The Investor October 2023

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ShareFinder’s prediction for Wall Street for the next 3 months(top) and the JSE (bottom).

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How we built the world’s top funds

By Richard Cluver

Since our somewhat surprising discovery recently that our Prospects portfolios might be among the world’s top performing investment funds, we have both published the fact and searched diligently for proof that other better performers might exist.

Expecting some challenges to emerge, we waited ready to apologise if some superior claimant might emerge, but after a year of repeating the claim, none have come forward and so I have concluded that it is time to tell the story or how we developed the ShareFinder software which made such portfolio performance possible and, more importantly, how to construct and use the relatively simple techniques which drive the selection process.

My new book, Wealth, is now available with all the proceeds going to my favourite charity, the St Mary’s Foundation Trust which is working towards ensuring that the brightest and the best of South African youth receive the best possible education. Details of how you might obtain the book and so assist in this most worthwhile of causes, appear at the end of this column.

Unknowingly, of course, readers of The Investor have had some access to the book since early this year because many chapters have appeared in condensed form in these very pages. But if you want to understand why I think the global economic system is headed for a disaster of which the current ‘Great Recession’ is merely the opening salvo in a steadily-deteriorating situation, you will need to read the book in sequence. More importantly, I am confident that if you take to heart the steps I have outlined in the book in order to avoid being a victim of the coming chaos, you ought to be able to navigate them with ease.

I make no apologies for the fact that some of the book is in parts autobiographic because I believe that in order to give context to the narrative it is important to relate the practical everyday experiences of a modern investor who has lived, and prospered, in the aftermath of the 20-year-long Great Depression which followed the 1929 Wall Street Crash. Having opened my first stockbroking account at the tender age of 14, I am also arguably one of the world’s longest-serving stock market technocrats.

To order your copy of Wealth in electronic form at a cost of R150.00 you can employ the Zapper below:  https://zapper.com/url/Yrcc_XrG6e

Alternatively use this Payfast  

Or you may make an electronic Transfer directly into the St Mary’s Foundation Trust Account Nedbank Account Number: 100 6960 953 Universal Branch Code: 198765 SWIFT Code: NEDSZAJJ

Thereafter please please email proof of payment to: foundationtrust@stmarysdsg.co.za

Furthermore, as a financial journalist and as the leader of the team which created the ShareFinder market analysis software whose output gave the world what we believe to be its four best-performing managed share portfolios, I consider I might be uniquely qualified to chronicle the financial market instability which has marked my lifetime: during the entire period of monetary mismanagement which began with the Bretton Woods system that was established in the closing stages of World War Two when 44 nations got together in July 1944 to both establish the World Bank and to craft a new world monetary system.

I have been around throughout and that has enabled me to chronicle how the USA greedily exploited the custodianship it was then given over the world’s reserve currency….and why I believe any other nation given the same authority over the value of all global currencies would probably do the same: because the system is capable of being bent to fit the perceived political objectives of fallible men and women.

More importantly, as I have detailed, the methods I employed to turn such instability to my own financial advantage might, hopefully, help others to do the same!

According to Morningstar data, the world’s top-performing commercially managed share portfolio since the start of 2012 was the GinsGlobal US Equity Index Fund which has delivered a 10-year annualised Total Return of 22.1 per cent. In South Africa, the highest return from an active fund over 10 years has been the 21.9 percent per annum generated by the Old Mutual Global Equity fund.

In stark contrast, four virtual funds created automatically by the ShareFinder computer program for subscribers to my Prospects newsletter have achieved compound 30.4 percent in Australia, 29.64 percent in London, 27.37 percent in New York and 23.1 percent in Johannesburg. As the leader of the team which created the ShareFinder market analysis software whose output gave the world these four best-performing managed share portfolios, this is the story of how we built the software which has created those record results and how readers might replicate the system for themselves.

Set against the background of a steadily-deteriorating global monetary system which needs to be completely understood if you are not to fall victim to it, I have done my best to simplify the economic history of the past century and forecast its likely future in order to help readers to develop a prosperity plan for themselves.



SA’s fiscal problem – what we can do about it

By Brian Kantor

A shortfall in South African government revenues has provoked something of a fiscal contretemps. The government has raised R60bn less revenue than was estimated in the February Budget. This followed the large windfall in 2021 that was linked to the post-Covid inflation of metal prices.

The recent pullback in metal prices and mining company profits has seen government revenues falling back sharply from peak growth rates of 25% in late 2021 to zero growth now. Government expenditure has stayed at an essentially modest growth rate of about 5% a year.

Recent trends in government revenues and expenditure

Recent trends in government revenues and expenditure

Source: SA Reserve Bank and Investec Wealth & Investment, 22/09/2023

Less revenue means more borrowing. South African taxpayers are already paying a high price for our highly compromised credit rating. We pay an extra 2.7% more than Uncle Sam to borrow US dollars for five years.

Towards the end of last month, the rand-denominated SA government (RSA) five-year bond offered investors 5.5 percentage points more than a US Treasury of the same duration (9.89% minus 4.39%). The spread on a 10-year RSA over the US Treasury yield was even higher and was at 7.3 % (12% minus 4.70%) on 3 October.

The reason for such expensive (after expected inflation, borrowing costs and risk spreads) is the persistent scepticism on the part of potential investors, about the willingness and consequences of South Africa having to live within the limits of government revenue that is expected to be heavily constrained by very slow economic growth.

The further forward lenders are asked to judge our growth prospects and fiscal policy settings, the wider have been the risk spreads and the higher the cost of issuing long-dated debt (what is called the “term premium” in the market jargon). We should add that the recent pressure on RSA yields has come from the strong upward move in the key US Treasury yields. The spread between the bond yields, while wide, has not increased in response to the news about declining South African tax revenues.

SA and US 10-year bond yields and risk spread

SA and US 10-year bond yields and risk spread

Source: Bloomberg and Investec Wealth & Investment, 22/09/2023

If there is a crisis in the bond market, then the burdens of raising debt on the taxpayer have been a long time in the making.  Government revenues have consistently lagged spending, by a percent or two each year ever since the recession of 2010. The Covid-19 lockdowns were also naturally harder on revenues than government expenditure.

These differences between revenue and expenditure have had to be covered by large volumes of additional government borrowing. The share of interest paid by the national government in revenues and expenditures has been rising sharply, doubling since 2014. Interest paid in serving the national debt is now 20% of all national government revenues and about 16% of all expenditures. It is not the kind of expenditure that helps to win elections.

Government revenue, expenditure and debt

Government revenue, expenditure and debt

Source: SA Reserve Bank and Investec Wealth & Investment, 22/09/2023

South African banks are now funding more of the national debt. In 2008 the share of government stock and Treasury bills was a mere 4% of all bank assets – this ratio is now 14%. After 2020, and as the fiscal deficit widened with less revenue and more post-Covid spending, the banks have increased their loans to the government by R600bn, mostly of short-term duration. The banks have thus substituted lending to the government for lending to the private sector, understandably so given the weakness of demand for credit by the private sector.

This has inflationary potential. Relying on banks to fund government expenditure when supported by abundant cash reserves supplied by the Reserve Bank may well lead to excess supplies of deposits (ie money) in the system. This is because banks lend more to the government on a scale that could become inflationary. If it leads to excess supplies of money, higher prices could follow as these excess supplies of money are exchanged for goods and services. These money-supply effects of extra lending and spending apply as much to government borrowing from the banks as they would to private sector borrowing and spending that finds its way into extra bank deposits.

The banks now hold substantial sums of excess cash reserves with the Reserve Bank, which encourages this through the interest it pays on these reserves. It has become the policy-determined rate that sets the basis for all short-term interest rates. The SA Reserve Bank, like the US Fed, believes it can control the demand for such cash reserves through its interest rate settings. By setting the right level of interest rates it pays on these reserves, it believes it will prevent the banks from turning cash into additional loans that end up as extra deposits as the loans are drawn down. It is a new world of monetary policy experimentation and it will be a space worth watching.

Holdings of Treasury bills and government stock by banks

Holdings of Treasury bills and government stock by banks

Source: SA Reserve Bank and Investec Wealth & Investment, 22/09/2023

Interest payments as a share of government revenue and expenditureInterest payments as a share of government revenue and expenditure

Source: SA Reserve Bank and Investec Wealth & Investment, 22/09/2023

The share of government debt with a maturity of more than 10 years has risen strikingly, from 30% to over 70% of all national government debt between 2008 and 2020 – at inevitably higher rates. The government could immediately relieve part of the burden of high interest rates by reducing the extraordinarily long duration of its debt, as indeed it has been doing since 2018.

Long-dated debt as a share of total debt and the average duration of all debtLong-dated debt as a share of total debt and the average duration of all debt

Source: SA Reserve Bank and Investec Wealth and Investment, 22/09/2023

Bond yield differences by durationBond yield differences by duration

Source: Iress and Investec Wealth & Investment, 22/09/2023

It was a form of hubris to think that lenders would be willing to take a 20-year or longer view of the fiscal outlook for South Africa without compensation. The long-term lender is highly exposed to inflation, which the short-term lender largely avoids. The benefit of borrowing long is that it avoids the risks attached to having to roll over short-term debt at inconvenient moments in the money market. However, this made less sense when National Treasury was building its cash reserves at the Reserve Bank, from R70 billion in early 2010 to R183 billion by January this year.

Managing the interest payment burden of national debt can play a small part in solving the problem of slow growth for the government. This is the case even if government and private spending remain constrained in real terms this year and next. Only faster growth can avoid the interest rate trap, however, since interest paid on all government spending should rise further. Absent growth, the burden of paying interest, rather than undertaking other forms of spending, is likely to make a resort to money creation irresistible. The growth-enhancing choices for economic policy should be obvious. There is no other way.



The Battle for Strategic Resources in Africa Heats Up

by Nick Giambruno

“We came, we saw, he died.” That was Hillary Clinton’s sociopathic spin on veni, vidi, vici, Roman leader Julius Caesar’s famous saying, which means “I came, I saw, I conquered.”

Hillary said those words as she cackled on national TV, recalling the gruesome death of former Libyan leader Muammar Gaddafi. US-backed rebels reportedly sodomized him with a bayonet and shot him in the head.

Using “humanitarian concerns” as their flimsy pretext, the US government and France led an effort to overthrow Gaddafi in 2011, turning one of Africa’s most prosperous countries into a chaotic hellhole.

However, thanks to WikiLeaks’ release of Hillary Clinton’s emails, we now know the real reason for their Libya intervention wasn’t so benevolent. According to her leaked emails, the US and France feared Gaddafi would use Libya’s vast physical gold reserves in Tripoli—estimated at around 4.6 million ounces—to create a pan-African currency based on the Libyan golden Dinar. Gaddafi intended to use this new gold currency to provide an alternative to the CFA franc, a French-controlled currency used by 14 countries in Central and Western Africa.

After Gaddafi’s death, plans for the gold-backed currency and Libya’s 4.6 million ounces of gold vanished.

With Gaddafi out of the way, the CFA franc and the West’s geopolitical influence over the vast reserves of strategic commodities in Central and Western Africa seemed secure… until recently.

Today, global power is shifting… Central and Western Africa are on the front lines of these historical changes.

That’s because the current US-led world order—in place since the end of World War II—is breaking down at an accelerating pace.

World orders are nothing new and simply describe the architecture for international political relations between countries. It’s how the big global powers have set the rules of the game for centuries. On a smaller scale, it’s similar to when the most powerful criminal groups in a given city—like mafias and street gangs—come together and agree on how to divide their activities and neighborhoods among themselves.

Sooner or later, though, these agreements always break down. Then, there is a violent power struggle until the criminal groups reach a new agreement reflecting the new power balance. A similar dynamic is at play with the most powerful countries and world orders.

Wars among the most powerful countries typically lead to a breakdown and restructuring in the world order.

Here is a brief overview of some of the most recent world orders. You can think of them as epochs or distinctive historical periods reflecting the shifting power balance among the biggest global players.

Peace of Westphalia (1648 to 1803): This agreement ended the Thirty Years’ War and set the framework for international relations in Europe for over two centuries by preserving the balance of power among major European powers. It brought together the Holy Roman Empire, Spain, France, Sweden, the Dutch Republic, and various German territories. This world order largely lasted until the outbreak of the Napoleonic Wars, which led to the need for a new international arrangement among the big powers.

Congress of Vienna (1814 to 1914): The military defeat of French Emperor Napoleon I led to this world order. It enshrined the British as the dominant global power. The Congress of Vienna formed the basis for European international politics until the outbreak of World War I in 1914.

Treaty of Versailles (1919 to 1939): The victors of World War I created this world order, which featured institutions like the League of Nations. It broke down after Germany, Italy, and Japan tried to overturn it and make their own world order during World War II.

The Current US-Led World Order (1945 to Today): The Allies crafted the current world order in the aftermath of World War II with the US as the leader. It features institutions like the United Nations, the World Bank, and the International Monetary Fund—all located in the US. The current world order has been largely unipolar, with the US exercising significant influence over international policies and decision making.

Changes to the world order are historical events with enormous investment implications. Countless millions throughout history were wiped out financially—or worse—as the world order changed because they failed to see the correct Big Picture and take appropriate action.

But what if you get the Big Picture right as the world order changes? The monetary system is self-destructing at an alarming rate and reaching the end of its shelf-life. The people really in charge—the central bankers and those behind them—understand all of this.That’s why they aim to corral people into an Orwellian system that monitors and controls every penny you earn, save, and spend.

In short, the current world order is transforming from US-led and unipolar to multipolar. As I see it, two main geopolitical blocks are competing.

First, there are the countries that are part of or allied with the West. I’m reluctant to call this block “the West” because the people who actually control it have values antithetical to Western Civilization. A more fitting label would be NATO & Friends.

The other block comprises Russia, China, and other countries favorable to a multipolar world order. Let’s call them the BRICS+. BRICS+ is not a perfect label, but it’s a decent representation of the countries favorable to the emerging multipolar world order.

While there already is friction in free trade—sanctions, tariffs, export bans, nationalizations, embargoes, strategic competition, etc.—between NATO & Friends and BRICS+, I expect it to grow substantially as the multipolar world order emerges. That will have serious consequences for commodities, which BRICS+ dominates.

As tensions between NATO & Friends and BRICS+ continue to rise, I expect it to disrupt commodity trade between the two further. We already see this manifest worldwide, including in Central and Western Africa. Here’s the bottom line. Supply disruptions mean higher prices. That’s an outcome I think we can bet on.

I expect countries in both geopolitical blocks will increasingly focus on securing critical commodities and ensuring their access to stable supplies. In short, I think the geopolitical competition between the two blocks will cause increased demand and unstable supplies. That’s why obtaining exposure to strategic commodities as the world order changes could be a winning move.

That’s where Central and Western Africa come in. These countries have strategic commodities such as gold, uranium, and cobalt. They recently found themselves on the front lines of this escalating geopolitical competition.

Seven Coups in Three Years

Western allies are falling like dominoes in Africa as the geopolitical competition heats up. Since 2020, military coups have replaced pro-Western governments in Burkina Faso, Sudan, Guinea, Mali, Niger, Gabon, and Chad with neutral governments or regimes aligned with Russia and China.

Of particular interest is the recent coup in Niger, one of the larger uranium producers in the world. It’s an excellent example of the scramble for strategic resources as the world order changes. Niger has produced uranium commercially since 1971—over 52 years. Even though Niger is one of the poorest countries in the world, it has a well-developed uranium industry.

Today, Niger is responsible for 5% of global uranium production and is crucial for European supplies. Analysts estimate that 24% of European Union uranium imports come from Niger. Take France, for example. According to the World Nuclear Association, nuclear power generates around 70% of the overall electricity in the country.

Analysts estimate that imports from Niger account for around 33% of France’s uranium needs or that one in every three light bulbs in France is powered from uranium from Niger. As a result of the military coup, European energy security is at higher risk. The uranium market is already tight, and finding alternative supplies is difficult. It typically takes ten years to bring a new uranium mine online.

In short, uranium has a situation with precarious supply and growing demand. There is only one way for this situation to resolve itself: for the uranium price to go up, precisely what has happened recently.



The Likelihood of a Crash

By Jared Dillian

Jared DillianMy friend Michael Gayed is calling for a crash. I’d include the tweet here, but he swears all the time. It doesn’t bother me, but he’s not everyone’s cup of tea.

I’ve been doing this for a while, and I’ve seen people call for crashes before. The funny thing is, I kinda agree this time.

Though you will never see me “call” for a crash, I will say when the probability of one is elevated. A few people called the crash of 1987 and positioned themselves for it. They are legends. A crash is not this random, exogenous thing that randomly happens. There are events that lead up to it.

In this case, the war in Gaza, but also relentless dollar strength, interest rates ripping higher, and out-of-control government spending. Even the casual observer can see there is stress in the markets. Positioning is at extreme levels. Gold is ripping higher.

https://images.mauldineconomics.com/uploads/bulls-eye/10thman_20231026_image1.jpg

None of this bodes well for stocks.

Here’s a headline from Bloomberg: “Paul Singer Says World More Perilous Than Markets Pricing In.” Singer and I agree on that, for sure. With all that’s going on in the world, it’s hard to believe that we’re at 4,200+ on the S&P 500, a full 20% off the lows, and not far off the highs. A crash certainly could happen, and nobody is positioned for it. Nobody is psychologically prepared for it.

The Definition of a Crash

What is the definition of a crash? I would say when the market goes down more than 10% in a single day. In 1987, the market went down almost 25% in a single day. The crash of 1929 was actually two crashes on consecutive days, 12% and 13%. The Flash Crash in 2011 was about 10%.

To my knowledge, we haven’t had many others aside from some really volatile days during the financial crisis and the pandemic. If we had a crash of 10%, that would be 420 points in the S&P 500. That would certainly get people’s attention.

As I write, Israel has not yet commenced its ground invasion of Gaza. If it does, and if it goes pear-shaped, that would be a potential catalyst for a crash. There are many.

So, the antidote here is to buy protection. In index options, it is not that expensive… yet. It has certainly been cheaper. It might not be a bad idea to waste 1%–2% of your performance on protection—you know, just in case. You can also get upside exposure to bonds, upside exposure to gold, upside exposure to oil, and upside exposure to volatility.

Insurance costs money. But I’m always struck by how many people are willing to insure their car and their house but not their portfolio, which is orders of magnitude bigger. Of course, having insurance on your car is a precondition for driving a car, and having insurance on your house is a precondition for having a mortgage. And, for sure, there would be some people who would elect to not have insurance if it was not compulsory. But you should get insurance—it is not a zero-sum game. I had insured my portfolio before the pandemic crash, which offset most of the losses. I felt pretty smug about that.

Worst-case scenario, you waste a little money in option premiums, and the stock market motors higher. Definitely not a bad outcome.

When Paul Singer says that the markets are not pricing in terrible peril, all you have to do is look at the VIX, which is below 20. Arguably, it should be above 30. This is an obvious mispricing, and maybe someday we’ll look back at what is an obvious mispricing.

Not to Be Confused with Bearishness

If you’ve been reading me for a while, you know that I’m not monotonically bearish, that I don’t go around calling crashes, and I don’t say splashy things for clicks. All I’m saying is that the probability of a crash has gone from 0% to 5%.

I don’t believe in market determinism. I like to look at things probabilistically instead. Five percent is big enough for me to take action. I want to be positively exposed to gains in disorder. If you are negatively exposed to gains in disorder, you will be suffering along with everyone else if the worst happens. If the worst happens, I want to be safe and secure. Best-case scenario: I want to win.

They say misery loves company—it really is true. In every bear market, people rationalize their losses by saying that everyone else is losing money, too. How could it have been prevented? These days, there are lots of simple and complex hedging tools available for people to avoid the blow-up. Whether they take advantage of them or not is another story altogether.



Time-Traveling Money

By John Mauldin

Debt has a defined sequence: The lender and borrower agree on terms, the loan is funded, the borrower repays according to a schedule, eventually pays the full amount, then it’s over. Often the parties move on to more such deals, then others, then others… in an almost (dare I say it?) cyclical fashion.

As I’ve said many times, debt isn’t inherently bad. It’s an efficient way to finance new productive capacity. This helps the economy grow and raises living standards for everyone. But debt is also easily misused, and that’s where it causes trouble. In fact, we have seen throughout history where debt has been used far more than was prudent, especially by governments, and you get a debt crisis for an individual company or country.

Professors Ken Rogoff and Carmen Reinhart described this process for governments in their magisterial book, This Time Is Different: Eight Centuries of Financial Folly. I think it is one of the most important books of the last 20 years. I have reviewed it extensively in the past and did a published interview with both Rogoff and Reinhart.

What I wrote in my 2011 letter The Beginning of the Endgame is the perfect set-up for dealing with the debt and deficits of the US (and then a possible survey of other debt-burdened economies).

“The lesson of history, then, is that even as institutions and policy makers improve, there will always be a temptation to stretch the limits. Just as an individual can go bankrupt no matter how rich she starts out, a financial system can collapse under the pressure of greed, politics, and profits no matter how well regulated it seems to be. Technology has changed, the height of humans has changed, and fashions have changed.

“Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained a constant. No careful reader of Friedman and Schwartz will be surprised by this lesson about the ability of governments to mismanage financial markets, a key theme of their analysis.

“As for financial markets, we have come full circle to the concept of financial fragility in economies with massive indebtedness. All too often, periods of heavy borrowing can take place in a bubble and last for a surprisingly long time. But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.

“This time may seem different, but all too often a deeper look shows it is not. Encouragingly, history does point to warning signs that policy makers can look at to assess risk—if only they do not become too drunk with their credit bubble-fuelled success and say, as their predecessors have for centuries, ‘This time is different.’

“[Back to my voice] Sadly, the lesson is not a happy one. There are no good endings once you start down a deleveraging path. …much of the entire developed world is now faced with choosing from among several bad choices, some being worse than others.

“And this is key. Read it twice (at least!):

“Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence—especially in cases in which large short-term debts need to be rolled over continuously—is the key factor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang! — confidence collapses, lenders disappear, and a crisis hits.

“Economic theory tells us that it is precisely the fickle nature of confidence, including its dependence on the public’s expectation of future events, which makes it so difficult to predict the timing of debt crises. High debt levels lead, in many mathematical economics models, to ‘multiple equilibria’ in which the debt level might be sustained—or might not be. Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability.

“What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fuelled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite.

The term Debt Supercycle was first used by Tony Boeckh of The Bank Credit Analyst (in the late ’60s) and further explored by my good friend Martin Barnes when he was editor. The concept has been refined over time, but the term still fits. There seems to be a cycle of debt followed by countries where they leverage their debt too much and we see the (all too frequently) ugly end of a Debt Supercycle. Rogoff and Reinhart offered data on those cycles.

I have been writing about US debt for decades. And the crisis has always remained in the future. And yet, we are now at almost $34 trillion of US government debt on our way to $60 trillion. Interest costs are beginning to significantly eat into the total revenues.

The most recent budget analysis from the US Treasury shows the net interest rate payments are getting close to total military expenses and will likely surpass that within the next few years. We will look at this more in depth over the next few weeks but let me just offer up a few charts from the Treasury website.

https://images.mauldineconomics.com/uploads/newsletters/IMAGE_1_20231020_TFTF.png


Source: US Treasury

Note that for the month of August net interest expenses were essentially equal to National Defence and larger than welfare (Income Security). Note that the average duration of federal debt is roughly 7 years. As longer-term paper with much lower rates rolls off, it is replaced with much higher-cost debt.

 The next chart from the Peterson Foundation (well worth perusing—but remove sharp objects as you do) illustrates that point. The chart shows that just a few years ago, total interest expense was in the $300 billion range. Today it is double that and projected to triple within four to six years. If interest rates continue rising it will be even worse.https://images.mauldineconomics.com/uploads/newsletters/IMAGE_2_20231020_TFTF.png


Source: Peterson Foundation

The US is now on an unsustainable path. While CBO projections are obviously based on assumptions, what happens when we are at $50 trillion total debt (highly likely!) and interest rates are 4% (certainly possible if the Bond Vigilantes wake up from their long slumber, which might happen soon.)

I will be looking at this problem in depth over the next few weeks because we are in for a rough ride if an economic crisis erupts at the same time the other cycles reach their own conclusions. I think it is critical investors get a handle on what we are facing and also on how to adjust our own lives in order to make sure that we, our families, friends, and communities get through it.

Debt Be Not Proud

Debt represents future consumption brought forward in time. When you buy a house, for example, your future spending on other goods and services will fall because you have monthly mortgage payments. Ditto for cars or any other debt-financed purchase. Even if you go bankrupt, somebody absorbs that debt, and whoever it is will have less to spend on other things.

Again, debt isn’t bad in itself. Debt is useful if you can repay it and you spend the borrowed money productively. Often one or both is lacking. When this happens on a large scale, it has macro effects that contribute to the “debt supercycle.”

I explained this more fully in my 2011 book (with Jonathan Tepper), Endgame: The End of the Debt Supercycle and How It Changes Everything. It is still available and, while I would change a few things (like the timing), it still describes the debt problem well.

Briefly, the problem isn’t simply lenders and borrowers making poor decisions. Powerful people and institutions, mainly in central banks, actively encourage these poor decisions by manipulating interest rates and credit conditions. They may have good intentions, but they are focused on the short term. Their goal is to avoid (or at least mitigate) recessions and financial crises. And indeed, they’ve had some success in forestalling the periodic asset bubbles and banking panics common in the 19th century and earlier. But this relative stability has a cost.

Here’s what happens: Central banks stimulate growth via loose credit conditions, which eventually spark inflation, forcing them to tighten. Some of the debt is liquidated but not all, so it’s still there for the next expansion. More debt gets added on top of it, then more in the next phase, and so on. As the debt load increases across the economy, its ability to stimulate GDP growth falls. More debt is required to produce the same amount of growth.

Needless to say, this can’t continue indefinitely but it can take several iterations of the business cycle to reach what I called the Endgame. This is evident mostly, but not exclusively, in government debt. Let’s take a closer look there.

Not an Accident

Last week the Congressional Budget Office estimated the FY 2023 federal budget deficit was $1.7 trillion, about $300 billion more than the prior year. Spending actually fell slightly but tax revenue fell even more. This brought the gross national debt to $33+ trillion, of which debt held by the public was $26 trillion (a distinction without a real difference!). I have been saying for a long time we would have a $50 trillion debt by 2030. That now looks laughably naïve.

 By the way, last year’s $26T debt almost exactly matches the “Alternate Scenario” I described last February (see Deficits Forever). I arrived at that by assuming CBO’s revenue projection would be 5% too high and its spending projection 5% too low, plus an allowance for off-budget spending. I still think those are reasonable guesses and, if they are correct again, the debt will widen a lot more in the coming years. Here’s that chart again.https://images.mauldineconomics.com/uploads/newsletters/IMAGE_3_20231020_TFTF.png

The debt is rising, first, because the government spends so much more than it collects in taxes, and it spends so much because serious spending cuts are politically impossible. Even the fiscal hawks would only nibble around the edges, with any actual cuts projected far out in the future. Trillions in COVID relief spending—some of which was necessary, to be sure—aggravated the problem.

The House passed a budget which would theoretically balance the budget in 10 years, but one needs to make some very positive assumptions. But it had no, as in zero, chance of getting through the Senate. And now, that won’t even get through the House. 20 GOP members opposed Jim Jordan for speaker because he wants to cut spending too much (at least that is what my sources say).

A particularly annoying part of this is that three different administrations—Obama, Trump, and now Biden—missed a chance to lock in historically low rates by issuing more long-term bonds. I feel sure they would have found buyers. Again, an insider sitting at the table told me that Mnuchin opposed offering 50-year bonds. Now? Fat chance. And it appears the opportunity won’t be back anytime soon.

As of right now, the Treasury’s average interest rate is around 3%. That has almost doubled since the Fed began raising rates in early 2022. It will go higher still as older bonds roll off. This St. Louis Fed analysis calculates higher rates will add $98 billion to the interest expense in 2023 alone. Again, this will grow even if rates stabilize at current levels.

There’s a lot of variables to this but it’s entirely plausible, if not probable, the government will soon be spending $1 trillion annually just for interest payments. In GDP terms, CBO estimates interest expense will grow from 1.9% to 3.6% of the economy in the next 10 years.

None of this is accidental. The Fed kept rates artificially low for years, which eventually helped kindle inflation, to which the Fed responded with higher rates. Raising rates to combat inflation was appropriate but it leaves us in a really uncomfortable fiscal situation… and brings the end of the Supercycle closer.

Highly Leveraged Future

Imagine for a moment your mortgage was structured like the federal debt. You keep adding principal every year, you can’t control the interest rate, but you do get to choose the maturity and payment schedule. What would that look like? Unless you are a pretty good bond trader, it would probably look like a mess.

Now, these are not fully comparable situations. Your lender can foreclose if you default on the mortgage. Treasury bond holders don’t have that choice. They can, however, stop lending or demand higher rates. And that’s very likely going to happen, in my opinion.

This would be a huge problem just by itself but there’s more.

Large parts of the private economy are over their heads in debt, too. Think of the many highly leveraged businesses living on borrowed money that will run out at some point, possibly before revenue rises to their optimistic targets. Much like the Treasury, they will have to refinance at much higher rates. How will that go?

This isn’t just a US problem. Everything I just described is, to varying degrees, applicable around the globe. China? Japan? Germany?

And finally, remember all this debt will come to a head just as the other cycles we’ve been talking about – the Fourth Turning, for example – are reaching their peaks. Can you say “instability?” And maybe much worse?

Now, in one sense this is very simple. Debt which can’t be repaid, won’t be. But remember, debt is future consumption brought forward. The scales will balance. The future has holes in it that somebody will have to fill. And whoever that is probably won’t be happy about it.

I’ve talked about a Great Reset grand bargain in which all this debt is somehow rationalized. But it won’t be so simple as flipping a switch. It will be a long, ugly, emotional, and potentially violent process. No one should assume they will escape intact.

But even if we muddle through, the debt will weigh on us. As it grows into a larger portion of the economy, less will be left for other things. This will depress GDP growth when the economy will already be struggling with demographic challenges. The math is clear, and we will go into it in future weeks. The CBO cannot assume, because they don’t know, any negative economic problems in the future. None of us know what’s coming, but experience says we shouldn’t expect a smooth ride over the next 10 years.

Sometimes I wonder what it must feel like not to care about all this. I really don’t enjoy being a budget scold, partly because we are a dying breed. It is getting lonely in my worry closet. Very few people truly care about government debt anymore, and even the number who pretend to care about it is shrinking, especially in Washington, DC, and Congress. And almost no one even talks about the drastic changes it would take to actually balance the budget—much less begin paying down the debt.

I titled this letter ‘Deficits Forever’ because, unfortunately, I think that’s probably what will happen. And that might be okay if we could at least keep the deficits somewhat smaller and more stable. That doesn’t seem to be in the cards, though. We are going to reckon with this debt for a long time.”

Lower GDP and even a recession (there is always another recession!) will reduce potential revenue (taxes) and increase spending. Deficits are likely to soar from already nosebleed levels. But that is fodder for the next few weeks.




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