Shot Across the Bow

In his 2021 annual letter to investors, Buffett stated “In its brief 232 years of existence … there has been no incubator for unleashing human potential like America. Despite some severe interruptions, our country’s economic progress has been breathtaking. Our unwavering conclusion: Never bet against America.”

Of course, he will be right every time. Until he isn’t. For the reason Buffet espoused, it is indeed very difficult to bet against America, but that does not imply that Buffett’s reason will be accurate forever. Whomever was the Warren Buffet at the peak of the Roman Empire, surely felt the same way, and the statement was as true in the Egyptian Empire, and most every other meaningful empire. But all have eventually fallen to the wayside. Although Buffett is largely correct, it is equally correct to say that at some point, the U.S. is likely to mismanage itself into decline – forever is a long time and history is not on our side. The question is when. At what point does our hubris cause us to fail to see clear warning signs? History teaches us that these things do not happen quickly, but that perception is in retrospect. In real time, we suspect that the slow erosion of the empire is rationalized away, such that when the fall finally occurs, it appears to happen rather suddenly.

Why the short lecture on empires? This week, Fitch sent another warning shot across our bow by cutting the U.S. credit rating from AAA to AA+. It is one that is likely to be ignored or rationalized away, just as we did the first warning shot in 2011 from S&P, when they took a similar action. But think about this. The highest quality tranches of structured debt, often comprised of 100% below investment grade debt, now have a higher credit rating than the U.S. government! Only in America!

Doomsday Delayed

Don’t misunderstand, it is not doomsday. We are not about to go over the cliff, but our position in the world is certainly in question and we should treat Fitch’s action as a wake-up call. In lowering the rating Fitch said “The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.”

In a Bloomberg interview discussing the Fitch downgrade, Bob Michele, of JPMorgan Asset Management added some color to that comment, saying that while the U.S. is headed toward a Debt to GDP ratio of 120%, the median of the remaining nine AAA sovereign credits was 39% Debt to GDP. In addition, the U.S. fiscal deficit is running at 6% to 7%, while the median of the remaining nine AAA credits is 0% (i.e., a balanced budget).

Our financial woes are not something that happened overnight. In our opinion, extraordinary intervention of the Federal Reserve into markets began about 25 years ago, during the Asian and Russian financial crises of 1997 and 1998, which caused the failure of Long Term Capital Management (LTCM) whose excessive leverage forced the Fed to intervene to save banks. (This is a terrific book about the LTCM debacle.)

Since then, we have gone from crisis to crisis (dot-com bubble, housing crisis/Great Recession, pandemic) which have each required not only greater levels of intervention, but also longer periods of intervention. In simple terms, this has allowed economic imbalances to be covered over, rather than addressed, and over time, these imbalances compound. The natural course for a free economy is for cycles of expansion and contraction, with the contraction cleansing the prior excesses, giving us a clean slate to move forward again. Now, we go out of our way to avoid contractions, which negates the cleansing process.

Here is one example. The U.S. is on track to spend $1 trillion annually on interest expense. Why? Because having Treasury rates that approached zero allowed the U.S. to issue massive amounts of debt at very low rates with very little impact on interest costs. Now, in response to inflation, rates are rising, or normalizing, and that is driving our interest costs ever higher, so much so that the U.S. now pays more in interest than it spends on national defense. Thus, rate normalization, an admirable goal, could actually create the next crisis.

In the chart below, note that from 1997 into the pandemic, Federal debt levels (red arrow) were rising quickly. During the same period, interest costs (blue arrow) were almost flat. The sudden spike in interest costs is due primarily to higher interest rates, and to a lesser extent, more debt. And we note that this process of rising interest costs has only just begun. As low-rate treasuries mature, they will be replaced with new securities that pay a significantly higher rate.

From a macro perspective, the logical conclusion is that this process will continue until the next crisis emerges, and rates head back down in response. This is precisely why the stock market is so fixated on tech stocks. What has been learned over the last 25 years is that when rates go down, tech stocks go up. And that will also be true, until it isn’t. That day arrives when the Fed loses control; when the market finally realizes the problems the U.S. has and won’t allow rates to decline as they have for so long now.

When does that happen? Who knows! It might happen next year; it might be 30 years. It might also be never. It all depends on how we respond in the present. The longer we avoid the cleansing process, the economic contractions, the harder and more damaging the cleansing will ultimately be. Fitch’s downgrade is another shot across the bow and the political class needs to take note, or we need to replace the political class.

Rate normalization is a desired economic goal, but it is exponentially harder to achieve when we are running large fiscal deficits. Deficit spending is more typical when unemployment is high in the midst of a recession, not when unemployment is near record lows. And those fiscal deficits run the risk of reigniting inflation, which would logically force interest rates higher still. Our position is more tenuous than most realize. It is not insurmountable, but we need government to start focusing on making some better economic decisions and focus less on the political sniping.


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By: thinkhouse