WEEK OF JANUARY 22, 2019 Weekly Relative Value Too Much Debt “Debt has exploded during a growing economy… but are we really growing or is it just because we increased the national debt?” – Jeffrey Gundlach, Chief Investment Officer of Double Line Capital (aka “The Bond King”) Tom Slefinger is Senior Vice President, Director of Institutional Fixed Income Sales at Balance Sheet Solutions. One cannot deny that we are now in the throes of a synchronized global slowdown, led by “The Big Four” – U.S. China, Japan and Germany. Slowing… THIS WEEK… • Too Much Debt • $22 Trillion and Rising Fast • China: Leveraged to the Hilt • The Return of Deflation • Drops and Pops • Recession Coming? PORTFOLIO STRATEGY Source: HedgeEye Risk Management In the U.S., real final sales growth throttled back to a 1% stall-speed in the third quarter. Vehicle sales peaked over a year ago and have declined irregularly since then. Meanwhile, the layoffs announced by auto manufacturers are tacit confirmation of faltering sales. New and existing home sales have fallen 23% and 7% from their recent peaks, respectively. Home prices slowed in December as sales slumped, marking the smallest annual increase since 2012 – the end of the last housing crash when the housing market was just beginning to climb out of the hole left by the collapse. Home builders have expressed concerns over the considerable weakness. www.balancesheetsolutions.org BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 2 Capex is nowhere to be seen. Growth slowed again in the third quarter and most of the leading indicators show little in the way of any forward momentum. To wit, the Duke CFO Global Business Outlook Survey revealed that expected capital spending growth in the coming 12 months has gone from 11.0% in the first quarter of last year, to 8.3% in the second quarter, to 5.7% in the third quarter and is now down to a mere 1.0% as of the fourth quarter — the lowest since the third quarter of 2016. The occurrence of such a significant shift makes an important statement regarding the major corporate tax cut in 2018 and the ability of firms to repatriate overseas funds at low tax rates. These fiscal actions were widely anticipated to lead to a capital spending boom, which has failed to materialize. CEO Confidence Plummets Meanwhile, the New York Fed recently updated its recession-risk model for the coming year; it is now up to a 21.4% chance, the highest since August 2008. As a matter of fact, it is precisely where it was in March 2001 — the date that a recession began! And this level accurately foreshadowed the 1990-91 recession by six months. That said, the New York Fed’s model isn’t perfect. There were two head fakes: the 1995 Mexican and Orange County fiascos and the 1998 Asian/LTCM crisis. They turned out to be “head fakes” because the Fed aggressively cut rates. Intermeeting too. And let’s face it, Fed Chair Jerome Powell may be talking less hawkishly, but he isn’t likely to ease policy just yet. (Remember, he tightened into a meltdown in December.) Back to the graph. You can see that this index does not go to 100%. Generally, the index gets the recession call right in 30%-40% of the time. So, on a “normalized” basis, these recession probabilities are really now between a flip of a coin and two out three. www.balancesheetsolutions.org BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 3 New York Fed Probability of a Recession 12 Months Ahead Source: Bloomberg Meanwhile in China, retail sales growth has weakened to a 15-year low. In December, auto sales in China plunged 13%, fourth months in a row of double-digit year-over-year declines. Auto sales for the whole year fell 4.1%, the first annual decline in 28 years! Industrial activity has contracted for the first time in 18 months. Corporate profits are in contraction mode. China’s exports for December were far worse than expected as the trade war bites, falling -4.4% from year-ago levels (consensus was +2.0% so quite the “miss”). In a sign of fledgling domestic demand, imports contracted -7.6% (again, the consensus was close but missed the “sign” as it was expecting a +4.5% result). Both readings were the softest in about two years. The Slowdown in China Source: Bloomberg Japan already printed a negative GDP for the third quarter. A clear sign that the Chinese slowdown is spreading. Ditto for Germany. If it managed to escape a technical recession in the fourth quarter, it was by a hair and no more. Manufacturing activity is in reverse in a major way. And don’t forget that the country is a juggernaut, accounting for about one-third of all output in the euro area. It caters to Chinese demand likely nobody else — and it has to be emphasized that China commands the biggest automotive sector on the planet. To be sure, recent German economic data have been disastrous and confirmed the sharp slowdown in the economy. It will be up to first quarter data to confirm or deny whether a German recession has arrived. www.balancesheetsolutions.org BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 4 In its second growth downgrade in three months, the International Monetary Fund (IMF) just slashed its forecast for 2019 global GDP to just 3.5% from 3.7% as of October (its lowest forecast in three years) while warning that trade tensions pose further downside risks to global growth. While its U.S. GDP forecast remained somewhat surprisingly unchanged, still seeing a solid 2.5% in 2019 GDP growth, the IMF took a machete to its German GDP forecast to only 1.3% this year. The IMF also said, “A range of triggers beyond escalating trade tensions could spark a further deterioration in risk sentiment with adverse growth implications, especially given the high levels of public and private debt.” These potential triggers include more trade tariffs, a renewed tightening of financial conditions, a “no deal” Brexit and a deeper-than-anticipated slowdown in China. TOO MUCH DEBT The biggest constraint on the global economy is excess debt. According to the just-released quarterly report from the Institute of International Finance, the world is “pushing at the boundaries of comfortably sustainable debt.” Indeed, global debt at $244 trillion is now equivalent to a whopping 318% of GDP. Japan and Greece are the most indebted countries in the world, with debt-to-GDP ratios of 237.6% and 181.8%, respectively. Meanwhile, the U.S. sits in the #8 spot with a 105.2% ratio. And, discussed below, the impact in terms of what this has meant for the economy is in full display $22 TRILLION AND RISING FAST In virtually every weekly missive emanating from my perch, I have warned that the growth of the federal deficit and other liabilities are approaching extremely high and counterproductive levels. The federal debt is now $22 trillion, and the deficit is exploding and just reached $800 billion. Typically, a strong economy is paired with low deficits (or even surpluses) – both because strong economic performance produces more revenue and because it creates the economic space for deficit reduction. Yet, despite the economy performing at or even above its potential, deficits are widening. In fact, the deficit has never been this high when the economy was this strong. The past two years are extremely abnormal in that we are running high and rising deficits despite low unemployment, no significant output gap, no recession, and strong economic growth. Imagine what happens to the deficits when we end up in a recession. www.balancesheetsolutions.org BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 5 Deficits Should Not be Rising The national debt grew by 6% of GDP last year, which is shocking. In the first three months of fiscal year 2019, the national debt grew by another 8% of GDP, which is equivalent to every U.S. household taking on another $15,000 of debt. The non-partisan Committee for Responsible Fiscal Budget (CRFB) released its own 75-year budget outlook, which projected an unsustainable fiscal outlook. Under current law, debt will rise from 78% of GDP in 2018 to 160% by 2050 and nearly 360% by 2093. Under the Alternative Fiscal Scenario, debt will exceed 600% of GDP by 2093. Further, state pension plans are underfunded by about 50%. And according to the usdebtclock.org, there are $122 trillion of outstanding liabilities, including the national debt, state and local government debt, pension fund liabilities and money owed by Social Security. This is six-times the U.S. GDP. Question: How can a $19 trillion-dollar economy support $122 trillion (and counting) of debt? Answer: It can’t. One consequence of a rising national debt is that it crowds out productive investment, which, in turn, slows income growth. The upshot is that lower debt can actually boost income growth. Congressional Budget Office (CBO) estimates that if debt were reduced to its historic average of about 41% of GDP by 2048, per-capita GNP (a rough parallel for www.balancesheetsolutions.org BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 6 average income) would be about $6,000 (6.5%) higher than under current law. Simply holding debt at current levels would boost income per person by $4,000 per year in 2048. Maybe the “crowding out effect” is why the deficit-financed tax cuts in the U.S. never did produce the economic results that the advocates were advertising. The effects were half what they were under the Reagan tax reform of the mid- 1980s because back then, the federal debt ratio was less than half what it is today.