The current public debt levels in the US have risen from 60% of GDP to over 100% since 2008. World War II saw public debt levels rise from 45% to 120%. The latest crisis control has cost the US government half of the cost of WWII.

US Federal Debt as % of GDP:

2008 bailouts cost European governments as well. Some countries managed to rein in their balance sheets but others have just kept going (Italy and the UK). Don’t bring up Japan. They are leading by miles with national debt at 2.5X GDP.

What does a government do in a financial crisis? Bail out the financial system, which includes the banks and their expensive managers and executives, since a failure of the financial system would inflict serious damage on the real economy, on output, employment and wages. Some compare this to Wall Street using Main Street as a human shield. And how does a government fund it?

Like this:

US Federal Debt Outstanding:

Thank goodness cost of debt was manageable. Imagine if the bond vigilantes had sold off US treasuries. But how does a government hold down the cost of borrowing?

Like this:

US Fed Balance Sheet:

If you face a buyers’ strike, there is nothing like buying your own bonds yourself. If you give it a scientific sounding name like quantitative easing (QE) and support it with academic research and the endorsement of renowned academics, it likely to appear less fraudulent.

9 years after the crisis and the economy has picked up and the justification for accommodative policy is receding. The Fed has begun (in 2015) to raise rates gradually and is considering normalizing its balance sheet. To what extent and how quickly can it normalize its balance sheet? It increased its balance sheet from just under a trillion USD to 4.4 trillion USD in the last 9 years. There will be limits to how much and how quickly it can reduce its balance sheet.

Here is one reason:

US Budget Balance as % of GDP:

If the current President’s plans to cut taxes and spend on infrastructure and defence are successful, the deficit will deepen, and it will need to be financed with more debt issuance.

The US needs to inflate away its national debt. However, rising inflation could threaten its long term funding costs which would force the Fed to remain underwriter for US treasuries. Ideally, the US would like to see asset inflation so that its asset to liability ratio improves in real terms, but low CPI inflation so that funding costs don’t rise excessively. This has been precisely what the economy has experienced these past 9 years. It is either a fortuitous coincidence or exceptional management by the Fed and Treasury.

Best guess predictions:

The Fed will raise rates gradually. They will also pay attention to market credit spreads which determine the actual cost of funding for the real economy.

The Fed will want buoyant asset markets as this debases the national debt. The Fed will therefore be sensitive to equity market and credit market stability, not just real economy data.

The Fed will go quite slowly in reducing its balance sheet. It cannot afford for interest rates to rise too far as it will impact the debt service costs of the government. Bond yields are likely to be range bound. The trading range and cycle will be influenced by central bank guidance and high frequency data.

There is significant risk from inflation. If inflation picks up it could impact the ability of the government to refinance itself.

Long term fundamental problems which will have to wait:

There does not appear to be any intention to decrease the national debt. This places the government under constant financial pressure which means it cannot invest in infrastructure or undertake reform which may have short term costs.

The size of the national debt puts pressure on the Fed and Treasury to keep rates low which in turn encourages the private sector to borrow and increases the level of leverage in the economy. If rates are artificially suppressed both government and private debt levels will not have a reason to recede.

With a persistently high and increasing or non-receding level of debt, both the private sector and the government has every motivation to keep rates contained or low. Low rates provide the government and the private sector every motivation to borrow more.

The above feedback loop implies that interest rates will be kept low until such time it is impossible to keep them low. But what could precipitate such an eventuality?

Possibly, inflation accelerates, in which case the Fed will have to be extra vigilant, a stance which could invert the yield curve, a position associated with recessions. A recession could throw asset inflation in reverse thus increasing the relative size of the total debt. Any loss of confidence could also throw asset markets in reverse with similar effect.

A loss of confidence could introduce a risk premium into US treasuries, currently a remote concept, but such is the modern economy that most assets and markets derive a significant portion of their value from confidence.

Not about to be paid down soon:

• all chart data sourced from Bloomberg

It is very hard to optimistic about anything about Britain. The people are divided, quite evenly, between those who wanted to stay in the EU and those who would leave it. A referendum has effectively documented this fact. The decision was taken without a thorough understanding of the consequences of leaving the EU, as various emotional arguments were pitched at the people. The winning side, the ones who voted Leave, fled leaving the job for separation to a marginal and now questionable Remainer. She, Theresa May, promptly adopted a combative stance for separation, affectionately called Hard Brexit. Labour is led by a Far Left extremist occasionally hiding behind a suit and tie but mostly eschewing conventional politics and economics to the extent that he is reviled by his own party. So low was Jeremy Corbyn’s popularity that the Prime Minister decided to hold an early election to extend her slim Parliamentary majority. This she promptly lost by being vague, aloof, belligerent and unprepared, leaving the country with a hung parliament and a billion pound bill to the DUP for a confidence and supply agreement to prop up the Tories, though it is not clear what anyone is confident of supplying except an unconscionable alliance of convenience. Would a proper coalition have cost two billion pounds?

Unemployment has been mercifully low but so has wage growth, slowing most recently to outright decline (of 1.5% YOY). Inflation, so persistently low before has perked up to 2.9%, overshooting the Bank of England’s target. An acutely weak sterling is pushing up the price of imports and diminishing purchasing power. For multinationals and exporters, the weak currency has provided a boost. Sterling assets have also become cheaper to foreign buyers. However, separation from the EU and the common market will present some tricky problems.

If greatness is born in adversity then the current conditions in the UK are certainly hopeful. Some quarters of the UK government had talked of making London a Singapore-Upon-Thames, a problematic idea, though one that certainly highlights the merits of adversity. Singapore’s success was in part fuelled by the existential threat it faced when it was ejected from Malaysia in 1965. The world was simpler then and Singapore was surrounded by resource rich and complacent neighbours, as well as being simply too weak and puny to be a threat in the region. The UK is not so puny or weak, the neighbours are doing well, neither resource rich nor complacent, but a fairly united bloc of determined and well organized economies, in roughly the same level of development as the UK. Competition will be fierce and the prospect of pursuing an independent economic course unnoticed will be difficult.

To succeed, the UK will need unity and pragmatism. It already has know-how and enterprise but it will require unity so that some minority interests will be subordinated to the greater good and pragmatism to prioritize not only objectives but principles. It is not the most natural thing for a liberal democracy but since liberal democratic principles and favour are eroding, why waste a bad thing.

Corporate taxes should be cut. This will be unpopular with many but if they want jobs and growth, corporate domicile is what the country is offering and prices need to be cut. Companies and businesses are welcome, especially super-efficient ones.

Income taxes should be raised. The existing rates for the existing bands should be maintained or even cut but new higher bands should be created with higher marginal rates. The bands and rates should rise sharply.

Defined benefit pensions and healthcare to be partially substituted for a defined contribution scheme. This is to ensure solvency and accountability. Defined benefit social welfare is by nature profligate, insolvent, and opaque. Defined contribution social welfare places the responsibility on the individual, is by definition solvent, and is transparent. Where it fails is as a safety net if individuals have insufficient earnings to contribute in the first place. Hence the need for a combination of defined benefit and contribution schemes.

The creation of a Strategic Sovereign Fund or SSF. The SSF will invest the liquidity and reserves of the sovereign and social welfare schemes along both commercial and strategic lines. To insulate the social welfare scheme from the SSF, the scheme will purchase bonds guaranteed by the sovereign and the sovereign will capitalize the SSF with equity capital. The SSF will pursue an investment strategy to include making a decent return while managing risk appropriately, co-investing in foreign direct investments and investing in strategic industries and countries globally.

London’s firepower as a repository of financial intellectual property must be mobilized, packaged, managed and deployed. Financial technologies once reserved for elite or insular groups such as leveraged finance and structured credit should be packaged and offered as solutions. The SSF will co-invest and make markets where necessary and appropriate to bring sophisticated solutions to a wider world, and help to overcome such hurdles as initial liquidity and scale.

To make Britain great again there will be a load a’ compromisin’, but satisfying everyone will be impossible and clinging to lofty principles and academic ideals while the country suffers as a whole will be a luxury eschewed.

I am neither British nor European, so I may not understand the historical and cultural context of Brexit. However, as an external observer, I can see great difficulties ahead for Britain, some of which I believe will be nearly impossible to resolve.

The UK voted to leave the EU by a vote of 52% for and 48% against. Such an even division of the nation between leaving and staying does not make any course of action, staying or leaving, tenable. Democracy requires that the minority accept the interests of the majority, aligning themselves with the collective decision and making the best of it as a nation united. This is not possible with a 52-48 split. A 4 point majority is a sign of a deep, unresolved divide which needs to be addressed.

The government cannot negotiate on behalf of the nation because it cannot negotiate on behalf of just half of the nation. A responsible government has to recognize that the people need to provide it with a clearer mandate. It’s not about choosing which party will represent it in Brussels, it’s about whom whichever party is in government will represent anywhere.

Whatever the plan, the intention, the objective, it has to be the will of at least 60% of the people, maybe more. And the losing side needs to accept the result and work together with the winning side, as one. Otherwise, democracy has not been done and the risk of repeal, of U turns, of changes of government, will remain.

I do not know what the British people want, but they do not want Hard Brexit, lower living standards, slower economic growth, slower wage growth, faster inflation and loss of access to the Common Market.

The referendum question was: Should the United Kingdom remain a member of the European Union or leave the European Union?

How a question is cast can influence its answer. Especially if the consequences of each option are not well understood. The question, as presented to the people of the UK, was unconstructive and exacerbated the division between Leavers and Remainers. Even the monikers were divisive and perpetuate division. A more constructive expression of the question could have led to a decision which united the people in a common purpose, instead of splitting the nation down the middle.

One alternative expression of the EU referendum question is the following: Should we renegotiate the terms of engagement between the UK and the EU? Such an expression would have united the UK in improving or repairing its relations with the EU. The original question partitioned Britons against one another according to their desire to leave or remain in the EU.

One of the problems to begin with was that the then ruling Conservative Party was itself divided. How could a divided party represent a united nation? The government would be unstable and vulnerable to coups and revolts, or, if it rallied behind a single cause, would lose a substantial portion of support from a divided electorate.

Neither the Conservatives nor Labour are credible candidates for government. Britain needs a new party representing a new reality. It needs a British equivalent to Le Republique en Marche, France’s new ruling party. Britain needs a government drawn from people from all walks of life, professionals, entrepreneurs, civil servants, economic agents other than career politicians. It needs this because the people have lost faith in career politicians. But they have not lost faith in themselves, the nation, or the British people.

The last few years are clear evidence that politicians have been winging it, have no better ideas than to maintain the status quo, to push harder, to follow each failure with more of the same. Politicians are no longer fit for purpose to manage the country. We need fresh blood, fresh ideas and people drawn from all walks of life, of varied experience and abilities.

The mood in Britain has been awful this past year. When the Leave camp won the referendum their leaders did not react with jubilation but with an awkward sense of anti-climax and dread. When Cameron resigned, a multiply-mutinous melee left a reluctant Remainer in charge, who went on to appoint Leavers in important and sometimes perplexing positions. Boris for Foreign Office? Instead of triumph and compromise, the new Prime Minister decides to pursue a brutal and ill-tempered Brexit. And then to call a snap election amidst a surge of popularity (relative to Labour), only to squander it with an ill prepared manifesto which only exposed the lack of vision and diligence, garnished with glib slogans and embarrassing policy U turns, and lose the slim majority Cameron had won.

The economy is still resilient, just. Manufacturing and Services PMIs remain firmly above 50, but are beginning to show signs of weakness. GDP growth at 2.0% is faster than the Eurozone’s. But inflation has risen steadily from 0.5% before the referendum to 2.9% in May 2017. Average weekly earnings have sagged from growing at 1.7% last year to shrinking at 1.5% year on year in April 2017. Sterling, already weak from mid-2014 and across 2015, fell from 1.50 pre referendum to a low of 1.20, a drop of over 20%. The cable has since stabilized but it hasn’t made a substantial recovery; why should it when a hung parliament, a shaky, grubby arrangement with the DUP, hang over the Brexit negotiations. Perhaps it is a cunning plan to encourage the EU to soften their position out of pity. The Bank of England now faces a slowing economy and rising inflation on account of weak sterling, an unenviable position.

And this is before separation.

When the divorce negotiations begin, it will be important to have a clear mandate from the people. It’s still 52/48 in answer to a naïve question with unknown and somewhat misrepresented consequences on both sides. The deal, therefore, will be unacceptable to either the 52, if too soft, or the 48 if too harsh. Such a deal will be hard to accept by the people and will have poor foundation. It is not enough for the people to vote on the deal once it has been crafted but not baked, it is necessary for the people’s intentions in terms of what kind of deal they want, since they will have to live with the consequences, to be heard before the negotiations begin.

This is an opportunity to deepen the divide, or to reunite. It will depend on what and how the question is put to the people. More than the practicality of obtaining a position, it is an opportunity to reunite the people behind a single cause, that of redefining the terms of engagement with the EU. A united front could make the negotiation a more honest, predictable and reasonable one.

Carry on regardless and this opportunity will be lost, any bargain struck, unsafe, and the rift between half the people will be swept under the carpet only to be rediscovered at some point in the uncertain future.

Given the importance of inflation to central bank policy and thus to investors, it is useful to look not only at headline growth rates of CPI but also at the components of the index and the behaviour of each component.

Housing represents 42.6% of the basket. Within that, owners’ equivalent rent, not a cash flow item, is 24.6%.

Which components of CPI are rising?

• Housing is rising at 3.1% for housing, 3.3% for owners’ equivalent rent.
• Transportation is rising 1.8% but mostly due to volatile gasoline prices. New vehicles are flat and used vehicles are falling (-4.2%)
• Medical care is rising at 2.7%. Hospital care is rising at 4.6%.
• Education costs are rising at 2.3%.
• Video and Audio recreation (+2.8%) all other recreation flat.

And which components are not?

• Food and Beverages are flat (+0.9%). Food at home is (-0.2%) with the inflation driven by food away from home (+2.3%).
• Apparel is deflating (-0.9%) and is generally weak.
• Communications including telephony, infotech, hardware and services are -6.3%.

A cursory look at prices in the economy reveals that apart from housing, healthcare and education, most sectors face flat to declining prices. That the housing component is over two fifths of the CPI means that apart from housing, the CPI would be much weaker. A rough estimate is that the 1.9% headline reading would indicate that the non-housing elements were growing at just over 1%.

The Fed has now raised interest rates 4 times since 2015. It intends to raise rates once more in 2017 and 3 times in 2018, if economic data remain constructive. Later in the year, probably September, it intends to normalize its balance sheet by placing caps on reinvestment of bond interest and principal maturing. Yet at the post FOMC news conference last week, Janet Yellen contemplated the concept of raising inflation targets, which would require slowing the pace of rate hikes and balance sheet normalization. In the context of the current rate hiking cycle and the impending process of balance sheet normalization, this appears incongruous. However, in the context of price levels in the economy, ex shelter, this is not so surprising. Accepting this will mean looking at the current rate hikes and balance sheet taper in a new light.

On the fiscal side, if President Trump’s infrastructure and tax plans are passed and implemented, inflation expectations might increase. In that case the treasury would miss the Fed’s transfers of profits from its asset holdings which may take some of the pressure off the Fed to be too hawkish, which seems to align with the Fed contemplating higher inflation targets. This might be a cynical view that the Fed is not in fact independent of the interests of the government. If the tax cuts and infrastructure expenditure plans fail to find approval, then inflation expectations are unlikely to rise.

In sum, bond yields at longer maturities are unlikely to rise significantly.

Can US equities sustain a bull market or even current levels without central bank support? Prior to unconventional monetary policy, the last 2 bull markets lasted from 1995 – 2000, and 2002 – 2007, or roughly 5 years in each case.

What is not so easy to explain is why equities and corporate bonds have both rallied as much as they have when the Fed is no longer expanding its balance sheet and has undertaken a number of rate hikes. This stark acceleration in valuations began in early 2016 and for equities at least, has yet to find a top.

Source* Bloomberg

We ask a number of questions.

If GDP growth fails to sustain current rates or if it weakens, what policy tools can be deployed?

The Fed has never before kept rates this low for this long. While it has made 3 rate hikes to date (12 June 2017), Fed Funds stands at 1%, which was the lowest level in the last cycle before it started hiking in 2004. To cut rates, the Fed has first to raise rates and it has to raise rates with sufficient care that it does not precipitate a slowdown. With growth rates at these tepid levels and interest rates at 1%, the Fed has not much room to manoeuvre.

The Fed began with a balance sheet size of less than 1 trillion USD before the financial crisis in 2008. Multiple rounds of QE later the balance sheet stands at nearly 4.5 trillion USD. Financial conditions and growth have stabilized to the extent that the Fed now contemplates the gradual normalization of its balance sheet. Quite what the normal size of the balance sheet and how gradual the path to normalization should be is not known. The Fed has signalled that it is considering the question and could begin some sort of normalization later this year.

The Bank of Japan’s experience is comforting, in a way. From 1997 to 2005, the BoJ increased its balance sheet by a factor of 1.7X. It was able to reduce its balance sheet by 33% when the 2008 financial crisis struck. Thereafter it increased its balance sheet by almost 4X and it hasn’t stopped. Over the last 20 years, the BoJ has increased its balance sheet size by 7.7X. The one time it shrank it, a crisis emerged, admittedly not of its own doing, within 2 years. The BoJ continues to buy JGBs and has added equity ETFs to the shopping list and does not look like stopping soon. Yet throughout the BoJ asset purchases, rate cuts, and the public debt to GDP rising (from 50% in the early 1980s, to 234.7% currently), no great calamity has been suffered by Japan, except over 20 years of disinflation, and stagnant wages. Unemployment is chronically low, inflation has not risen, the currency has been relatively stable and indeed inexplicably strong, corporate profits relatively robust and bond yields have been remarkably stable.

Of course the Fed would like to achieve better than to limp along and claim that incapacity is victory over death. The US situation may not be as tractable given the open economy and open markets, especially the internationalization of the USD. The BoJ has maintained control over the interest rates because it is currently the proud owner of nearly 44% of the national debt.

Besides monetary policy fiscal policy can be engaged to support a flagging economy. However, it is often necessary to engage both fiscal and monetary policy to tackle flagging growth. Fiscal policy needs to be financed, and the US national debt, while small by Japanese standards is some 104%, which puts limits on how much it can borrow and spend before the Fed will need to help cap debt service costs.

The ECB has a repo rate of -0.25% and the BoJ has a policy rate of -0.10%. Most Eurozone countries are close to or beyond their budget deficit thresholds making fiscal policy difficult at best. The BoJ as noted earlier, is special. Neither region can sustain much negative surprises as policy is already acutely accommodative. For the BoJ, the time at which it may need to cancel some of the JGBs it holds may be drawing closer.

Do asset prices make sense?

This is a very wide and general question. Let’s begin with a few specific examples.

Does a yield of -0.75% make sense for 2 year German bunds?

How about Italian 2 year bonds at -0.36%, or Spain at -0.36%, or France at -0.56%?

Germany probably needs higher interest rates, certainly more than the -0.36% EONIA rate, but what about Italy and Spain? If we look from the point of view of what policy rates each country requires, then the periphery needs low rates to support their economies while Germany does not. If we look from the point of view of credit quality, then peripheral rates should be higher to compensate for default risk.

Does a current PE of 22X make sense for the S&P when it has historically been trading at around 18X? The S&P has only traded at or above 22X during late 1987, 1992 – 1993, 1997 – 2002, late 2009. The period in 1987 ended with a sharp correction. The period 1992 -1993 saw decent returns of circa 5% – 6% annualized. The period 1997 – 2002 saw a return of about -4.5% to -5% annualized. And in 2009, the market topped out at the end of the year and traded range bound till late summer 2010.

It is interesting to note that Nasdaq has tended to trade at high valuations, ostensibly due to the high expected growth rates. On a historical basis, Nasdaq trading at today’s 26X is less over-valued than the S&P trading at 22X. In the years prior to 2008, Nasdaq maintained a steady valuation of between 30X – 33X whereas the S&P traded at between 16X- 18X.

Does the Baa spread of 2.2% make sense given the economic cycle and credit fundamentals? The Baa spread has traded as low as 1.5% in 2007 just before the mortgage crisis. An over accommodative Fed drove spread tightening from 2002 to 2007 before the mortgage crisis all the way up to the demise of Lehman caused spreads to spike to as much as 6.2%. Corporate leverage rose from 2014 to 2016 but has since declined. Default rates remain well contained and recovery rates have stopped deteriorating. It seems that credit is expensive but not egregiously so.

How about leveraged loans? Loan coupon spreads have compressed to below 4% and 60% of the market trades above par. On average, performing loans are yielding a paltry 4.7%. While default rates are 1.3% having recently peaked at 2.17% in mid-2016, loan repricings have topped 200 billion in Q1 alone and could further dampen returns. Loan spreads were steady at 4% for most of 2014 then rose sharply in 2015 into Q1 2016. Since then spreads have come in well below the 2014 levels making the asset class definitely expensive.

Bond spreads are tight as well but whereas the continuously callable nature of loans places a limit on the loan price, so that significant proportions of loans trading above par are a clear sign of overvaluation, such technicalities do not exist for the bond market. We therefore ask if 2.4% spread between Baa corporate credit and treasuries makes sense. Surprisingly the answer is, while the bond market is not cheap, neither is it too expensive. It can be described as moderately expensive. Low end investment grade spreads ranged from between 0.70% and 3.05% from the late 1960s to the early 1980s. The low end of spreads was about 1.4% from the 1980s to 2007, before the big spike in spreads as the mortgage market collapsed. Post 2008, spreads have been trading between 2.1% to 3.5%. In this recent context, current spreads of 2.4% appear tight. However, risk in the financial system has been addressed and reduced, banks are better capitalized, risks are more ring-fenced and contagion risk diminished. Moreover, despite slow growth, corporate balance sheets have improved, companies are profitable again and growth has become more broad-based. One might assert that a central tendency of 1.8% – 2.0% is reasonable in which case the current market is moderately but not acutely expensive.

Parting comments:

The current flow of economic data seem to indicate a world of steady if moderate economic growth on the one hand and of high if not excessive asset valuations on the other. Seen in commercial and economic terms, markets appear to be properly priced in the main with a few exceptions. High valuations do not cause market corrections but imply deeper losses if and when they occur. Exogenous forces could cause a market correction, factors such as politics and policy. The acute inequality faced by many countries leads to less stable governments and less stable social contracts.