Personal Debt

April 15, 2018

by Steve Stofka

Until the financial crisis, I thought that other people’s debt was their problem. In 2008, debt became a nation’s problem and a national conversation with two aspects – the moral and the practical. Moral conversations are not confined to church; they drive our politics and policy. Many laws contain some language to contain moral hazard, which is the danger that language loopholes in a law or policy promote the opposite of the intended effect of the law. This is particularly true of many entitlement policies. Let’s leave the moral conversation for another day and turn to the practical aspects of current policy.

Bankers learned their lesson during the financial crisis, didn’t they? Maybe not. A decade of absurdly low interest rates has starved those who depend on the income earned by owning debt. Even a savings account is money loaned to a bank, a debt that the bank must pay to the account holder. In their hunger for income, investors have turned to less prudent debt products. So long as the economy remains strong, no worries.

A fifth of conventional mortgages are going to people whose total debt load, including the mortgage, is more than 45% of their pre-tax income. By comparison, at the market’s exuberant peak in late 2007, 35% of conventional mortgages were going to such households, who were especially vulnerable when monthly job gains turned negative in early 2008.

The real estate analytics firm Core Logic also reports that Fannie Mae has started backing mortgages to those with total debt loads up to 50%. FICA, federal, state and local income taxes can amount to 25% of a paycheck (Princeton Study). Add in 45% of that gross pay for mortgage and debt payments, and there is only 30% left for food, gas, home repairs and utilities, child care, etc.

I’ll convert these percentages to dollars to illustrate the point. A couple grossing $80,000 might have a take home pay of $60,000. The couple has $36,000 in mortgage and other debt payments (45% of $80,000). They have $24,000, or $2000 a month for everything else. This couple is vulnerable to a change in their circumstances: a layoff or a cut back in hours, some unexpected expense or injury.

For those who get a conventional loan despite their heavy debt load, where is the money coming from? Banks suffered huge losses during the financial crisis. The Federal Reserve tightened capital requirements for banks’ loan portfolios, forcing them to improve the overall quality of their debt. As a result, banks turned away from their most lucrative customers – subprime borrowers and those with heavy debt loads who must pay higher interest on their loans. Profits in the financial industry fell dramatically. A broad composite of financial stocks (XLF) has still not regained the price levels of 2007.

The banking industry employs some very smart people. What solution did they create? The big banks now loan money to non-financial companies who loan the money to subprime borrowers. After bundling the consumer loans into securities, the non-financial companies use the proceeds to pay the big banks back. In seven years this kind of borrowing has expanded seven times to $350 billion. Doesn’t this look like the kind of behavior that almost took down the financial system in 2008? The banks say that this system isolates them from exposure to subprime borrowers. If large scale job losses cause a lot of loan defaults, it is the investors who will bear the pain, not the banks. Same song, different lyrics.

The 2008 financial crisis is best summed up with a chart from the Federal Reserve. In the post WW2 economy, the weekly earnings of British workers rose steadily. The growth is especially strong when compared to the earlier decades of the 19th and 20th centuries. In 2008, earnings peaked.
WeeklyEarnUK

Developed countries depend on the steady growth of tax receipts generated by weekly earnings. An assumption of 3% real GDP growth underlies the health and continuation of post-war social welfare policies. For more than a decade, the U.S. and U.K. have had less than 2% GDP growth.  Both governments have had to borrow heavily to fund their social support programs.  How long can they increase their debt at such a rapid pace?

I am reminded of a time more than 40 years ago when New York City held a regularly scheduled auction to sell  bonds to fund their already swollen debt load.  None of the banks showed up to bid for the bonds.  The city is the financial center of the world.  The lack of interest stunned city officials.  To avoid a messy bankruptcy, the city turned to the Federal government for a loan (NY Times).

The Federal government is not a city or state, of course. It has extraordinary legal and monetary power, and its bonds are a safe haven around the world.  But there could come a time when investors demand higher interest for those bonds and the rising annual interest on the debt squeezes spending on other domestic programs.

Debt causes stress.  Stress causes anxiety.  Anxiety weakens confidence in the future and causes investment to shrink. Falling investment leads to slower job growth. That causes profits and weekly earnings to fall which reduces tax receipts to the government.  That increases debt further, and the cycle continues.  Other people’s debt is everyone’s problem after all.

Vulnerable

September 3, 2017

Hurricane Harvey invaded the lives, homes and businesses of so many people in Houston and the surrounding area of southeast Texas. People around the world watched the plight of so many who were caught in the rising waters. I was cheered by the dedication of first responders, by those who came from near and far to help with their boats, with food and clothing. I have never been in a flood. Some of those interviewed had been in several. Why do they stay there, I wondered? The answer is some or all of these: their family, their church, their job, their school, their culture.

Watching so many vulnerable people reminded me of my own. If given a few minutes to leave my house, what would I put in a garbage bag? In the urgency and stress of the moment so many people in Houston forgot their medications.  My list: Pets, papers, clothes, medications. Food? Will the shelter have food? Pet food, as well? Where are we going? Oops, what about a phone charger? And the laptop. What about the list with all the passwords? That too. What about the photos in the closet? I was going to get those scanned in and uploaded. No time now. Take a few of the smaller framed photos on the shelf in the living room. Out of time. Gotta go. All the questions that must have been bouncing around inside the heads of those forced to evacuate as the brown water took possession of their house.

If I don’t call it Climate Change, I could call it Flood Frequency, or Flood Freak for short. Here is a chart showing the increased frequency of flooding during the past century. This was from an article in the WSJ (paywall).

FloodFrequency
This week’s theme – vulnerability. The signs of it and what we can do to lessen it. Debt is a vulnerability. For the past three years, households have been increasing their debt load in mortgages, auto and student loans. Here’s a breakdown of household debt from the NY Fed. (As a side note, this report gives a breakdown of the different types of debt by credit score. For example, the median credit score for an auto loan is about 700).

DebtBalance2016.png
Mortgage debt is more than 2/3rds of total debt. Despite the rise in home prices, more than 5 million homes, or 7%, are still badly “under water.” (Consumer Affairs)

Credit card debt has stayed stable for the past thirteen years. Households are only using 10% of their after-tax income to service their debt.

DebtService2016

Despite low interest rates, households are continuing to deleverage, to decrease their vulnerability. The ratio of household debt – the total of that debt, not the payments – to income climbed above 2.5 in late 2007. It has fallen below 2.2 but is still high. We are still up to our eyeballs in debt.

HouseholdDebtIncomeRatio

Debt reduction will curb economic growth for the near future. According to several cabinet members, Trump is focused on GDP growth in discussions about trade policy, defense policy, infrastructure spending, and the regulatory environment. How does this or that policy get us to 3% growth? he asks.

2/3rds of the nation’s economy is based on the public willingness to spend money. Jobs helps. Higher wage growth helps. Low interest rates help. But without the willingness to take on more debt relative to income, policymakers may feel like they are trying to goad a stubborn mule to go faster. Tough to do.

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Unemployment

Continuing the theme of vulnerability.  As a percentage of the unemployed, the number of long-term unemployed remains stubbornly high at close to 25%.  I call them the 27ers because 27 weeks of unemployment is the cutoff that the BLS uses to determine whether someone is categorized as long term unemployed. 27 weeks or six months is a long time to be actively looking for work and not finding a job.  Eight years after the end of the recession, today’s percentage of 27ers is at the same level as the worst of most past recessions.

LTUnemploy

During any recession the number of long term unemployed climbs higher. When these past few recessions have ended, the number of 27ers doesn’t start to decline.  Instead, they continue to increase and reach a peak several months after the recession is officially over. In the last three recessions, the peaks came later than previous recessions.

UnemployLTPctCLF
This more vulnerable cohort in the labor force struggles to recover after a recession.  Manufacturing is the more volatile element in the business cycle.  As manufacturing has declined, recessions are less frequent. However, manufacturing used to put a lot of people back to work at the end of recessions.  In a recovery, the service sectors are not as quick to add jobs.

The structural shift in the labor force will continue to leave more workers and families vulnerable and needing help just as many older workers are claiming retirement benefits. More than half of voters, both Republican and Democrat, have received benefits from at least one of the six entitlement programs (Pew Research). Elected officials offer promises of future benefits in exchange for taxes, and votes, today. When circumstances force a clash of priorities and promises, Congress seems incapable of resolving the conflict. President Trump’s approval ratings are in the low thirties, but his popularity far exceeds the public’s dismal ratings of Congress.

In a crisis, Americans come together to help each other but why do we wait till there is a crisis? Have we always been a nation of drama queens?  Maybe that’s the American charm.

Dance of Debt

April 9th, 2017

Last week I wrote about the dance of household, corporate and government debt. When the growth of one member of this trinity is flat, the other two increase. Since the financial crisis the federal debt has increased by $10 trillion. Let’s look at the annual interest rate that the Federal government has paid on its marketable debt of Treasuries. This doesn’t include what is called interagency debt where one part of the government borrows from another. Social Security funds is the major example.

In 2016, the Federal government paid $240 billion in interest, an average rate of 1.7% on $14 trillion in publicly held debt. Only during WW2 has the Federal government paid an effective interest rate that is as low as it today. World War 2 was an extraordinary circumstance that justified an enormous debt. Following the war, politicians increased taxes on households and businesses to reduce the debt. Here is a graph of the net interest rate paid by the Federal government since 1940.

InterestRate

In 2008, before the run up in debt, the interest rate on the debt was 4.8%. If we were to pay that rate in 2017, the interest would total $672 billion, more than the defense budget. Even at a measly 3%, the interest would be $420 billion.  That is $180 billion greater than the interest paid in 2016.  That money can’t be spent on households, or highways, or education or scientific research.

The early 1990s were filled with political arguments about the debt because the interest paid each year was crippling so many other programs. Presidential candidate Ross Perot made the debt his central platform and took 20% of the vote, more than any independent candidate since Teddy Roosevelt eighty years earlier. Debt matters. In 1994, Republicans took over Congress after 40 years of Democratic rule on the promise that Republicans would be more fiscally responsible. In the chart below, we can see the interest expense each year as a percent of federal expenses.

PctFedExp

Let’s turn again to corporate debt. As I showed last week, corporate debt has doubled in the past ten years.

CorpDebt2016

In December, the analytics company FactSet reported (PDF) that the net debt to earnings ratio of the SP500 (ex-financials) had set another all time high of 1.88. Debt is almost twice the amount of earnings before interest, taxes, debt and amortization (EBITDA). Some financial reporters (here, for example ) use the debt-to-earnings ratio for the entire SP500, including financial companies. Financial companies were highly leveraged with debt before the crisis. In the aftermath and bailout, deleveraging in the financial industry effectively hides the growth of debt by non-financial companies.

What does that tell us? Unable to grow profits at a rate that will satisfy stockholders, corporations have borrowed money to buy back shares. Profits are divided among fewer shares so that the earnings per share increases and the price to earnings (profit), or P/E ratio, looks lower. Corporations have traded stockholder equity for debt, one of the many incidental results of the Fed’s zero interest rate policy for the past eight years.

Encouraged by low interest rates, corporations have gorged on debt. In 2010, the pharmaceutical giant Johnson and Johnson was able to borrow money at a cheaper rate than the Federal government, a sign of the greater trust that investors had in Johnson and Johnson at that time.

Other financial leverage ratios are flashing caution signals, prompting a subdued comment in the latest Federal Reserve minutes ( PDF ) “some standard measures of valuations [are] above historical norms.” Doesn’t sound too concerning, does it?

Each period of optimistic valuation is marked by a belief in some idea. When the bedrock of that idea cracks, doubts grow then form a chasm which swallows trillions of dollars of marketable value.

The belief could be this: passively managed index funds inevitably outperform actively managed funds. What is the difference? Here’s  a one-page comparison table. In 1991, William Sharpe, creator of the Sharpe ratio used to evaluate stocks, made a simple, short case for the assertion that passive will outperform active.

During the post-crisis recovery, passive funds have clearly outperformed active funds. Investors continue to transfer money from active funds and ETFs into index funds and ETFs. What happens when a smaller pool of active managers make buy and sell decisions on stocks, and an ever larger pool of index funds simply copy those decisions? The decisions of those active managers are leveraged by the index funds. Will this be the bedrock belief that implodes? I have no idea.

Market tensions are a normal state of affairs. What is a market tension? A conflict in pricing and risk that makes investors hesitate as though the market had posed a riddle. Perhaps the easiest way to explain these tensions is to give a few examples.

1. Stocks are overvalued but bond prices are likely to go down as interest rates rise. The latest minutes from the Fed indicated that they will start winding down their portfolio of bonds. What this means is that when a Treasury bond matures, they will no longer buy another bond to replace the maturing bond. That lack of bond purchasing will dampen bond prices. Stocks, bonds or cash? Tension.

2. Are there other alternatives? Gold (GLD) is down 50% from its highs several years ago. Inflation in most of the developing world looks rather tame so there is unlikely to be an upsurge in demand for gold. However, a lot of political unrest in the Eurozone could drive investors into gold as a protection against a decline in the euro. Tension.

3. What about real estate? After a run up in 2014, prices in a broad basket (VNQ) of real estate companies has been flat for two years. A consolidation before another surge? However, there is a lot of debt which will put pressure on profits as interest rates go up. Tension.

In the aftermath of the financial crisis, we discovered that financial companies, banks, mortgage brokers and ordinary people resolved market tensions through fraud, a lack of caution, and magical thinking. Investors can only hope that there is enough oversight now, that the memories of the crisis are still fresh enough that plain old good sense will prevail.

During the present seven year recovery there have been four price corrections in the Sp500 (Yardeni PDF). A correction is a drop in price of 10 – 20%. The last one was in the beginning of 2016. Contrast this current bull market with the one in the 2000s, when there was only one correction. That one occurred almost immediately after the bear market ended in the fall of 2002. It was really just a part of the bear market. From early 2003 till the fall of 2007, a period of 4-1/2 years, there was no correction, no relief valve for market tensions.

Despite the four corrections and six mini-corrections (5 – 10%) during this recovery, the inflation adjusted price of the SP500 is 50% higher than the index in the beginning of 2007, near the height of the market.  Inflation adjusted sales per share have stayed rather stable and that can be a key metric in the late stages of a bull market. The current price to sales (P/S) ratio is almost as high as at the peak of the dot com boom in 2000 and that ratio may prove to be the better guide. In a December 2007 report, Hussman Funds sounded a warning based on P/S ratios.  Nine years later, this report will help a reader wanting to understand the valuation cycles of the past sixty years.

An Interest-ing Debt

February 12, 2017

Republicans used to talk about the country’s debt load but such talk is so inconvenient now that they control the House, Senate and Presidency. Perhaps it was never more than a political ploy, a rhetorical fencing. Now there is talk of tax cuts and more defense spending, and a $1 trillion dollar infrastructure spending bill. 48 states have submitted a list of over 900 “shovel-ready” projects.

House Speaker Paul Ryan used to be concerned about the country’s debt. Perhaps he has been reading that deficits don’t matter in Paul Krugman’s N.Y. Times op-ed column. For those of us burdened with common sense, debts of all kinds – even those of a strong sovereign government like the U.S. – do matter. The publicly held debt of the U.S. is now more than the country’s GDP.

debt2016q3

In 2016, the Federal interest expense on the $20 trillion publicly held debt was $432 billion, an imputed interest rate of 2.1%. Central banks in the developed world have kept interest rates low, but even that artificially low amount represents 11% of total federal spending. (Treasury)  It represents almost all the money spent on Medicaid, and more than 6 times the cost of the food stamp program. (SNAP)

The latest projection from the CBO estimates that the interest expense will double in eight years, an annual increase of about 9%. The “cut spending” crowd in Washington will face off against the “raise taxes” faction at a time when a growing number of seniors are retiring and wanting the Social Security checks they have paid toward during their working years.

In the past twenty years the big shifts in federal spending as a percent of GDP are Social Security and the health care programs Medicare and Medicaid. These are not projections but historical data; a shift that the CBO anticipates will accelerate as the Boomer generation enters their senior years. Ten years ago, 6700 (see end of section)  people were reaching 65 each day. This year, over 9800 (originally 11,000, which is a projection for the year 2026) per day will cross that age threshold.

cbospendcomp1996-2016
CBO Source

A graph of annual deficits and federal revenue shows the parallel paths that each take. The trend of the past two years is down, promising to accelerate the accumulation of debt.

fedreceiptsdeficit1998-2016

More borrowing and higher interest expense each year will crowd out discretionary spending programs or force the scaling back of benefits under mandatory programs like Social Security, Medicare and Medicaid. President Trump can promise but it is up to Congress to do the hard shoveling.  They will have to bury the bodies of some special interests in order to get some reform done.

[And now for a bit of cheer.  Insert kitten video here.]

We already collect the 4th highest revenue in income taxes as a percent of GDP. Canada and Italy head the list at 14.5%.
South Africa 13.9%,
U.S. 12.0%,
Germany 11.3,
and France 10.9 all collect more than 10%. (WSJ) Those who already pay a high percentage in income taxes will lobby for a VAT tax to increase revenues. Income taxes are progressive and impact higher income households to a greater degree. Poorer households are more affected by a VAT tax.  Cue up more debate on what is a  “fair share.” Many European countries have a VAT tax and the list of exclusions to the tax are bitterly debated.

Adding even more social and financial pressure is the lower than projected returns earned by major pension funds like CALPERS. For decades, the funds assumed an 8% annual return to pay retirees benefits in the future. In the past ten years many have made 6% or less. Several years ago, CALPERS lowered the expected return to 7.5% and has recently announced that they will be gradually lowering that figure to 7%.

Each percentage point lower return equals more money that must be taken from state and local taxes and put into the pension fund to make up the difference. Afraid to call for higher taxes and lose their jobs, local politicians employ some creative accounting to avoid the expense of properly funding the pension obligations. In a 2010 report, Pew Charitable Trust analyzed the underfunding of many public pension funds like CALPERS and found a $1 trillion gap as of 2008. (Pew Report) The slow but steady recovery since then may have helped annual returns but the inevitable crisis is coming.

In December 2009, I first noted a Financial Times Future of Finance article which quoted Raymond Baer, chairman of Swiss private bank Julius Baer. He warned: “The world is creating the final big bubble. In five years’ time, we will pay the true price of this crisis.”
That warning is two years overdue. Sure hope he’s wrong but … here’s the global government debt clock. The total is approaching $70 trillion, $20 trillion of which belongs to the U.S.  We have less than 5% of the world’s population and almost 30% of the world’s government debt.  As Homer Simpson would exclaim, “Doh!”

Correction:  Posted figure for 10 years ago was originally 9000.  Current figure was originally posted at 11,000.  Projected for the year 2026 is 11,000.)

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Market Valuation

Comments by President Trump indicating a “sooner than later” schedule for tax cuts helped lift the stock market by 1% for the week. The Shiller CAPE ratio currently stands at 28.7, just shy of the 30 reading on Black Tuesday 1929. (Graph) Since the average of this ratio is about 16, earnings have some catching up to do. Today’s reading is still a bargain compared to the 44 ratio at the height of the dot com boom. Still, the current ratio is the third highest valuation in the past century.

The Shiller Cyclically Adjusted Price Earnings (CAPE) ratio
1) averages the past ten years of inflation adjusted earnings, then
2) divides that figure into the current price of the SP500 to
3) get a P/E ratio that is a broader time sample than the conventional P/E ratio based on the last 12 months of earnings.

The prices of long-dated Treasury bonds usually move opposite to the SP500.  In the month after the election, stocks rose and bond prices went lower.  Since mid-December an ETF composite of long-dated Treasury bonds (TLT) has risen slightly.  A number of investors are wary of the expectations that underlie current stock valuations.

The casual investor might be tempted to chase those expectations.  The more prudent course is to stick with an allocation of various investments that manages the risk appropriate for one’s circumstances and goals.

 

Productivity And Labor Unions

February 5, 2017

About 10% of all workers, public and private, belong to a union. Today the percentage of private sector employees who are unionized is the same as in 1932, eighty years ago. (Wikipedia) The rise and fall of unon membership looks like the familiar bell curve, with the peak in the 1970s. The causes of the decline are debated but some attribute the erosion of union power as an important factor in wage stagnation.

The major factor is not declining union membership but declining productivity, and that persistent decline has economists and policymakers baffled.  Higher productivity should equal higher wage growth and, in the 30 year post-war period 1948-1977, multi-factor productivity (MFP) annual growth averaged 1.7%. MFP includes both labor and capital inputs. In the 40 year period from 1976-2015, MFP growth averaged about half that rate – .9%.

prodmfp1948-2015

In the debate over the causes of the decline, some contend that all the easy gains were made by 1980.  Productivity is now returning to a centuries long growth trend that is less than 1%. In an October 2016 Bloomberg article, Justin Fox picked apart BLS data to show that growth has been flat in some key manufacturing areas for the past three decades. The ten-fold surge in productivity growth in the tech sector is largely responsible for any growth during the past 30 years. OECD data indicates that other developed countries are experiencing a similar lack of growth (OECD Table) When no one can conclusively demonstrate what the causes are for the decline, policymakers face tough challenges and even tougher debate over the solutions.

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LoanGate

LoanGate may the next scandal. A few months ago, the Dept of Education (DoE) revealed that they had seriously undercounted student loan delinqencies because of a programming error. When the Wall St. Journal analyzed the revised data, they found that the majority of students at 25% of all colleges and trade schools in the U.S. had defaulted on their student loan or failed to make any repayment.  (WSJ article)

The Obama administration forced the closure of many private institutions whose students had low repayment rates. In 2015, Corinthian Colleges shuttered the last of its schools and filed for bankruptcy. The revised data show that many more institutions, both public and private, should be shut down.

This latest programming error at the DoE follows other embarrassing episodes during the two Obama terms. In October 2013, the rollout of Obamacare was riddled with programming errors that blocked many applicants from enrolling in a plan with healthcare.gov.

In 2010, the IRS delayed many applications for 501(c)3 tax status from mostly conservative political groups. Lois Lerner, the head of the agency, first claimed that these had been innocent clerical mistakes by an overworked staff, but a series of hearings uncovered the fact that employees at the IRS had acted on their own political feelings and deliberately targeted these groups. (Mother Jones)

In yet another incident, the Office of Personnel and Managment (OPM), the HR dept for thousands of Federal employees, revealed in 2016 a data breach involving 22,000,000 personnel records, including Social Security numbers.  Unchecked programming errors and data breaches erode the public’s faith in public institutions.  That these mistakes happened under a Democratic administration favoring ever bigger public institutions to solve ever bigger social problems is especially embarrassing.

When Obama first took office in 2009, the inflation adjusted total of student debt had quadrupled in the 15 year period (DoE paper – page 1) since 1993. By the time he left office eight years later, student debt had grown ten-fold to $1.3 trillion. The delinquency rate on that debt is 11% but the repayment rate is considered a better predictor of future delinquencies. The revised data reduced the combined repayment rate to a little more than 50% (Inside Higher Ed), far lower than the 75% plus repayment rates of a few decades ago.

The defaults are coming and there will be an inevitable call for a taxpayer bailout.  A popular element of Bernie Sanders’ Presidential platform was that a college education should be free. In the real world, nothing is free, so somebody pays.  Who should pay and how much will further aggravate tensions in an already divided electorate.

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Five Year Rule

A few weeks ago I wrote about the 5-year rule, a backstop to any allocation rule. Any money needed in the next five years should be in stable assets like short to intermediate term bonds, CDs and cash. Why 5 years of income? Why not 2 years or 10 years? Answer: History.

Let’s look back at 80 years in 5 year slices, or what is called 5-year rolling periods. As an example, the years 2000 – 2004 would be a 5-year rolling period. 2001 – 2005 would be the next period, and so on.

Saving me the time and effort of running the data on stock market returns is a blogger at All Financial Matters who put together a table of this very data for the years 1926-2012. The table shows that the SP500 has held or increased its inflation adjusted value (very important that we look at the real value) almost 75% of the time. So the 5-year rule guards against a loss of value the other 25% of the time.

The 5-year rule can apply whenever there are anticipated income needs from our savings: retirement, college expenses, sickness or disability, and even a greater chance of losing our jobs. In a retirement span of 25 years, 6 of those years will fall into that 25% category. The 5-year rule minimum usually kicks in toward the end of retirement when a person’s reserves are lower and prudence is especially important.

 

The Weathervane of Growth

April 10, 2016

CWPI (Constant Weighted Purchasing Index)

March’s survey of Purchasing Managers showed a big upsurge in new orders for the manufacturing (MFR) sector. Export orders were up 5.5% in both the manufacturing and services (SVC) sectors and overall output increased 2% or more.  After contracting for several months, MFR employment may have found a bottom.  The total of new orders and employment is still growing but below five year averages.

The broader CWPI is still expanding but at a slightly slower pace for the past seven months.  The cyclic pattern of declining growth followed by a renewal of activity has changed. While there is no cause to make any strategic changes to allocation, it does bear watching in the months ahead.

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IRA Standard of Care

Financial agents – investment advisors, stock brokers and insurance agents – have had different standards of care when they deal with their clients.  The first and highest standard is fiduciary: the agent should operate with the best interests of the client in mind.  Registered Investment Advisors (RIA) are registered with the SEC and follow this strict standard. The second and more lax standard is suitability: the agent should not sell the client anything that is not suitable for the client based on what the client has told them about their circumstances.  Here’s a short paper on the difference between the two standards.

This week the Obama administration issued new guidelines for agents servicing IRA account holders, requiring agents to maintain the higher fiduciary standard starting in 2017.  This requirement was left out of the Dodd-Frank finance reform bill because many in the investment industry lobbied against it.  Here is the first rule proposal in February.

Opponents will criticize the Obama administration for this “new” set of regulations but this policy has been recommended by some in the industry, on both sides of the political aisle, for at least 25 years.  During the 1980s Congress made several changes that made IRA accounts available to a wide swath of savers, most of whom were unfamiliar with the marketplace of financial products now available to them.

Some in the insurance and investment industries fought against the imposition of a stricter fudiciary standard because it would require more training and would likely reduce the sales commissions of agents.  The growing volume of tax deferred employee retirement plans has generated a steady stream of fees for those in the financial industry.

Keep in mind that the new policy only applies to retirement accounts.

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Debt

Banks are in the business of loaning money, meaning that they must loan money to stay in business.  Most of the time some part of the economy wants to borrow money.  Borrowers come in three types:  Household, Corporate and Government.  If households cut back on their borrowing, corporations may increase theirs.

A historical look at total debt as a percent of GDP shows several trends.  Keep in mind the leveling of debt since the financial crisis.  We’ll come back to that later.

In the thirty years following World War 2, debt levels remained fairly consistent with the pace of economic activity.  The three types of borrowers offset each other.  Households and corporations increased their borrowing while government, particularly the Federal government, paid down the high debt incurred to fight WW2.

In 1980 the Reagan administration and a Democratic House began running big deficits, contributing to a spike in the the total level of debt.  By 1993, when President Clinton took office, Federal and State Debt as a percent of GDP was about the same as it was at the end of WW2.

A combination of higher tax rates and cost cutting by a Republican House elected in 1994 led to a reduction in government spending as household and corporations increased their spending.  Total debt levels flattened during the late 1990s.

Following the 9/11 tragedy and a recession, government debt levels increased but now there was no offset in household borrowing as mortgage debt climbed.  Helping to curb the pronounced rise in total debt levels, a Democratic House at odds with a Republican president dampened the growth of government borrowing in the two years before the financial crisis.

Arguably the most severe crisis in eighty years, the financial crisis caused both households and corporations to cut back on their borrowing.  Offsetting this negative borrowing, the Federal government assumed an often overlooked role – the Borrower of Last Resort.  We are accustomed to the role of the Federal Reserve Bank as the Lender of Last Resort, but we might not be aware that some part of the economy has to be the Borrower.  That role can only be filled by the Federal government because the states and local governments are prohibited from running budget deficits.

Look again at the second chart showing the huge spike in government borrowing following the financial crisis.  Now remember the leveling off of total debt shown in the first graph.  The Federal government has increased its debt level by more than $10 trillion.  Almost $4 trillion of that has come from the lender of last resort, the Fed, but the rest of that borrowing has offset a significant deleveraging by corporations and households.  Had the Federal government not borrowed as much as it did, many banks would have experienced significant declines in profits to the point of going out of business.

There is a potential bombshell waiting in the $2 trillion in corporate profits that businesses have parked overseas to delay taxes on the income.  If Congress and the President were to lower tax rates so that corporations could “repratriate” these dollars, two things would happen: 1) corporations could lower their debt levels, using the cash to pay back the rolling short term loans they use to fund daily operations; and 2) the Federal government would lower its debt levels as the corporations paid taxes on those repatriated profits.

Great.  Lower debt is good, right?  Unless households were to step up their borrowing, total debt could fall significantly, causing another banking crisis.  Although politicians on both sides like to talk about bringing profits home, such a move will have to be done slowly so that the economy and the banking system can adjust in slow increments.

Partisans cheer when candidates express strong sentiments in rousing words, but cold caution must quench hot spirits. We can only trust that candidates for public office will temper their campaign rhetoric with prudence if entrusted with the office.

Rebound

October 25, 2015

Last week we looked at two components of GDP as simple money flows.  In an attempt to understand the severe economic under-performance during the 1930s Depression, John Maynard Keynes proposed a General Theory that studied the influences of monetary policy on the business cycle (History of macoeconomics).  In his study of money flows, Keynes had a fundamental but counterintuitive insight into an aspect of savings that is still debated by economists and policymakers.

Families curtail their spending, or current consumption, for a variety of reasons.  One group of reasons is planned future spending; today’s consumption is shifted into the future.  Saving for college, a new home, a new car, are just some examples of this kind of delayed spending.  The marketplace can not read minds.  All it knows is that a family has cut back their spending.  In “normal” times the number of families delaying spending balances out with those who have delayed spending in the past but are now spending their savings.  However, sometimes people spend far more than they save or save far more than they spend, producing an imbalance in the economy.

When too many people are saving, sales decline and inventories build till sellers and producers notice the lack of demand. To make up for the lack of sales income, businesses go to their bank and withdraw the extra money that families deposited in their savings accounts.  Note that there is no net savings under these circumstances.  Businesses withdraw their savings while families deposit their savings.  After a period of reduced sales, businesses begin laying off employees and ordering fewer goods to balance their inventories to the now reduced sales.  Now those laid off employees withdraw their savings to make up for the lost income and businesses replace their savings by selling inventory without ordering replacement goods.  As resources begin strained, families increasingly tap the several social insurance programs of state and federal governments which act as a communal savings bank,   Having reduced their employees, businesses contribute less to government coffers for social insurance programs.  Governments run deficits.  To fund its growing debt, the Federal government sells its very low risk debt to banks who can buy this AAA debt with few cash reserves, according to the rules set up by the Federal Reserve.  Money is being pumped into the economy.

As the economy continues to weaken, loans and bonds come under pressure.  The value of less credit worthy debt instruments weakens.  On the other side of the ledger are those assets which are claims to future profits – primarily stocks.  Anticipating lower profit growth, the prices of stocks fall.  Liquidity and concern for asset preservation rise as these other assets fall.  Gold and fiat currencies may rise or fall in value depending on the perception of their liquidity.

Until Keynes first proposed the idea of persistent imbalances in an economy, it was thought that imbalances were temporary.  Government intervention was not needed.  A capitalist economy would naturally generate counterbalancing motivations that would auto-correct the economic disparities and eventually reach an equilibrium.  Economists now debate how much government intervention. Few argue anymore for no intervention.  What we take for granted now was at one time a radical idea.

While some economists and policymakers continue to focus on the sovereign debt amount of the U.S. and other developed economies, the money flow from the store of debt, and investor confidence in that flow, is probably more important than the debt itself.  As long as investors trust a country’s ability to service its debt, they will continue to loan the country money at a reasonable interest rate.  While the idea of money flow was not new in the 1930s, Keynes was the first to propose that the aggregate of these flows could have an effect on real economic activity.

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Stock market

A very good week for the market, up 2% for the week and over 8% for October.  A surprising earnings report from Microsoft lifted the stock -finally – above its year 2000 price.  China announced a lower interest rate to spur economic activity.  ECB chair Mario Draghi announced more QE to fight deflation in the Eurozone. Moderating home prices and low mortgage rate have boosted existing home sales.

The large cap market, the SP500, is in a re-evaluation phase.  The 10 month average, about 220 days of trading activity, peaked in July at 2067 and if it can hold onto this month’s gains, that average may climb above 2050 at month’s end.

The 10 month relative strength of the SP500 has declined to near zero.  Long term bonds (VBLTX) are slightly below zero, meaning that investors are not committing money to either asset class.  The last time there was a similar situation was in October 2000, as the market faltered after the dot-com run-up.  In the months following, investors swung toward bonds, sending stocks down a third over the next two years.  This time is different, of course, but we will be watching to see if investors indicate a commitment to one asset class or the other in the coming months.

The Future is Past

June 21, 2015

Returning to our Heaven On Earth scenario: why can’t the government just print up a bunch of money and give it to people?  Centuries of historical data shows that inflation inevitably results when governments do this.  However, the Federal Reserve has pumped in almost $4 trillion dollars in the past seven years and no inflation has resulted.  We saw that the Federal Reserve has been offsetting the lack of private spending, particularly the lack of savings that is devoted to investment.

Whatever we don’t consume is called savings.  Savings can be put to two different uses:

1) Invest in Yesterday’s spending, or debt.  This can be either our own debt or the debt of others.  We might pay down a credit card balance we owe or a mortgage.  We might buy a corporate or government bond.  Savings, checking and money market accounts are an investment in debt.

Household and business non-financial credit market debt is more than $21 trillion.  Included in that amount is $9.3 trillion in home mortgages.  Most of us who buy a home don’t think of it as “yesterday” spending.  To us it is an investment in our future.  However, the purchase of a home consists of two components:
1) the transfer of the replacement cost of the dwelling – yesterday’s spending adjusted for the change in price of the labor and material to build the home.
2) Someone else’s profit, and this is the key component of these two types of spending, yesterday and tomorrow.  Whether buying a new home or existing home, we are buying the costs and profit of the builder or previous owner.

Below is a chart of household and business non-financial credit market debt as a percentage of GDP.  From 1980 through the end of 1994, the SP500 index quadrupled from 110 to 470, an annual gain of a bit over 9.5% per year.   In the mid-1990s, household and business debt started a steep climb to 140% of GDP by 2007 and this probably pulled in more savings to service that debt. In the next 15 years, the SP500 grew by only 233%.

But wait!  That’s not all! – as the late night commercials remind us.  Governments at all levels borrow savings from private households and businesses.  The current total is about $16 trillion.

Adding the $16 trillion government debt to the non-fianncial debt of the private sector totals $37 trillion of yesterday’s spending that needs to be fed with today’s savings..

2) The other option for savings is to invest in equities – Tomorrow spending – and the profits generated from that spending.  We might buy stocks, real estate or some other physical asset which will generate some production, a profit, or a capital gain from an appreciation in the value of that asset.  The World Bank estimated the total market capitalization in the U.S. in 2012 at $18.7 trillion.  Add on 33% or so since then to get an updated total of about $25 trillion.  We could debate the valuation but it is clear that debt – investment in yesterday’s spending – is clearly winning the race against investment in the profits of tomorrow’s spending.

If future growth looks modest it is because we are still in a defensive posture – weight on our back foot, so to speak. Low interest rates encourage investment in Tomorrow spending and the Federal Reserve has kept rates low to encourage us to lean in, to shift the weight, the energy of our investment from the past to the future.

Transfer Payments

February 16th, 2014

In this election year, as in 2012, the subject of transfer payments will rear its ugly head with greater frequency.  In the mouths and minds of some politicians, “transfer payments” is synonymous with “welfare.”  Don’t be confused – it is not.  As this aspect of the economy grows, politicians in Washington and the states get an increasing say in who wins and who loses.  Below is a graph of transfer payments as a percent of the economy.  I have excluded Social Security and Unemployment because both of those programs have specific taxes that are supposed to fund the programs.

Transfer payments, as treated in the National Income and Product Accounts (see here for a succinct 2 page overview), are an accounting device that the Bureau of Economic Analysis (BEA) uses to separate transfers of money this year for which no goods or services were purchased this year.  The BEA does this because they want to aggregate the income and production of the current year. Because that category includes unemployment compensation, housing and food subsidies, some people mistakenly believe that the category includes only welfare programs.   Here’s a list of payments that the BEA includes:

Current transfer receipts from government, which are called government social benefits in the NIPAs, primarily consist of payments that are received by households from social insurance funds and government programs. These funds and programs include social security, hospital insurance, unemployment insurance, railroad retirement, work­ers’ compensation, food stamps, medical care, family assistance, and education assistance. Current transfer receipts from business consist of liability payments for personal injury that are received by households, net in­surance settlements that are received by households, and charitable contributions that are received by NPISHs.

That settlement you received from your neighbor’s insurance company when his tree fell on your house is a transfer payment.  Didn’t know you were on welfare, did you?  Some politicians then cite data produced by the BEA to make an argument the government needs to curtail welfare programs.  Receiving a Social Security check after paying Social Security taxes for forty plus years?  You’re on welfare.  A payment to a farmer to not grow a bushel of wheat – an agricultural subsidy – is not a transfer payment.  A payment to a worker to not produce an hour of labor – unemployment insurance – is a transfer payment.  Got that?  While there are valid accounting reasons to treat a farmer’s subsidy check and a worker’s unemployment check differently, some politicians prey on the ignorance of that accounting difference to push an ideological agenda.

That agenda is based on a valid question: should a government be in the business of providing selective welfare; that is, to only a small subset of the population?  Some say yes, some say no.  If the answer is no, does that include relief for the victims of Hurricane Katrina, for example?  Even those who do say no would agree that emergencies of that nature warrant an exception to a policy of no directed subsidies or welfare payments.  It was in the middle of a national emergency, the Great Depression, that Social Security and unemployment compensation were enacted.  Government subsidies for banks began at this time as well.  Agricultural subsidies began in response to an earlier emergency – a sharp depression a few years after the end of World War 1.  Health care subsidies were enacted during the emergency of World War 2.  The pattern repeats; a subsidy starts as a response to an immediate and ongoing emergency but soon becomes a permanent fixture of government policy.

Tea Party purists think that the Constitutional role of the federal government is to tax and distribute taxes equally among the citizens.  Before the 16th Amendment was passed a hundred years ago, the taxing authority of the Federal Government was narrowly restricted.  However, the Federal Government has always been selective in distributing  the resources at its disposal.  Land, forests, mining and water rights were either given or sold for pennies on the dollar to a select few businesses or individuals. (American Canopy is an entertaining and informative read of the distribution and use of resources in the U.S.) By 1913, the Federal Government had dispensed with so much land, trees and water that it had little to parlay with – except money, which it didn’t have enough of.  Solution: the income tax.

In principle, I agree with the Tea Party, that the government at the Federal and state level should not play God.  How likely is it that the voters of this country will overturn two centuries of precedent and end transfers?  When I was in eighth grade, I imagined that adults would have more rational and informed discussions.  Sadly, our political conversation is stuck at an eighth grade level on too many issues.

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While most of us pay attention to the unemployment rate, there is another statistic – the separation rate – that measures how many people are unemployed at any one time.  The unemployment can be voluntary or involuntary, and last for a week, a month or a year.  Not surprisingly, younger workers change jobs more frequently and thus have a higher separation rate than older workers.  In the past decade, almost 4% of younger male workers 16 – 24 become unemployed in any one month.  Put another way, in a two year period, all workers in this age group will change jobs.  For prime age workers 25 – 54, the percentage was 1.5%.  In a 2012 publication, Shigeru Fujita, Senior Economist at the Philadelphia Federal Reserve Bank, examined historical demographic trends in the separation rate.

On page five of this paper, Mr. Fujita presents what is called a “labor-matching” model that attempts to explain changes in unemployment and wages, primarily from the employer’s point of view. Central elements of this model, familiar to many business owners, include uncertainty of future demand and the costs of finding and training a new worker.  Mr. Fujita examines an aspect that is not included in this model – the degree of uncertainty that the worker, not the employer, faces.  In the JOLTS report, the BLS attempts to measure the number of employees who voluntarily leave their jobs.  These Quits indicate the confidence among workers in finding another job.  The JOLTS report released this week shows an increasing level of confidence but one which has only recently surpassed the lows of the recession in the early 2000s.

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Labor Participation
In a more recent paper, Mr. Fujita examines the causes of the decline in the labor participation rate, or the number of people working or looking for work as a percentage of the people who are old enough to work.  As people get older, fewer of them work; the aging of the labor force has long been thought to be the main cause of the decline.  That’s the easy part.  The question is how much does demographics contribute to the decline? What Mr. Fujita has done is the hard work – mining the micro data in the Census Bureau’s Current Population Survey.  He found that 65% of the decline of the past twelve years was due to retirement and disability.  More importantly, he discovered that in the past two years, all of the decline is due to retirement.  The first members of the Boomer generation turned 65 in 2011 so this might come as no surprise.  The surprise is the degree of the effect;  this largest  generational segment of the population dominates the labor force characteristics. During the past two years, discouraged workers and disability claims contributed little or nothing to the decline in the participation rate.  Another significant finding is that relatively few people who retire return to the work force.

In this election year, we will be bombarded with political BS: Obamacare or Obama’s policies are to blame for the weak labor market; the anti-worker attitude of Republicans in Congress are responsible.  Politicians play a shell game with facts, using the same techniques that cons employ to pluck a few dollars from the pockets of tourists in New York City’s Times Square.  Few politicians will state the facts because there is no credit to be taken, no opposing party to blame.  Workers are simply getting older.

In 2011, MIT economist David Autor published a study on the growth of disabiliity claims during the past two decades and the accelerating growth of these claims during this Great Recession.  Mr. Fujita’s analysis reveals an ironic twist – at the same time that Mr. Autor published this study, the growth in disability claims flattened.  The ghost of Rod Serling, the creator and host of the Twilight Zone TV series, may be ready to come on camera and deliver his ironic prologue.

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Lower automobile sales accounted for January’s .4% decline in retail sales. Given the continuing severity of the weather in the eastern half of the U.S., it is remarkable that retail sales excluding autos did not decline.  In the fifth report to come in below even the lowest of estimates, industrial production posted negative growth in January.  By the time the Federal Reserve meets in mid-March, the clarity of the economy’s strength will be less obscured by the severe winter weather.

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A reader sent me a link to short article on the national debt.  For those of you who need a refresher, the author includes a number of links to common topics and maintains a fairly neutral stance.  I still hear Congresspeople misusing the words “debt,” the accumulation of the deficits of past years, and “deficit,” the current year’s shortfall or the difference between revenues collected and money spent.  Could we have a competency test for all people who wish to serve in Congress?

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The House and Senate both passed legislation to raise the debt ceiling this week.  The stock market continued to climb from the valley it fell into two weeks ago and has regained all of the ground it lost since the third week of January.

Tax Cuts and Us

Until the end of the year, we will hear and read a lot about the expiration of the Bush tax cuts.  For those who want to extend all the Bush tax cuts, you will hear stuff like this: “The non-partisan Congressional Budget Office (CBO) has predicted a recession in 2013 if the Bush tax cuts are allowed to expire.”  As with most political claims, this is slightly true.  Remember that politicians are little more than magicians practicing a logical sleight of hand in order to convince you of some claim.  What the CBO actually said in a May 2012 report was “if the fiscal policies currently in place are continued in coming years, the revenues collected by the federal government will fall far short of federal spending, putting the budget on an unsustainable path.” (Source)  In the next sentence, the CBO cautions “On the other hand, immediate spending cuts or tax increases would represent an added drag on the weak economic expansion.”  Is there room for compromise in this dysfunctional Congress?

While many politicians are aware of the difficult trade-offs, they dare not mention that to voters, who, they presume, are stupid.  On Fox News, MSNBC and other media, we will continue to hear simplified versions of a complex debate because – well, we’re just too dumb to pay attention to complex arguments that involve math.  If you are like most voters, many politicians reason, you have already stopped reading this because it has too many adjectives, verbs and commas.

The CBO does its best to estimate the long term impact on the federal budget and economic activity as a result of a paticular policy. To illustrate just how difficult this task is, let’s look at a July 2007 letter from the CBO to the Congressional Budget Committee projecting “For 2008 through 2011, CBO’s baseline budget projections show deficits of $113 billion, $134 billion, $157 billion, and $35 billion, respectively.”  Deficits were actually $458 billion, $1,413 billion, $1,293 billion and $1,300 billion.  Actual deficits were almost ten times what the CBO projected!  Knowing that ten year projections are almost pure fantasy, Congress continues this practice.  Each party uses the CBO estimates to support or attack a particular policy. 

The CBO projects a recession in 2013 if ALL tax policies were allowed to expire, including the Bush tax cuts.  “These include the Bush tax cuts, the alternative minimum tax (AMT) patch, the temporary payroll tax cut, and other temporary expiring provisions, many of which are commonly referred to as “tax extenders.” (Source)   The Congressional Joint Committee On Taxation (JCT) has a complete seven page (!!!) list of “temporary” tax cuts that are due to expire at the end of this year. 

What is the bottom line for the individual taxpayer if ALL the fiscal policies, including the Bush tax cuts, were allowed to expire?  In a 2012 report by the Congressional Research Service, they cite estimates by the Tax Policy Center that, in 2010, “the Bush tax cuts resulted in the lowest 20% of taxpayers seeing their income rise by 0.5%, while the top 20% saw their after-tax incomes rise by 4.9% and the top 1% saw their income rise by 6.6%”. (Source).  What will be the impact on most taxpayers if the Bush tax cuts expire?  Some but certainly not as dire as some politicans predict.  But that is not how politicians get votes.  To get us to the polls, politicians and their pundit lackeys who appear on TV and radio talk shows try to breed fear in voters.  The media is happy to oblige; fear makes for better ratings.

Based on estimates from the Tax Policy Center and the IRS, below is a comparison of what 2012 tax rates would be with and without the effect of what are commonly called the Bush tax cuts. (Source) This is just a “what if” scenario since the Bush tax cuts are still in effect for the 2012 tax year, but it does give us a good guesstimate of the effect of letting the tax cuts expire.

Using that data, I have projected what the effective tax rate on adjusted gross income would be for 2013 if the tax cuts are allowed to lapse.  It includes the tax brackets that includes the majority of tax payers.

The couple making $40K in adjusted gross income would pay $645 more in Federal income taxes.  The couple making $80K would pay $2225 more; the couple making $120K would pay $6669 more.  Those in the top 20% would see tax increases of $16K and more.  It is understandable that taxpayers with income in the millions would want to keep their gravy train going.  They need government mostly to protect their property rights; everything else, all the regulations and social support programs, is just wasted tax money.  Most of the rest of us don’t like paying taxes either.  We could step up to the plate and pay down some of the debt that we have run up; or maybe we should just let our kids figure it out.