Fantasy. Pure Fantasy. U.S. investors have their heads in the clouds. Bluebirds chirp and encircle their heads like wreathes.
KP7 continues to have very little exposure to the U.S. economy.
In the fall of 1929, the United States was closing off a decade of prosperity. The U.S. Federal Government ran a budget surplus each and every year in the 1920s. That allowed it to reduce its debt as a percent of GDP (which had spiked to 36% during the First World War) to just 16% by the end of 1929.
The U.S. Federal Reserve, meanwhile, worked its balance sheet down from 9% of GDP at the start of the decade to just 5% by 1929.
Remember, the size of the Fed’s balance sheet reflects its economic stimulus activities. When it buys assets in the open market, it grows its balance sheet and stimulates the economy. When it sells assets, it shrinks its balance sheet and removes stimulus from the economy. The Federal Reserve shrank its balance sheet in the 1920s and removed liquidity and stimulus from the U.S. economy.
In the fall of 1929, both the U.S. Federal Government and the U.S. Federal Reserve had lots of dry powder to deal with future adversity. The U.S. Federal Government had enormous untapped borrowing capacity and the U.S. Federal Reserve had the ability to ramp up its asset purchases and stimulate the economy.
As we now know, adversity was not far off. By 1933, unemployment would reach 25%, industrial production would decline by nearly 50%, and GDP would drop by 30%. Hitler, meanwhile, invaded Czechoslovakia in 1938 setting in motion one of the biggest military conflicts in human history.
Thank God the U.S. Federal Government and the U.S. Federal Reserve had dry powder to address these adversaries. By the time things got back to normal in 1945, U.S. government debt had skyrocketed to 125% of GDP and the Fed’s balance sheet as a percent of GDP had quadrupled to 20%. Both institutions had literally pulled out all the stops to first combat the Great Depression and then take on and defeat Germany and its allies.
Some might argue (including us) that the U.S. didn’t use its resources effectively, especially in fighting the Great Depression. It made some massive mistakes which likely prolonged and deepened the depression. But, having the firepower available heading into the 1930s was undeniably a major asset. It gave the U.S. the resources it needed to deal with and conquer both adversaries.
If a Martian were magically airdropped into the United States today, he would naturally assume the country had just come through some sort of economic tragedy or some massive military conflict or both. One look at the positioning of the U.S. Federal Government and the U.S. Federal Reserve would show, without question, the government had come through a period of massive spending and the Fed through a period of massive stimulus. Yes that is true, yet no major adversary has been conquered. It just sort of happened.
U.S. Government debt is about 130% of GDP today and the Fed’s balance sheet stands at about 25% of GDP. Both figures are higher than they were in 1945. Both figures, in fact, are higher than they have been in the history of the country. Yet no major adversary has been conquered.
The central problem with being so overextended in time of economic prosperity and peace is neither institution has bullets left to fight future adversaries, be they military or economic. The U.S. has shot its bullets to combat recent crises from the Global Financial Crisis of 2008 to the COVID pandemic of 2020 and has not made the sacrifices necessary to replenish its arsenal.
Is it possible for a country like the U.S. to actually run out of ammo? We think it is. Natural limitations exist for both U.S. debt and the Fed’s balance sheet.
In Too Much to Bear, we described how the interest on the U.S. federal debt would likely exceed $1 trillion in 2023, more than double the amount paid in 2022. Interest expense on U.S. federal debt will likely increase another 50% in 2024, to something in the vicinity of $1.5 trillion. That will be 5% to 6% of GDP just to pay the interest on federal debt. The limitation on any borrower’s debt capacity is its ability to service and repay the debt in fully-valued currency. The U.S. Federal Government is getting close to the limit. We, in fact, believe it is actually past the limit: the U.S. Federal Government has no choice but to either default on its debt or devalue its currency even in the absence of a future adversary.
In The Thermostat Fallacy, we described how the negative correlation between unemployment and inflation breaks down under extreme conditions. Countries like Zimbabwe, Argentina, and Haiti, as well as the U.S. in the 1970s, experienced high levels of inflation and high levels of unemployment simultaneously because they turned the thermostat up a few too many times. Their central banks created so much money through asset purchases that people lost confidence in the currency, which lead to high levels of inflation, fundamental breakdowns in their economies, and high levels of unemployment. Loss of confidence in the currency ultimately limits the amount of assets a central bank can buy without triggering inflation and unemployment. We think the U.S. Federal Reserve is likewise already past that threshold even in the absence of a future adversary.
The U.S. will get through it, it always does. But, the sacrifices and economic pain required to address a major military or economic adversary in the future will be far higher starting out with an empty arsenal versus starting out with a full complement of ammunition.
The Fed is overextended. The U.S. Federal Government is overleveraged. Equity indices, meanwhile, keep powering ever upward. We believe equity markets have become untethered from the underlying reality. Investors piling into the U.S. equity markets today are blind to the very large underlying risks associated with too much leverage and an overextended Federal Reserve. Their fantasy, in our opinion, will come crashing down as those hidden and ignored risks take center stage in the months ahead; KP7 is doing its best to avoid a direct hit.
