Growth That’s Bought But Not Paid For

Very clear warning signs are now flashing that the U.S. economy could be heading for trouble and that the longest expansion in recent memory may soon end. But as usual, financial media and mainstream investors are once again flushed with optimism as the stock market plows higher.

Last week, the Fed gave a narrative confirmation to the dangers when they officially called off their monetary tightening campaign. The curtain came down far earlier than just about anyone in the mainstream had predicted. Just a few months ago, most assumed that the Fed would continue raising interest rates and shrinking its balance sheet well into 2020 and beyond. Now it has indicated no further hikes for 2019, and perhaps just one for 2020. Similarly, it now plans to end its balance sheet reduction program by September (Federal Reserve Board, FOMC press conference, 3/20/19). The program was supposed to last for many years and cut the Fed's $4.5 trillion stash of government and mortgage-backed bonds, by 50% or more. But now the Fed only anticipates a few hundred billion in total reductions, which will barely put a dent in its huge stack.

The Fed's rapid reversal should have caused many to wonder if the economy is far weaker than they had thought, or more precisely, if it was merely a bubble fueled by the monetary stimulus the Fed was withdrawing. Technical confirmation for the Fed's concern arrived last week when the yield curve inverted for the first time since the 2007 lead-up to the Great Recession, meaning investors are receiving lower interest on 10-year government bonds than on three-month Treasury bills. This reversal of the normal rules of duration risk, where investors get higher rates for longer lock ups, usually precedes a recession (Yield Curve & Predicted GDP Growth, March 2019, Cleveland FRB). In fact, many economists regard yield curve inversion as the single most reliable recession predictor.

So after the heady gains in the market over recent years investors should be very concerned that the game will change. Instead, after one of the worst Decembers in history, investors jumped back into stocks with passion in January and powered the S&P 500 to its best quarterly performance since third quarter 2009. As has been the case for years, investors seem to have been fixated on low interest rates as the only driver that matters. The disconnect is most pronounced in the Trump Administration itself, where former monetary hawk and current White House economic advisor Larry Kudlow, called for the Fed to immediately cut rates by 50 basis points, even while lauding the miracles of the Trump Economy. If the economy is the "best in American history" as Trump likes to suggest, why then the urgent calls for rate cuts?

Last week, many of those who remain confident in the economy and the markets pointed to the newly released data that showed relatively strong GDP growth for 2018. Although the numbers did reveal a slowdown in the fourth quarter, the full year came in at a modestly healthy 2.9%, tying with 2015 and 2006 for the highest growth rate since 2005 (U.S. Bureau of Economic Analysis). In fact, 2.9% is 38% faster growth than the average 2.1% achieved since 2000. With a business-friendly administration still in the White House (that can finally look past the specter of the Mueller investigation), many see the return of another Goldilocks era for the U.S. economy.

But, to make that assumption, forecasters not only must ignore the elephant in the room, but they must ignore the fact that the elephant is now sitting on top of the house. The 2.9% growth achieved in 2018 came amidst a staggering expansion of government debt. It's bad enough that the deficit came in at $779 billion, the most red ink since 2012 (when the economy was still struggling in the shadows of the Great Recession), but the national debt surged by a staggering $1.481 trillion (data from Economic Research Division, FRED, FRB St. Louis).

Many people would assume that the annual budget deficit, which is the difference between what the government spends and what it raises in taxes and other revenues, would be the same as that year's actual expansion of the debt. But so far this century, the annual deficit has averaged $552 billion, while the annual debt expansion has been 55% higher, averaging $853 billion. The difference comes from the fact that deficit numbers exclude expenditures that are considered "off-budget" which inexplicably includes such line items as Social Security and the Postal Service. The amount of those off budget items fluctuates wildly from year to year, but was particularly high in 2018.