Summary

  • After the 2008 crisis, the US economy deleveraged slightly, but not enough to facilitate organic economic growth.
  • From 2010 through 2020, secular economic forces were working against the economy, and we chose a path of debt and leverage to patch over the underlying weakness.
  • After the COVID-19 crisis hit, it became clear that the debt problem was too large or too painful to solve through defaults, so we decided to re-lever the economy.
  • More debt on top of an existing debt problem has predictable repercussions in terms of growth. We can use clues from the past to guide our asset allocation decisions in the upcoming economic environment.
  • While inflation always is a tail risk, the prevailing conditions favor a deflationary tilt to an otherwise balanced asset allocation mix.
  • I do much more than just articles at EPB Macro Research: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

Prior to the COVID-19 crisis, the overindebtedness of the corporate sector and federal government were commonly discussed “tail” events that were usually downplayed as the recency bias of historical equity returns that countered any negative economic possibility.

Within weeks, the corporate debt bubble exploded and was re-patched by a series of Federal Reserve term sheets and several trillion dollars of brand new debt.

Heading into 2008, the United States had a debt crisis, primarily in household debt. After the Great Financial Crisis, households deleveraged, which was helpful to the long-run economic health of the country. Still, the corporate sector and the federal government took the baton an increased debt to historically unprecedented levels.

As a whole, the economy only slightly deleveraged after the 2008 crisis before expanding debt to nearly $80 trillion as of the latest report through Q1 2020.

Very clearly, “we” (or the powers that be in the United States) chose to patch an indebtedness problem by increasing debt exponentially. Adding new debt on top of bad debt temporarily alleviates the pain associated with defaults and deleveraging, only leading to a more significant problem down the road.

One of these misconceptions regarding over-indebtedness is that “it is not a problem until it is,” or that if there’s not a major crisis, the debt is not a problem. This fallacy has caused analysts and investors to lose sight of the growing economic crisis that has unfolded before our eyes for the last decade in the form of weaker economic growth, a growing wealth gap, and supercharged risk profiles seeking to maintain the accustomed 8%-10% annual return.

Increasing leverage or pushing the economy deeper into debt, both public and private debt, has predictable repercussions in terms of growth, a phenomenon experienced over the last 10 years.

Eventually, overindebted economies experience both an inflationary “tail” and a deflationary “tail” – history makes this eventuality very clear. Thus, preparing for both inflation and deflation, as well as prosperity and recession, is the most prudent path that can be achieved through a balanced portfolio approach (discussed later).

Using history and an understanding of debt, it’s reasonable to “tilt” your portfolio in the direction of the most likely outcome – not removing any “tail” from your portfolio but rather adding extra weight to the current secular trend and economic probability.

In this note, we will outline the path “we” have chosen in terms of re-leveraging the economy, what the likely ramifications of that choice are, and what you can do to prepare your portfolio for the probable outcome.

First, let’s take a look at the path of re-leveraging the economy in more detail.

Re-levering An Over Leveraged Economy

As noted above, at the peak of the debt crisis in 2008, total debt in the economy exceeded 380% of GDP, a level that had not been recorded in US history.

Total Debt As A % Of GDP:

While the level of debt relative to the economy was soaring for decades, the 2008 crisis was known for the leverage in the household sector.

After the crisis, the economy deleveraged slightly, with the total debt to GDP ratio falling to roughly 345%. Still, this level of debt was unprecedented relative to history and enough to suffocate economic growth to an average annual rate of just 2.1%. The US economy did, in fact, deleverage slightly after the crisis.

The deleveraging mainly came from the household sector and mortgage debt.

Household and Nonprofit Debt To GDP Ratio:

Source: Federal Reserve, BEA, EPB Macro Research

After 2008, the United States was one of the only major developed nations to deleverage the economy (slightly) as most other nations accelerated the upward path.

Japan, Europe, Canada, Australia, and China all increased their relative indebtedness after 2008, while the US did not make a new peak.

Total Debt To GDP:

Source: Hoisington Management

Due to the decline in growth in Q2 2020 and another massive increase in debt, it’s possible to see total US debt to GDP increase beyond 400%. A 4x debt to GDP ratio would be uncharted waters for the US economy, but not unprecedented globally as Japan, Europe, and China already have reached that milestone.

As a result, we can have some idea of the economic impact of increasing debt to these levels.

In Q1 of 2020, according to the Z.1 Financial Accounts report released by the Federal Reserve, total debt outstanding increased $2.391 trillion, pushing the total debt outstanding across all sectors to a stunning $77.861 trillion.

The domestic non-financial sector, which includes the government, households, and non-financial businesses, was responsible for 67% of the quarterly increase in debt, rising $1.597 trillion.

Total Debt Outstanding By Sector: Quarterly Change

Source: Federal Reserve, EPB Macro Research

Looking at the domestic non-financial sector in more detail shows the government sector adding $684 billion of debt in Q1. All of the increase in the government sector was from the Federal level, state and local debt outstanding increased just $1 billion in Q1.

The non-financial business sector, which includes both small businesses and large corporations, posted an even more substantial increase than the federal government, with debt outstanding rising $754 billion. These numbers are also expected to rise more significantly in the Q2 report.

Total Debt Outstanding By Sector: Domestic Non-Financial, Quarterly Change

Source: Federal Reserve, EPB Macro Research

The increase in debt across all sectors of the economy pushed the total debt to GDP ratio up by 14% to 362%. It’s important to note that while federal debt often receives the most publicity, about 75% of the total debt outstanding comes from other sources.

In the next section, we will outline the probable economic impact of increasing leverage in the economy from all sectors, public and private.

Year-Over-Year Change In Total Debt Outstanding Through Q1:

Source: Federal Reserve, EPB Macro Research

After the 2008 crisis, the economy deleveraged very slightly. Debt as a percentage of GDP declined but still remained north of 340%. The economy did not deleverage sufficiently to remove the burden of excessive debt.

The Probable Economic Path

I recently wrote an article on Seeking Alpha titled “The Inflation vs. Deflation Tug Of War,” which dives into some detail regarding debt and monetary policy. This section will take a slightly different angle to attack the same problem.

The two primary secular forces putting downward pressure on economic growth are falling rates of population growth and increasing levels of unproductive debt, which erodes productivity growth. Unproductive debt can be identified by any use of new capital that does not generate a sustainable income stream to repay the borrowed funds.

As the economy became saddled with too much debt after the turn of the century, core economic growth started to decline relative to the long-run trend.

The chart below shows the five-year annualized growth rate of “core GDP” or real personal consumption plus real private fixed investment. In other words, real GDP excluding net exports, government spending, and inventory.

“Core GDP” 5-Year Annualized Growth Rate (%):

Source: BEA, EPB Macro Research

The horizontal red line at the 250%-275% level represents the debt threshold by which economies start to experience deleterious growth effects.

Total Debt To GDP:

Source: Hoisington Management

This can be empirically confirmed as the annualized growth rate in “core GDP” declined by nearly 50% after the US economy breached the 275% threshold after the turn of the century.

We know that these impacts become nonlinear at higher levels of debt. Hence, increased leverage in the economy beyond 400% is likely to have a predictable consequence on the rate of “core GDP,” dropping real growth well below the 2% level.

“Core GDP” Annual Growth By Decade (%):

Source: BEA, EPB Macro Research

It may be easy to refute these facts by quoting the annual return for the S&P 500. Still, it’s essential to understand how and why the mega-cap index has been able to sustain 7%-10% annual returns in the context of economic growth that has declined 50% to an anemic 2%.

If we look at true corporate profits from the national income and product accounts “NIPA,” reported with GDP from the BEA, we can have a more accurate measure of corporate profit growth in the entire economy.

The NIPA reports profits for the entire corporate sector rather than just the largest 500 companies without distortions from share buybacks, and corporate loopholes in Non-GAAP financial reporting.

Pre-tax corporate profits declined 14% in Q1 to $1,836 billion.

Since Q3 2011, pre-tax corporate profits have increased by less than 1%, as shown in the highlighted image below.

The growth rate (or lack thereof) of corporate profits is entirely consistent with the significant decline in core GDP growth.

US Corporate Profits (Pre-Tax) With Inventory and Capital Consumption Adjustments:

Source: Bloomberg, EPB Macro Research

After-tax corporate profits declined a similar 14% in Q1, erasing all the gains from the Tax Cut and Jobs Act.

After taxes, corporate profits are stagnant since 2012, even before the pending decline in the report for the second quarter.

US Corporate Profits (After-Tax) With Inventory and Capital Consumption Adjustments:

Source: Bloomberg, EPB Macro Research

Over the last five years, through Q1 2020, pre-tax corporate profits have declined 2.9% per annum, the worst growth rate in over 50 years.

It’s important to note that negative profit growth began before the COVID-19 crisis, with sub 2% growth rates starting as early as 2016.

US Corporate Profits (Pre-Tax) With Inventory and Capital Consumption Adjustments, Five-Year Annualized Growth Rate (%):

Source: Bloomberg, EPB Macro Research

Corporate margins, proxied below via corporate profits as a percentage of GDP, declined sharply in Q1 as expected.

Pre-tax corporate profit margins declined to 8.5%, on the way to the 6.5%-7.5% range that typically signals a recessionary trough.

The right-hand panel shows after-tax corporate profit margins making higher lows and higher highs for the past several decades, mainly as a result of pushing the effective tax rate down to roughly 10%.

Corporate Profit Margin Proxy:

Source: Bloomberg, EPB Macro Research

The chart below shows the ratio of corporate taxes paid as a percentage of total pre-tax corporate profits.

In Q1 2020, corporate taxes paid were just below 11% of total corporate profits.

In order to keep after-tax profits up, the economy has allowed corporations to pay lower tax rates on total profits.

Taxes On Corporate Income:

Source: Bloomberg, EPB Macro Research

There has been a long-standing trend in corporate America that has contributed to higher asset valuations relative to weakening economic growth. Corporations have paid fewer taxes as a percentage of total profits for decades and paid out increasingly large dividends as a share of profits.

The chart below shows net corporate dividends paid as a percentage of total profits. In Q1, highlighted in the box on the upper left, dividends paid increased by $19 billion, while total profits fell $295 billion. As a result, dividends paid as a percentage of total profits spiked to 75%, the highest level since the depths of the 2008 recession.

Over the last five years, corporations paid an average of 62% of total pre-tax profits in net dividends. That average jumps to 73% of after-tax profits.

These trends highlight how and why productivity growth has faltered. Incentives have shifted to financial engineering rather than productive investment. This trend has been beneficial to asset holders while negative for the broader economy.

Corporate Dividend Payments Relative To Profits:

Source: Bloomberg, EPB Macro Research

At this point, it’s clear that true corporate profit growth has followed the decline in core economic growth. S&P 500 earnings per share “EPS,” however, have continued to rise while pre-tax corporate profits were flat as a result of share buybacks and lower tax rates.

In order to generate the same 7%-10% annual stock market returns that pension funds require and the investing public has become accustomed, it’s necessary to enhance financial engineering tactics by tacking on additional debt and leveraging the balance sheet of corporate America.

Financial Engineering Gap:

Source: BEA, Bloomberg, EPB Macro Research

The charts above and below show true pre-tax corporate profits from the NIPA and S&P 500 EPS. As the chart below shows, since Q3 2014, pre-tax corporate profits from the NIPA are down 16% while earnings per share have increased by 27%. This is the financial engineering gap. The increase in EPS is entirely unrelated to the underlying economy, while true profits from the NIPA are actually reflective of growth trends.

Financial Engineering Gap:

Source: BEA, Bloomberg, EPB Macro Research

The chart below shows the five-year annualized growth rate of pre-tax corporate profits from the NIPA, S&P 500 EPS, and the S&P 500 index. As the chart clearly shows, true profit growth has followed economic growth lower.

EPS has been able to increase, deviating from underlying profit growth thanks to share buybacks, lower effective tax rates, and more leverage.

EPS, True Profits and S&P 500 5-Year Growth Rate (%):

Source: BEA, Bloomberg, EPB Macro Research

The corporate sector has leveraged its balance sheet in order to squeeze more returns out of lower growth with corporate debt as a percentage of GDP reaching the highest level in American history.

The staggering size of the corporate debt market is a driving force behind why the Federal Reserve was required to support this market. A lack of support and a deflating of the corporate debt bubble would have lowered EPS growth to match underlying profit growth in negative territory, making it hard for the broader S&P 500 index to continue generating returns in excess of the underlying economy.

Non-Financial Corporate Debt As A % of GDP:

Source: Bloomberg, EPB Macro Research

The US economy has a debt problem that was exposed during the COVID-19 crisis. S&P 500 EPS has been able to grow far in excess of the weakening underlying economy due to increased leverage, share buybacks, and reduced effective tax rates.

The above trends have a shelf life, and a longer-term analysis of assets proves this to be the case.

Most analysts and investors suffer from recency bias, using the last 40 years of asset price returns to make forward-looking assumptions.

Christopher Cole wrote that “recency bias has become a systemic risk” in his groundbreaking paper, “The Allegory Of The Hawk And Serpent.”

In the next section, we will look at why having deflationary and inflationary “tail” hedges in your portfolio is crucial, but why tilting toward deflation is still the more prudent choice.

Why A Deflationary Tilt To A Balanced Portfolio Makes The Most Sense
In the paper by Christopher Cole, cited above, Cole outlines how a “buy the dip” strategy in the S&P 500 index resulted in bankruptcy three times over 90 years and compounds at less than 0%.

Despite this factual analysis, investors are hardened into the belief that the long-run performance of stocks is nearly guaranteed to be 7%-10% because the “secular boom” cycle from 1980-2007 is the most recent history.

Buy The Dip:

Source: Christopher Cole, Twitter

To further emphasize this point, Cole notes that virtually the gains of a traditional stock and bond portfolio came from one secular period from the 1980s through the early 2000s.

Investors are seemingly unaware that there have been multiple 20-year periods in which stocks did not generate a positive return.

If you are 20 years from retirement and are banking on 7%-10% stock returns, your strategy may work, but you are falling victim to recency bias and projecting that the next 20 years will look the same as the last 40.

Recency Bias:

Source: Christopher Cole, Twitter

Periods of secular decline, like 1929 through 1946, are not as friendly to stock-heavy portfolios and are characterized by overleveraged economies, 0% interest rates, aging populations, and high levels of wealth inequality. Both deflationary shocks and inflationary shocks are highly possible.

During a secular decline, deflation is more probable, or at least more likely to occur first, before a true inflationary solution is attempted.

As a result, starting with a portfolio that has an equal amount of “risk” to all four economic scenarios will guard your assets against a secular period that looks different from 1980-2007.

Balanced Risk Approach:

Source: Bridgewater

A portfolio of stocks, bonds, gold, and commodities is the best way to achieve exposure to growth, recession, inflation, and deflation.

Currently, the United States has a record “output gap,” which tilts the probability of inflation or deflation towards deflation. The output gap will not close in several years, so low inflation is likely to persist once the COVID-19 crisis and the pent-up demand recovery subside.

The Congressional Budget Office publishes a measure of “potential” GDP based on a variety of factors, including potential hours worked and total factor productivity.

If we take reported real GDP and subtract it from potential GDP and express the difference as a percentage relative to potential GDP, we have the “output gap,” or the gap between current GDP and long-run potential.

As the chart shows, recessions create a large output gap.

Using the optimistic assumptions from Bloomberg, denoted in the lower-left box, we can see that by the middle of 2021, even if these assumptions hold true, that the US economy will still be left with an output gap that matches the depths of the Great Recession.

After the COVID-19 crisis, assuming 2.5% growth in perpetuity (highly optimistic) results in an output gap that lasts through 2029.

Closing The Output Gap:

Source: Bloomberg, BEA, CBO, EPB Macro Research

After the 2008 recession, it took about 10 years to close the output gap, which makes another 10-year work-off period a reasonable assumption, if not longer given that 2.5% GDP growth is highly optimistic.

The output gap is correlated to core inflation, as the chart below highlights, making a deflationary or disinflationary bias a reasonable position.

Output Gap and Inflation:

Source: Bloomberg, BEA, CBO, EPB Macro Research

Starting from a balanced portfolio, like the All-Weather or All-Seasons portfolio below, provides a stable baseline and preparedness for a variety of economic scenarios.

All-Weather or All-Seasons Portfolio:

Source: Portfolio Charts

From a balanced starting point, you can use the probable economic scenario to tilt your balance of risk towards the assets most likely to achieve a stable risk-reward.

Adding stocks to the balance would favor growth, while over-allocating Treasury bonds favor recessions or deflation.

The table below shows that you can also add cash to the portfolio and keep the balance of risk constant by proportionally reducing all the weightings of the assets in the portfolio.

Adding Cash To An All-Weather or All-Seasons Portfolio:

Source: EPB Macro Research

This approach and favoring a disinflationary tilt has allowed the model portfolio at EPB Macro Research to achieve a positive return in 2017, 2018, 2019, and so far in 2020 with a return/volatility ratio of more than 1.5.

I recently joined Seeking Alpha’s Jonathan Liss on the Let’s Talk ETF Podcast to discuss this outlook and strategy in more detail. You can listen to the podcast by clicking here.

In short, increasing unproductive debt in the economy will result in core economic growth declining further from the already depressed 2.0% level. As a result, true corporate profit growth will follow the economy and remain stagnant for years.

In order to keep EPS growing at 7%-10% to achieve a similar return in the broader stock market, financial engineering tactics will have to be used even more aggressively over the next 10 years. It may prove challenging to achieve this result as several engineering tactics, such as tax rates, already have been pushed to historical limits.

Starting from a balanced portfolio provides a strong baseline and preparedness for a variety of economic scenarios. Tilting the balance of risk in the direction of the most probable change in conditions will result in a more stable, uncorrelated return stream.

If you understand the economic cycle, you can profit from the opportunities that emerge from its ebb and flow.

To learn more about our long-term, low-volatility model portfolio strategy for all markets, click the link below to try EPB Macro Research risk-free for 14 days.

You have nothing to lose by joining for free but if you learn how to navigate the economic cycle, it will change the way you invest forever.

Author: Eric Basmajian

Source: Seeking Alpha: Our Chosen Path: Re-Leveraging An Over-Leveraged Economy – What Happens Next

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