shift either more bullish or bearish, so shall we.
If you have any questions or comments, please feel free to email or call anytime.
Have a wonderful week,
Donald L. Hagan, CFA
— Written 11-30-2017
Print Copy of Article: Day Hagan Research Update November 30, 2017 (PDF)
Disclosure: The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Day Hagan Asset Management (DHAM), any of its affiliates or employees, or any third-party data provider, shall not have any liability for any loss sustained by anyone who has relied on the information contained in any Day Hagan Asset Management literature or marketing materials. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before investing. DHAM, accounts that DHAM or its affiliated companies manage, or their respective shareholders, directors, officers and/or employees, may have long or short positions in the securities discussed herein and may purchase or sell such securities without notice. DHAM uses and has historically used various methods to evaluate investments which, at times, produce contradictory recommendations with respect to the same securities. When evaluating the results of prior DHAM recommendations or DHAM performance rankings, one should also consider that DHAM may modify the methods it uses to evaluate investment opportunities from time to time, that model results do not impute or show the compounded adverse effect of transactions costs or management fees or reflect actual investment results, that some model results do not reflect actual historical recommendations, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, the performance of DHAM’s past recommendations and model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors. The S&P 500 Index is based on the market capitalizations of 500 large U.S. companies having common stock listed on the NYSE or NASDAQ. The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected growth values. Indexes are unmanaged, fully invested, and cannot be invested in directly.
The S&P 500 Index is based on the market capitalizations of 500 large U.S. companies having common stock listed on the NYSE or NASDAQ. The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected growth values. Indexes are unmanaged, fully invested, and cannot be invested in directly.