On My Radar: The Debt Bubble and the Interest Rate TriggerLearn more about this firm
“At a time when the unemployment rate is well below full employment and inflation is accelerating, the Federal Reserve (Fed)
is already on a course to tighten policy in order to cool the economy. Fiscal stimulus has only served
to elevate concerns about economic overheating, meaning that the Fed will likely lean harder against much
of the boost from tax cuts and government spending in the form of higher interest rates.”
– Scott Minerd, Brian Smedley, Matt Bush of Guggenheim, “Forecasting the Next Recession”
Let me begin by saying our equity market trend model signals remain moderately bullish and our bond market trend model signals remain bearish. With that caveat, I do see us speeding down the road with limited visibility to the problem that exists just around the next turn. The mother of all bubbles exists and it is in the debt markets. It is global in scale and there is no easy way around the problem. Like bubbles past, this too will pop. The trigger? Rising interest rates.
First, a quick look at the market. Tech is doing well this week and the S&P 500 has successfully held the 200-day moving average line and has made a positive break out to the upside as circled in the next chart.
Here’s how to read the chart:
- The thin red line is the 200-day moving average line (i.e., the average price of the S&P 500 Index for the prior 200 days).
- The red circle shows the test and hold of that trend line.
- The two black lines show a triangle pattern.
- Bottom line: The break out to the upside is bullish from a technical perspective.
While good news for the short-term trend, the larger macroeconomic picture has its challenges. We face a number of headwinds, the biggest issue is DEBT.
The debt situation in the U.S. is bad. As of December 31, 2017, it stands at 329% debt-to-GDP. It’s worse in the Eurozone at 446% debt-to-GDP. For perspective, credible studies show countries get into trouble when debt-to-GDP exceeds 90%. But what does this really mean for the economy and for you?
Think of debt-to-GDP as how much debt you have versus how much income you make. If you owe $300,000 on your mortgage, $20,000 on your car loan and $9,000 on your credit cards and you earn $100,000 per year in income, your total debt-to-GDP is 329% ($329,000 in debt and $100,000 in income). For your personal and family economy, at what point do your mandatory monthly interest and principal payments become a drag on your personal situation? With less to spend, it impacts the overall economy.
Now that’s not a big deal if it is your brother who is the only person who’s borrowed too much. Picture what happens to him when interest rates rise. Even more of his $100,000 income has to be used to cover the debt. His problem!
It is a really big problem for our collective economy if many people/corporations/governments are deeply in debt all at the same time. As you’ll see in the chart to follow shortly, we don’t experience very good growth when debt is high. We get great growth when debt is low.
If we don’t get good economic growth, we don’t get good business growth. Period. So earnings struggle and if stock prices are high relative to earnings, then something has to give. Earnings must rise to justify current prices or prices must fall to get back to fair value. And based on the high level of debt and the evidence you’ll see in the chart below, outside of a short-term shot to the arm in the form of tax cuts and shareholder buybacks, I don’t think we will get greater earnings. So equity prices will likely mean revert back to fair value. Fair value on the S&P 500 based on 52 years of price-to-earnings ratios is about 1,821.96, as of the end of April 2018. That’s a decline of 35% from the current level 2,790 of the S&P 500.