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Musings Report 2023-32 8-5-23 The Moment of Truth Is Approaching
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The Moment of Truth Is Approaching
We are approaching a financial-economic Moment of Truth that confirms that either 1) "the status quo is unchanged and will continue on the same path"--employment will be strong, inflation and interest rates will decline ("the soft landing"), profits will continue to rise and all will be right with stocks, housing, consumer spending and the global economy--or
2) fundamental changes are occurring beneath the surface that will destabilize a great many things we currently take for granted: the permanence of low unemployment, inflation and interest rates, and of course soaring profits, housing and stock market valuations.
This is a thorough overview, so please refresh your beverage of choice.
In broad brush, here's what happened the past year: to tamp down inflation, the Federal Reserve raised bond yields/interest rates at the fastest rate in decades. These higher interest rates broke the stable earnings of many medium-sized banks, which then saw capital flowing from banks to money-market funds that paid much higher yields on cash.
On March 10 2023, Silicon Valley Bank collapsed, and the Fed rushed to create a new fund to ease access to credit, the Bank Term Funding Program (BTFP). As this chart shows, the fund quickly expanded to $100 billion (blue line), which then sparked a massive stock market rally (red line) as this new liquidity immediately boosted equities. Euphoria over the profit potential of AI and rising confidence in "the soft landing"/ no recession added bullish fuel to the rally.
The banking crisis appears to have been resolved, but the higher interest rates have changed the flow of capital and the profitability of banks. The stability created by the flood of Fed liquidity may well be temporary.
Concurrently, the rise in interest rates doubled mortgage rates from the 3% range to the 6% to 7% range while housing valuations skyrocketed, supposedly due to scarcity. Statistically, the number of housing units per capita (per person) in the US has never been higher, so it seems the demand outstripped supply for financial reasons, what my colleague CH calls an "interest rate driven, credit deluge bubble."
I also see the massive corporate buying of houses for rentals and individual-investor mass-market buying of dwellings to cash in on the AirBNB boom (that's now drying up) as major sources of housing demand that were largely driven by (pandemic-generated) excessively low rates and easy credit.
Recall that buyers are motivated to "buy now rather than later" as mortgage rates start to rise to lock in a rate before they move even higher.
The consensus holds that the Fed will soon start lowering interest rates back to zero as inflation falls back to the 2% annual target. (So our money only loses 22% of its purchasing power every decade, and that's "low inflation"?)
Many (myself included) have made the case for systemically higher inflation due to global scarcities, higher costs of resource extraction, deglobalization, labor shortages, re-industrialization and the decay and reversal of financialization, i.e. the stupendous expansion of credit, leverage and commoditized global financial instruments.
Meanwhile, the Federal government, corporations and state and local governments, have been borrowing money at rates that have reached parabolic heights.
This unprecedented expansion of federal debt outside of war or recession triggered a downgrade of the federal credit rating.
The "risk" in Treasuries isn't default of course, as they can create money (or borrow it into existence via the Fed) to pay the interest; the risk is inflation driven by all that money-creation. In a deflationary economy like Japan, the inflationary money-printing to buy government bonds offsets the "real economy's" deflation. In an inflationary economy, this "self-funding of debt" via creating money to fund soaring government debt will drive inflation higher.
This inflationary consequence was masked by ZIRP (zero-interest rate policy) but given the real-world inflationary drivers (scarcity, deglobalization, re-industrialization, labor shortages, etc.) it will not be possible to drop rates back to near-zero.
Analysts such as Louise Yamada have tracked long-term cycles of interest rates / bond yields for decades, and the 40-year era of declining interest rates has ended (from 1982 to 2022). The cycle of higher yields and interest rates has just begun, yet the consensus expects this one year of higher rates to quickly dissolve and the good old days of zero-interest rates to return. This is not how cycles work: extremes get more extreme and then conditions change and a new cycle begins.
As for labor shortages, I've endeavored to explain the complexity of the labor market. As experienced workers in key industries retire, there's a shortage of workers with the skills and dedication to fill these slots. There is also a scarcity of lower-skill manual labor (hotel maids, service workers) because there is a structural mismatch between the work employers need done, the wages they are offering, the workforce's skills and the expectations of the younger demographic entering the workforce.
In effect, there's a surplus of working-age people with inadequate skills and unrealistic expectations and a scarcity of workers willing to do the work that needs to be done at the wages being offered.
The net result is the economy can suffer from highly inflationary labor shortages at the same time there is high unemployment in the workforce with mismatched skills and expectations.
At the same time, pandemic-related disabilities are rising and some demographics (many young men, for example) are not entering the workforce at all. Corporations no longer train new workers, they prefer poaching workers from other companies where they have already acquired the desired skills. This pushes wages higher while doing nothing to alleviate the shortage of skilled workers.
Many industries are being upended by new models and technologies. Many look at AI to continue this trend, but there are many other forces at work other than AI. Entertainment--Hollywood, television and the music industry--has been gutted by streaming, which enables customers to "consume" as much as they want for a modest monthly fee. The old model of cable TV, movie theaters, DVD/CD rentals and sales, etc. generated "residuals" for talent and the owners of rights from TV re-runs, music broadcasts/rights and DVD/CD rentals/sales. The income streams from streaming pay little to no residuals.
You can find stories on the web of musicians with one-hit wonders from the 1960s and 70s still collecting royalties from their one hit, while current artists receive something like $26 for hundreds of thousands of subscribers streaming their song. Jerry Seinfeld has reportedly earned $100 million in re-run residuals for "Seinfeld." The stars in current streaming TV shows will earn nothing.
This structural change is why Taylor Swift has re-recorded and re-issued her earlier works: by issuing new versions of her previously recorded songs, she now has sole rights to these new versions. Her live performances are chalking up revenues in the $1 billion range, showing that the soaring ticket prices for live performances are the gravy train, at least for the few at the top who can command ticket prices in the hundreds or thousands.
To compensate, networks are charging much higher fees for cable TV licensing, which is driving the cost of cable much higher, further incentivizing consumers to drop cable and rely solely on streaming or ad-supported "free" streaming (YouTube, ad-supported Netflix, etc.). There are many such self-reinforcing "doom loops" in play: as costs rise, people opt out, leaving fewer customers to support the higher costs.
Many other sectors are dependent on debt (consumers and companies buying products and services with borrowed money) without grasping the fragility of this dependence. Credit offers instant gratification but the costs and consequences come later. Everything's great until the credit card is maxed out and the higher interest rates eat up the shrinking discretionary income.
As Tim Morgan (Surplus Energy Economics) and other have detailed, inflation in essentials (fixed costs, including debt service, housing, energy, transportation, food, healthcare, etc.) has dramatically reduced the disposable / discretionary income left in the budgets of the bottom 90% of households. Once credit dries up (as credit cards are maxed out and credit lines are withdrawn), all the sectors dependent on free-spending consumers and companies will suffer a significant decline in sales.
To manage their risk, lenders are reducing the credit available to higher-risk borrowers, which increasingly includes a vast spectrum of companies and households.
The "wealth effect" generated by soaring stock and housing valuations has encouraged the top 10% who own almost 90% of the income-producing assets to splurge on consumption and gambles (oops, "investments"). Should the credit-generated bubbles in stocks and housing deflate, the "wealth effect" goes into reverse: people feel less wealthy and so they tighten their belts. This is also a "doom loop," as reduced speculation and spending only further deflate the bubble-illusion of "wealth."
One well-recognized "doom loop" is commercial real estate (CRE), as the structural shift to remote work, combined with massive over-investment (i.e. mal-investment) in CRE, has created a mismatch of supply and demand that will never be resolved by increasing demand--only a massive reduction in supply can save the sector from collapsing demand.
It's important to remind ourselves of Peter Drucker's insight that enterprises don't have profits, they only have costs. Offloading costs will become an obsession once the consuming public no longer accepts 20% price hikes in products and services.
The enormous increase in federal borrowing has in effect replaced private-sector borrowing, artificially boosting the economy but locking in of ever-higher interest expenses. Higher federal interest payments (approaching $1 trillion annually) generate two "doom loops":
1) as more federal tax revenues go to interest, there are fewer revenues available to spend elsewhere, and borrowing more to compensate only pushes future interest payments higher; and
2) since the wealthy own the vast majority of Treasury bonds, this siphoning of national income to pay Treasury interest enriches the already rich, not the bottom 90%. This exacerbates already extreme wealth-income inequality.
Given the ultra-high levels of debt, higher interest rates are a systemic "doom loop," as the economy cannot function without sustained increases in credit/debt to fund additional consumption. As borrowing slows due to higher interest payments, spending also slows. Borrowing more to substitute borrowed money for income only shifts more future income to debt service.
This is a doom loop with no escape other than a rapid return to zero interest rates. But since such a move will push inflation higher, that "fix" is not a solution; it will only increase the problem.
The consensus holds that "good inflation" (i.e. 2%-3% annually) will painlessly eat away the debt, while the Fed's "higher for longer" interest rates will tamp down inflation. This Goldilocks scenario ignores what happens when debt expansion (and other claims such as future Disability. Medicare/Social Security entitlements) go parabolic: 3% inflation may eat away $2.5 trillion in existing debt, but if we're adding $5 trillion in new debt / obligations every year, then the debt will still rise to unsustainable levels.
Raising inflation high enough to extinguish debt at a rate faster than our expansion of debt will destabilize the currency and economy, as inflation this high becomes "bad inflation" that self-reinforces into hyper-inflation that destroys wealth and the purchasing power of wages.
The ability to borrow money cheaply has papered over a host of stunning structural cost increases. Home insurance in some states is either becoming unavailable or extraordinarily costly: $6,000 annually is apparently not uncommon. This is ten times the cost of home insurance in less risky climes.
EVs (electric vehicles) have higher insurance rates, and come with other problems rarely mentioned in news reports: they cannot be towed conventionally, for example, and even minor damage to their battery packs causes the insurers to 'total" the vehicle. Will Insurance Costs Derail The EV Revolution?
Once borrowing more money is no longer possible (due to tighter credit and higher debt payments), then all these higher costs will start impacting discretionary spending on tourism, eating out, etc.
Costs don't matter until they do. The public has absorbed 50% to 80% increases in short-term rental rates (AirBNBs) and resort fees in the past two years without crimping their vacation spending. Perhaps this is "revenge spending" so costs don't matter, but once credit tightens and debt service soaks up income, costs will matter: how many households can fund a $5,000 or 10,000 vacation out of earnings rather than credit?
In summary, those who believe the status quo is unchanged are not assessing the risks created by these many fundamental forces. While it's possible that nothing will change, the risks of something breaking are rising.
As I often note, the global economy and financial system are tightly bound systems, which means all the moving parts are inter-connected in long, complex dependency chains. Should one link break, multiple chains will break down in potentially chaotic fashion as the system has been stripped of redundancies and resilience.
Perhaps employment stays strong and inflation continues declining. But given the intrinsic fragilities created by fast-rising global debt and the fundamental forces pushing fixed costs / costs of resource extraction higher, should the Fed and other central banks drop rates to combat sluggish growth, this might unleash an even larger wave of inflation as yet another flood-tide of cheap / easy credit will fuel demand and speculation rather than productive investment.
Many mistakenly believe "inflation is always caused by expansion of the money supply." As the oil shock of 1973-74 showed, scarcities of essentials create massive inflation regardless of what happens to the money supply. Labor costs are also drivers of inflation, as the 45 years of capital siphoning off national income from labor has reversed, and now labor will siphon national income from capital.
Borrowing trillions of dollars every year to maintain the illusion of "prosperity" is a form of denial: the costs and consequences cannot be pushed forward indefinitely, especially as interest rates continue climbing.
Rising interest payments are the ultimate doom loop, for as more discretionary income is diverted to debt service, there is no longer enough left to support the consumer economy. And once debts reach critical levels, lenders will no longer extend more credit to over-extended borrowers.
Once the economy can no longer "borrow its way to prosperity," it will only have the income left after paying for essentials and debt service, which will decline towards zero as interest payments take an ever-larger share of the national income. Once debt can no longer expand faster than the economy, consumer spending will decay. The economy will enter a recessionary cycle or possibly fall into a depression.
Lastly, speculation has taken hold of the national zeitgeist: investing for the long-term is out, zero-expiration options are in. It will take an 80%+ decline in stocks to break this reliance on gambling for gains in wealth and income. Housing could (and arguable should) decline 50% in a run-of-the-mill return to trend.
The Moment of Truth is approaching. Perhaps we will get a taste of disruption in the usual September-October risk period, but the real test will likely be in 2024-25.
The reality is current wages are not even close to equivalent in purchasing power to the wages we earned 40 years ago. To actually qualify as "living wages," wages will have to rise significantly. This is inflationary.
All speculative bubbles pop, no matter how sacrosanct the justifications. Once the Everything Bubble pops, the wealth effect will reverse, and this will generate a doom loop of reduced speculation (further deflating valuations), borrowing and spending in the top 10% that account for 40% of all consumption.
Relying on debt, as the world does now, has costs and consequences. Reliance on tightly bound, hyper-financialized systems also has costs and consequences. Relying on speculation for income and "wealth creation" also has costs and consequences. All these costs and consequences have been pushed forward or papered over with borrowed money.
Risk is inherently difficult to assess, especially when the herd is running and infused with confidence. Right now, the risk of something breaking is viewed as near-zero. This doesn't align very well with visible uncertainties, costs and potential consequences. Being prepared for the possibility that the Moment of Truth will favor non-linear, unpredictable changes rather than favoring unchanging stability seems wise.
Once risk becomes visible to all, it's too late to mitigate it. Plan accordingly.
Highlights of the Blog
The Wealthy Are Not Like You and Me--Our Terminally Stratified Society 8/3/23
Even the Aliens Are Boring 8/1/23
Best Thing That Happened To Me This Week
Breadfruit harvest (most shared / given away) and a typical Tex-Mex / Japanese / French dinner: Tex-Mex casserole, brown rice and natto, and home-grown green beans with Provence herbs.
From Left Field
NOTE TO NEW READERS: This list is not comprised of articles I agree with or that I judge to be correct or of the highest quality. It is representative of the content I find interesting as reflections of the current zeitgeist. The list is intended to be perused with an open, critical, occasionally amused mind.
Many links are behind paywalls. Most paywalled sites allow a few free articles per month if you register. It's the New Normal.
Do High Interest Rates Fix High Inflation? (via Mark S.)
A beachside city became California’s legal cannabis capital. Not everyone is stoked
Pay, Productivity, and the Labor Share (via cryptocomicon)
Resilience through simplification: revisiting Tainter’s theory of collapse (part 2) (via Ryan K.)
The Vanishing Family: They all have a 50-50 chance of inheriting a cruel genetic mutation (via Richard M.)
Beijing Is Still Too Confident About China’s Economy
The Myth of the Sustainable City (via Ryan K.)
Crucial CBDC’s with Professor Richard Werner: YOUR Future is Being Decided! (1:08 hrs) (via Mark S.)
Breakthrough Could Allow The US To Meet 450% Of Its Energy Demand From A Single Carbon-Free Source: Widespread enhanced geothermal power is inching closer to reality.
Small Modular Nuclear Reactors Put Dollar Sign Dreams In Nuclear Industry’s Eyes: They lose thermal efficiency, won’t gain economies of numbers and persist problems of security and waste management
The Life of a Female Hikikomori: The Truth The Media Will Never Share
"A slave is one who waits for someone to come and free him." Ezra Pound
Thanks for reading--
charles |
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