Did we grow our way out of WWII debt?

 

We are facing a major debt crisis in the US, yet the alarm bells don’t seem to matter. The argument is that we run the economy hot, and stronger growth will get the debt issue under control, or at least allow us to see a decline in the debt-to-GDP ratio. 

The argument for growing our way out of the debt crisis rests on the view that we have seen high debt before and solved it through growth. The WWII debt was huge, but the debt-to-GDP ratio declined during the post-WWII expansion. The COVID debt expansion was like a world war, yet we can solve the problem through strong post-COVID expansion. 

In an interesting paper, “Did the United States Really Grwo out of Its World War II Debt”, we find that this argument may be wrong. Debt/GDP would have declined much less if not for the policies of the pre-Accord peg (financial repression) and the distortion of real rates from surprise inflation. 

The debt/GDP ratio fell from 106 to 23 percent in actual history, but if not for the rate distortions, it would have declined only to 74 percent.

This is an interesting application of counterfactual analysis, yet it is a sobering thought that solving the debt/GDP problem will have to come through surprise inflation and financial repression.

Bonds are not always a safe asset.

The new paper "Are Government Bonds Safe in time of war and Pandemic?" examines the behavior of bonds during periods of war and other non-financialcrises. Not surprisingly, there is a difference. Wars are associated with sharp declines in real returns and with returns that lag growth. The reasons are clear. There is elevated surprise inflation during a war, and governments impose financial repression, which creates a wedge between real returns and grwoth/. The bondholders bear the cost of war, even relative to risky assets. That is not the case during a financial crisis or a pandemic. Pandemics are similar to war in that they entail labor supply constraints, trade restrictions, a surge in spending, and significant increases in central bank balance sheets. 

All risks are not equal. Bonds are not always safe. The assumption that government bodies are always safe will be costly. Now, the war scenario may be easy to adapt to, but the real question is whether there are other government or geopolitical-induced events that are adverse for bonds. That is the real current question. When is the environment not safe for bonds? 

Howard Marks on bubbles - thoughtful advice

It is good to get some perspective on the current bubble discussion across assets. The following comments from Howard Marks provide useful insights that are evenhanded yet focus thinking on the problem. These excerpts are from a longer letter with sage advice on how to think through the AI bubble and associated thinking on financing data centers.

I’ve concluded there are two different but interrelated bubble possibilities to think about: one in the behavior of companies within the industry, and the other in how investors are behaving with regard to the industry.

Newness plays a huge part in this. Because there’s no history to restrain the imagination, the future can appear limitless for the new thing. And futures that are perceived to be limitless can justify valuations that go well beyond past norms – leading to asset prices that aren’t justified on the basis of predictable earning power.

The key thing to note here is that the new thing understandably inspires great enthusiasm, but bubbles are what happen when the enthusiasm reaches irrational proportions.

Struggling with whether to apply the “bubble” label can bog you down and interfere with proper judgment; we can accomplish a great deal by merely assessing what’s going on around us and drawing inferences with regard to proper behavior. 

The key realization seems to be that if people remained patient, prudent, analytical, and value-insistent, novel technologies would take many years and perhaps decades to be built out. Instead, the hysteria of the bubble causes the process to be compressed into a very short period – with some of the money going into life-changing investment in the winners but a lot of it being incinerated.

Debt is neither a good thing nor a bad thing per se. Likewise, the use of leverage in the AI industry shouldn’t be applauded or feared. It all comes down to the proportion of debt in the capital structure; the quality of the assets or cash flows you’re lending against; the borrowers’ alternative sources of liquidity for repayment; and the adequacy of the safety margin obtained by lenders. We’ll see which lenders maintain discipline in today’s heady environment.

I know I don’t know enough to opine on AI. But I do know something about debt, and it’s this:

• It’s okay to supply debt financing for a venture where the outcome is uncertain.

• It’s not okay where the outcome is purely a matter of conjecture.

• Those who understand the difference still have to make the distinction correctly.

from Howard Marks Is It a Bubble? Oaktree Client Letter 

 

 

Bubbles and crash risk is associated with positive expectations

 

There has been more talk about bubbes in the last six months than over the last few years. The paper, "Optimism Everywhere: Beliefs during stock price bubble", focuses on the boom and bust cycle by looking at expectations from analysts. When there is a price surge, analysts forecast exceptional earnings growth and high near-term returns. Short interest will be low, and the overall level of optimism is a strong indicator of future crashes. There are few skeptics during a bubble period. 

This research adds to our bubble story, yet there is a problem of whether optimism leads to price increases or whether price increases create optimism. The line of causality would be beneficial, although it is likely that price increases and optimism are closely linked. Yet it would be helpful to understand why some price increases become bubbles. What is the driver of optimism, and how is optimism spread into price behavior?

EU fragmentation - the impact on capital markets

Market fragmentation is an issue in the EU. There is not one market for bonds but a set of markets that may move together when there is no crisis, but will then diverge when there is a liquidity issue or a macro shock. The ECB may try to align key bond markets, but there are limits to what it can do without favoring one market over others. This problem is nicely described in the short VOX article, Financial fragmentation as a vulnerability in euro area bond markets.

There is evident fragmentation as outlined by the first and second principal components. The extent of Euro area fragmentation can be measured over time. Although it is lower than during most of the post-GFC period, it is clear that during periods of macroeconomic shocks, fragmentation increases, leading to lower liquidity and greater spread dislocation. It will be hard for the Euro area to produce a safe asset across the EU if there is high fragmentation.   

 

 

The current credit bezzle

 

With the bankruptcies of First Brands and Tricolor, there are clear signs that we are facing mounting credit issues. More importantly, we are seeing the classic Bezzle described by John Kenneth Galbraith in his book on the 1929 crash. We are not faced with a downturn in the business cycle. There is no recession; however, there is an exuberance that has been described by Minsky in his financial instability hypothesis. When overly optimistic views of the economy are coupled with extreme asset values, there is a higher likelihood that some will take advantage of the situation and cut corners, potentially committing fraud.

A review of the bankruptcies and new reports suggests that, in both cases, there was potential fraud or financial complexity that did not provide debtors with accurate information about the economic health of the firms. If we are seeing this under current healthy conditions, we can imagine more bankruptcies if asset prices fall. This is called the "febezzle" by Charlie Munger, referring to the false wealth created by high asset prices. If prices fall, the excessive wealth will quickly fall.

The key takeaway is that credit risk premiums should increase and investors should be paid more to hold risky debt.

John Kenneth Galbraith and the "bezzle" - It is a global issue

The bezzle and markets - Risks could be rising

From monetary to fiscal activism or both

 

There are policy regimes that will impact markets. The post-GFC period was focused on monetary policy as the key tool, with quantitative easing and extremely low rates (negative in some countries). This was also a period of fiscal austerity, with governments not attempting to push debt-to-GDP levels to extremes. There were, of course, exceptions. The pandemic also saw quantitative easing used again to avert a crisis, along with fiscal policy as an additional tool. This was clearly the case in the US, with what may have been considered temporary turning into something that looks more permanent. 

The switch to more aggressive fiscal policy affects the central bank's independence and alters the credit risk exposure for many investors. The cost of financing is an issue, as well as the potential term premium needed to attract bond investors. The potential for a credit crisis is heightened. Indeed, there is a change in the relative safety of different sovereign debts.

How countries go broke - cycles or one bad policy after another

 

Ray Dalio's new book, How Countries Go Broke - The Big Cycle, is a continuation of his earlier work on credit and debt cycles across history. In some sense, what he is proposing is not new but a reformulation of many of his past ideas. Dalio is neither a historian nor a macroeconomist but a successful practitioner who has studied credit markets and debt cycles as deeply as anyone. If you are expecting a deep history of debt cycles, as one would in an academic treatise, think again. 

Through narrative, many charts and tables, and highlights from Dalio, you are reading the argument he has for big credit cycles mixed with smaller cycles. He believes there are clear, recurring cycles that are predictable through repeating patterns of excessive credit, which must be adjusted through changes in monetary policy and structural reforms. Credit cannot be separated from money creation and policies. Excess credit can be addressed, but it will be painful. In the case of excess government debt, the options are spending cuts, tax increases, or inflation. Much of the theory is well known, but Dalio focuses on the behavioral patterns that create a cycle. 

The strident tone of Dalio may be off-putting, but he clearly formulates his arguments, and you can then debate the specifics. If you are worried about debt cycles, this is a book worth reading to frame future discussions on how debt cycles may collapse.

Cockroach Theory and credit risk

 

Regional banks are under stress based on the "cockroach theory" of credit. If you find one, there usually are more. If we have one credit problem with short-term and factor lending, there usually will be other firms that may have a problem. Credit problems are generally not just one-off. There can be fraud in some cases, but fraud is usually caused by stress in the system. Firms may not plan fraud. They are forced to cut corners, which generally leads to illegal action. One cut corner leads to others, which leads to cover-ups. 

Smaller banks have diversified portfolios, but a loss across several business sectors can have an impact on earnings and impair the sale of loans. We are not near the earlier lows in April associated with tariffs. Again, selling is based on higher uncertainty.

 

Cockroach Theory or "It's just one darn thing followed by another"

No room for error in the bond market - First Brands carryover

 

There is no room for error in the corporate bond market. Look at the spreads: the market is pricing in very little corporate debt risk. 

That tightness may be changing with the First Brands failure. Most corporate debt does not present the problems associated with First Brands, but we now have an environment where every credit manager is conducting a full review of their portfolio. Go back to basics, as there's FOMO around credit. 

The FOMO of a credit event. You want to be the investor who avoids risk, so it is time to start reducing risk exposure, especially in the high-yield space. If there is a credit problem with First Brands, there is likely to be problems somewhere else. There will be specific credit risks for firms that may have to rollover debt in the next year. Short-term debt should be less risky, except when there is a near-term credit problem or a threat of new funds not being available. If bank lines are cut, some firms will have less funding in the short run. 

Perception on Public Debt and Policy - Not very encouraging

 

A recent IMF paper, "Perception of Public Debt and Policy: Evidence from Cross Country Surveys," examines the responses of 27,000 participants to assess their knowledge and beliefs about how government debt influences expectations of tax and expenditure policy changes. Individuals often underestimate their debt levels, especially in countries with high debt, and the burden of fiscal adjustments will disproportionately affect them. People expect that tax increases will outweigh spending cuts when considering how debt levels can be reduced. 

The most interesting part of the survey is that respondents do not understand the relationship between government expenditures and budget deficits, tax revenues and budget deficits, and budget deficits and government debt. The analysts find that only about 50% of the respondents correctly identify the relationships. There is significant government budget illiteracy.

Most people do not have accurate perceptions of their debt levels. The average person does not understand government budget dynamics, nor do they appreciate the current levels of debt.

Financial crises are inherent within our system

 

Gary Gorton provides a good history of financial crises in the US financial system from the free banking period to the Great Financial Crisis. These crises are not one-off events but are inherent in our financial system. There will be credit booms and busts,  and our history is filled with them. What is unusual is that we had a long period from the Great Depression to the 1980s when there were no crises. Innovations that change the financial landscape, moral hazard issues, too-big-to-fail, and shortages of bank capital all contribute to liquidity crises and contraction of credit. Through following economic history, we can see how the seeds of crises are sown. Gorton does a good job in this short book of providing the history and theory for why we should always be concerned about the possibility of a financial crisis.

The next credit crisis - student loans again?

Corporate spreads are at all-time lows and household finances seem to be in good shape, but there is one area of concern - student loans. There was an extended moratorium on student loan payments during the Biden Administration due to the COVID pandemic, but that is in the past. Borrowers now have to pay up, and the bailouts are not there. The result has been an increase in delinquencies. This is especially the case for older borrowers who are nearing retirement. We are not at a crisis, but this is an area of concern that impacts spending and the ability of these consumers to take on any other debt. 

Corporate bond stress falling - what will it take to change spreads?

Despite all of the noise in politics, policy uncertainty, and geopolitical tensions, corporate bond spreads have fallen to levels seen at the beginning of the year. While there was a significant increase in stress in April, overall stress levels remain below the peak during the COVID-19 pandemic. Indeed, the market is sensitive to changes in policies that will impact earnings; yet, corporate buyers have overlooked these risk and uncertainty issues. The next test will be softness in the real economy, yet the link between economic uncertainty and spread risk does not seem strong.

 

Business and financial cycles are different but an important indicator

The idea of a countercyclical risk premium tied to consumption asset pricing models is the standard view in macrofinance, but there is also a growing view that there is a financial or credit cycle with booms peaking before macroeconomic real behavior. Equity and factor premium are tied to credit availability and balance sheet constraints. Hence, investors should not just look at business cycles, which are intermittent, but also at the financial environment to capture poor financial environments. See the paper "Financial and Business Cycle Risk Premia". 

Using a Markov switching model, the author identifies financial and business cycle regimes. Recession states suggest that there will be higher equity excess returns the following quarter, but this equity premium will be even greater if it is consistent with a financial crisis. This impact is even greater if the poor regimes are matched with deteriorating macro conditions. There will be higher unconditional equity returns if there are favorable financial conditions. 

Regardless of the model being used, knowing where you are positioned relative to the business and financial cycles is critical. While the extremes in the business and financial cycle are not frequent, tracking these regime changes will have an appreciable impact on asset allocation.

Relative uncertainty impacts safe asset demand

 

What is a safe asset? There is growing discussion on this issue, yet we think that, at its core, a safe asset does not face significant uncertainty. If there is more policy uncertainty, safety fundamentals are in jeopardy. A safe asset, whether short-term Treasury bills or a safe haven currency, will have low volatility, so we must devise other means of measuring safety. 

A safe currency will have low volatility, but most safe-haven currencies will also have low volatility. A better measure may be relative uncertainty. If the US has high uncertainty compared to other safe-asset countries, then on margin, the US will see fewer safe-asset flows. The dollar outflow will mean that capital must move to another safe haven. It could flow into the Euro or Japan, or if there is a general increase in policy uncertainty, it will be gold. Note that the dollar increased during the pandemic, even though US uncertainty spiked versus Europe, so more work has to be done on this topic. 

A good second-order effect is to examine policy uncertainty not just in the US but globally. It is the relative uncertainty that matters. 

Living in an uncertain world - All policy uncertainty indices point in the same direction

 

Several policy uncertainty indices can be found in the FRED database. All tell investors the same thing: We live in an uncertain world. There is a difference between risk and uncertainty. Risk is measurable, has a specific measure, and is based on counting. Uncertainty cannot be counted. It is subjective and based on our ignorance of what we do not know.  The policy uncertainty indices try to turn this ignorance measure into something that can be measured.  

While the trade policy uncertainty is off the charts, all the other measures are close to extremes. This will have an effect on markets, investment decisions, and consumption. Regardless of current data, the future does not look bright.  

Dollar during a crisis - The tariff issue is different

 

The current dollar performance is different from other crises. In general, the dollar has been a safe haven compared to other currencies. The Asian crisis, which started outside the US, saw dollar improvement. During COVID, a global crisis, money also flowed into the dollar. The same effect occurred with the GFC or the Lehman crisis, yet this trade crisis is different. We are seeing the dollar decline from an overvalued level. This is a concern that foreign investors, in this case, do not want increase dollar exposure. 

The current credit crunch

 

Risky bond issuance has fallen off a cliff. This is the result of uncertainty. When faced with high uncertainty, delay investment decisions. Issuance will decline, and the price necessary to hold risky debt will fall to clear the market. Hence, we are seeing wider spreads. The result is that we are facing a credit recession crunch. 

Treasury trades and liquidty

 

Most of the Treasury RV trades all have something to say about liquidity. In the past, traders often looked at the TED spread as an indicator of liquidity concerns and stress. Now, we have a wider set of liquidity indicators based on hedge fund-levered Treasury trades. A shock in these spreads is based on a change in Treasury yield expectations and will lead to a decline in liquidity that will force deleveraging or arbitrageurs to leave the market.

Treasury Basis trade—The difference between Treasury futures and the cheapest-to-deliver bond. Treasury futures trade at a premium to cash bonds, yet that premium will change with market conditions, albeit converge at delivery. Hedge funds can sell futures and buy the cheapest-to-deliver bonds to capture this premium.

Off-the-run vs. on-the-run trade - The difference between the current Treasury bond most recently issued and bonds that are slightly older since issuance. There is a liquidity premium with holding the on-the-run bond that offers investors an opportunity to profit from the differences in the price of these similar bonds.

Swap-treasury trade—The difference between fixed-pay swaps and Treasury yields, especially for longer maturities, given that the swap will often require less capital than holding the Treasury bond based on the supplemental leverage ratio. Hence, the swap spread will be negative.

SOFR RV trade - Differences in short-term yields based on the technical issues of SOFR versus other short-rate alternatives.