Risk/Reward Vol. 373
THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN
In breathtaking fashion, the Dow Jones Industrial Average broke through the 24,000 mark this week. This was the fifth time that it has surpassed a 1000 point milestone this year and it took barely a month. The impetus this time was the prospect and now reality of tax reform. And not even the guilty plea of General Flynn could derail it. The Dow and NASDAQ are both up over 20% year to date, and the S&P 500 is up over 18%. As has been discussed in numerous editions, the reasons are clear (low interest rates, TINA and an improved economy). No end is in sight, but I am intrigued by what could stop this bull run.
As I discussed last week, I see credit defaults as the biggest risk. But, that is not to dismiss other potential causes arising out of the surfeit of debt worldwide. Indeed, in her Congressional valedictory, out going Fed Chair Janet Yellen said that the trajectory of US government debt (currently $20trillion) was something "that should keep people awake at night." How ironic, Janet! Guess who is primarily responsible for this hot mess? How much of a mess is it? Let's look at the recently enacted budget. In the next fiscal year, the US government will spend $4.094trillion, $315 billion of which will be spend on interest payments on that $20trillion debt. Total government revenues from income tax, withholding, etc. are projected to be $3.654trillion under the old tax regime, a number that may total less under the tax plan passed this week. That leaves a deficit of $440 billion. Now, it does not take a genius to see that our Federal government is not only NOTrepaying debt, but is adding to it and borrowing money TO PAY THE INTEREST ON THAT DEBT. And the future looks worse. Next year 62% of all of that spending goes to MANDATED programs (Social Security and Medicare) which are scheduled to escalate rapidly in coming years as more Baby Boomers retire. Now you see why Janet can't sleep.
But will adding to the deficit adversely impact the stock market anytime soon? I don't think so. In fact, it likely will keep the "easy money" machine and thus the TINA effect (There Is No Alternative to stocks) alive. Think about it. What would happen if the Fed actually "normalized" interest rates? They would double thus raising interest payments from $315billion to $630 billion. In turn that would increase the deficit to over $700billion, and more borrowing would be necessary. No one, least of all those at the Federal Reserve wants to be responsible for that. So here is the dirty little secret that no one wants to admit. The Fed can't normalize rates because we can't afford the interest payments. And if you think the US is in the debt hell, take a look at Europe, Japan and China. To quote my favorite economist, Oliver Hardy, "Well here is another fine mess you've gotten us into."
So how does this play into credit defaults? Remember that all private debt is priced in relation to government debt. If Treasury bonds pay low interest then corporate bond rates correspondingly are low. And at present they are near historic lows. So the corporate world continues to borrow. Why not? Money is cheap. The corporations comprising the S&P 500 now have a debt to adjusted earnings ratio of 150%. Historically that number has been 0.70%. That's right, corporate debt has doubled and is growing. The ratio for less credit worth companies is worse. As investors in search of yield lend even more money to even riskier ventures, the likelihood of massive credit defaults increases. Keep your eye on this. I am. Remember it was credit defaults (eg subprime mortgage foreclosures) that caused the crash of 2008-2009
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