The Teflon US Economy

US economic news has been impressive, causing the stock market to make historical, new highs led by the Towering 10—Apple, Amazon, Eli Lilly, Google, Meta, Microsoft, Netflix, Novo-Nordisk, Nvidia, and Tesla. Price Earnings (P/Es) ratios are generally supported by 2024 earnings expectations and AI is expected to bring a tidal wave of productivity improvements. All this makes us bullishly cautious for the very near term (six months).

But there are headwinds as well. Germany, UK, Japan, and China are now in recession and that may reduce trade. Although the US is not in recession, it’s because our GDP is growing due to energy exports and massive Government deficit spending. The Congressional Budget Office projects deficit spending to rise to $2.6 trillion annually in 10 years—that’s $54.4 trillion national debt should we continue as we are. And inflation is proving tough to tame while an inverted yield curve suggests we still have Recession risk.

According to Dr. Laura Veldkamp of Columbia University Graduate School of Business and a Research fellow at the National Bureau of Economic Research as well as a consultant to the Federal Reserve Bank of New York, the size of US’s debt is not a problem. She reasons that if the US economy is analyzed like a household’s balance sheet for a mortgage loan (on an Income to Debt Service basis) then current US debt is about 1.3 times US income (GDP). With interest on our debt averaging 4.0%, the government needs to pay only 5.2% of GDP to service its debt. US tax receipts are 18% of GDP, this is less than a third of US income. Dr. Veldkamp argues that what’s important is how we allocate our spending. If it’s allocated to investments that will provide a good future return, spending more isn’t a problem.

We don’t entirely agree with her logic but do agree the US can likely add more debt. The fact is the US is not just spending its tax receipts, it is creating money by spending trillions more than the income we produce, and higher interest rates are amplifying our debt service needs. We spend growing amounts on Entitlements and Defense that are not primarily future income investments? Both provide benefits and real security, yet people receiving government assistance and social security but who don’t become productive, and military expenditures to provide for national security are much like insurance premiums. The money spent is for peace of mind and “just in case,” they are not investments expected to increase US future income. (Of course, there is a valid argument that Entitlement spending supports families, education, and upward mobility while Defense spending preserves the US position as the policeman of the world, but that is not her argument. Should we worry then?

Our concern is for a “Black Swan” event like the UK experienced when Liz Truss, their 45-day prime minister, announced more UK stimulus with tax cuts. That resulted in a Bond rout the Bank of England had to intervene in by announcing it would by an unlimited quantities of government bonds to stop the meltdown. Congress now has a bipartisan bill for tax cuts for business permitting R&D expenses to be written-off immediately instead of being amortized over five years and it allows for retroactive tax return amendments going back to 2019. Could such a 2025 bill combined with $35-36 trillion in debt cause the ‘rebellion’ against the US Dollar Jamie Dimon, CEO of JP Morgan Chase is warning about?

We must ask: Does the Fed’s expectation to cut interest rates this year mean they expect a weaker economy? If so, will a rate cut in a slowing economy boost stock prices? And does the Fed believe they have overshot interest rate hikes so that Treasury can finance even more debt at under .0% interest rates?

Interest rate cuts are already priced into the market, but lower interest rates would ease pressure on commercial office loans helping banks while also providing needed help to consumers. Looking at the Fed’s Financial Conditions Index we think the Fed eyed it in December signaling a too tight policy prompting Chairman Powell to suggest a 75-basis point cut may be appropriate. Since then, the FCI-G index has dipped slightly on higher inflation, strong jobs, and higher mortgage rates. (Note the light and royal blue boxes representing Mortgages and the Dollar and the red boxes for BBB+ credit.) It’s not “politically correct” to question whether there are sufficient buyers of Treasuries, but the Treasury auctioning mostly short-term T-Bills, and not 10-30 Treasury Bonds, suggests lackluster demand for longer term bonds at current market rates. We believe it’s because investment managers look at inflation-adjusted, after-tax return yields. Current sub four percent yields aren’t attractive.

Unless the economy goes into Recession, we expect the Fed will make liquidity plentiful this year and ultimately let inflation run “Hot” for years to payback our debt in cheaper dollars. We also believe there is a small probability the US will have 10 more years to pile on debt. If we compare AI’s potential contribution to US growth, AI is at a very early adoption stage and this boom could extend several more years until prices become ridiculous. Indeed, Nvidia’s earnings justify a higher price.

To navigate potential risks, our process routinely evaluates the health of the market by looking at facts. We use an algorithm employing real-time data to evaluate whether we are in an expansionary, uncertain sideways, or contracting economy. We look at ‘most likely’ scenarios as well as euphoria in prices and sectors along with these readings. Then we work to build-in flexibility to navigate what we expect. Part of that equation is having some dry power to take advantage of opportunities when uncertainty rises. Our objective is always to be vigilant of events that may cause loss and to be proactive in navigating through them. Our goal is to deliver good returns all the time while avoiding big setbacks that wreck compounding. It’s a careful process striving to own the best growing companies where the reward-for-risk is compelling while also playing Defense with hedges to lessen volatility when prices rise and when the economy starts contracting. That said, there are of course no guarantees of return or profits.

In summary, today there are geo-political risks, Inflation, and Recession risks. The dollar is strong, jobs are plentiful, Q4 earnings indicate prices could rise 10%, and government debt levels are not excessive. With these positives outweighing the negatives, our take-away is that an outlier event in the Bond or Credit Market is the greatest short-term risk so we are closely monitoring Bonds and market liquidity.

We thank you for your trust and confidence. If you have questions or want to discuss reducing your account(s) risks please get in touch.