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The Fed's Catch-22
Americans have always spent beyond their means.
It feels like it’s a part of our DNA.
The idea of keeping up with the Joneses is alive and well.
Look across the street. Know that person makes as much as you. Yet has so much more “stuff.” Whether it’s a nicer car. A vacation home. Nicer clothes.
Then wonder, ‘how can they afford that?’ The most probable answer is obvious.
Debt.
Auto loan debt. Mortgage debt. Credit card debt. Buy now, pay later debt.
Below is a chart highlighting Americans’ total debt balance, broken out by housing debt and non-housing debt.
(Source: New York Fed)
Americans hold $841 billion in credit card debt. According to NerdWallet, 1 in 5 Americans (20%) report increasing their overall credit card debt during the pandemic.
Before you go judging about which generation has debt…
(Source: ElitePersonalFinance.com)
Here’s auto loan debt… which stands at $1.4 trillion:
(Source: St. Louis Fed)
We could go on and on.
There’s little financial prudence. Americans spend their income the second they earn it. No savings whatsoever. More than 1/2 the country has less than $500 in savings.
(Affordability or the lack thereof is a huge issue. One we, of course, acknowledge. But it’s obvious Americans tend to spend more on “wants” vs. “needs.”)
Even American businesses have a hard time spending below their means. Corporate debt sits at almost $12 trillion.
(Source: St. Louis Fed)
Debt of all kinds only goes one direction… up.
The large — main — culprit was effectively being able to borrow money for free since 2008. When the Federal Reserve cut interest rates to zero.
Free money distorts every asset class.
Every asset class hit record levels last year. Stocks. Bonds. Crypto. Real Estate. Art. New and Used Cars. Watches. Collectibles.
That’s the result of free money, plus giving people stimulus checks, then forcing them to stay home.
For example, it allowed record-breaking mergers and acquisitions. Here’s what we said on November 23rd, 2021 in our note Why Corporate Debt Is At All Time Highs:
“When money is free, there’s no financial risk for companies to acquire others.
Let’s say Apple wants to buy another company for example. It could pay for the company with cash in the bank. Issue debt. Or issue equity and dilute shareholders.
How does Apple choose? It’s got around $200 billion in cash on its books. And it produces around $80 billion in free cash flow each year.
So it could acquire a company with cash in the bank plus the profits it makes selling its products. So it doesn’t need to issue equity and dilute shareholders.
But what about debt? Earlier this year, it issued $14 billion worth of bonds. Included were $2.5 billion worth of 5-year bonds with 0.7% interest. And $1.75 billion worth of 50-year bonds at 2.8%.
That means it’s paying just $175 million per year in interest on those five year bonds.
Apple makes $200+ million in free cash every day.
Meaning the cost to borrow $2 billion is worth one day's operating free cash flow to Apple... Aka there’s literally no consequence to Apple borrowing money.
It’s why if you take a look at Apple’s balance sheet, they’ve gone from $0 in long term debt to $110 billion over the past 8 years.
Apple never needed to borrow a single dollar. They did because they could. Why not borrow money if it’s practically free?
Expand this across the globe and you can see why corporate debt is at all-time highs. With companies still borrowing record amounts of money… and using it to acquire others. Easy formula. Borrow money for free. And acquire fast-growing companies.
Should that acquisition not work out… no biggie. It won’t cost you. You practically borrowed money for free.
This is how 0% interest rates are distorting the free market.
There should be a risk to borrowing money. But that’s not the case anymore. Not since 2009 when the Federal Reserve dropped rates to 0%. Eventually things will end badly. Interest rates will go up. Companies won't be able to refinance their debt.”
Inflation is running rampant.
The Fed can’t control supply chains. They can only control demand by removing the free money punch bowl.
This is why they’re forced to raise rates and shrink the balance sheet.
They’ve even mentioned hiking rates above the “neutral rate” to curb inflation. The neutral rate is just the interest rate at which the economy can stand on its own.
How high that is remains to be seen… but it’s what’s causing all markets to go down.
Investors are freaking out because we’re in a new policy regime. One where the Fed is committing to raising rates until inflation comes down. That’s the exact opposite of the Fed’s actions the past 20 years.
The cost of debt is going up. No one will be able to borrow money for free anymore.
Individuals. Corporations. And the government.
Federal debt sits at over $30 trillion.
(Source: St. Louis Fed)
It was $6 trillion just ten years ago. In fact, we’ve effectively doubled the rate of Federal debt over every decade since the 1970s.
(If you were the bank and the government was a client… how long ago would you have cut them off?)
With interest rates rising, the government has to pay more in interest on all of its debt.
According to the Congressional Budget Office, the U.S. government paid $345 billion year in interest payments alone in 2020 — equal to 1.6% of GDP. It accounted for 5.3% of total spending.
That number will only go up as interest rates rise. Every 1% increase in rates adds $70 billion to the deficit.
Meaning that money can’t go elsewhere such as healthcare, social security, etc…
All of this debt will be more expensive. All of this debt is/will start to unwind. Credit card. Auto. Corporate. U.S. government.
No one knows how far the Fed will go. Which is what’s causing such violent moves. Most to the downside.
Stocks are off to their worst start in decades. Bonds are off to their worst start ever. Crypto is imploding. Real estate is slowing down at multi-decade lows.
Something will break.
We’ve cautioned our readers and clients time and again. A good summary of our cautious tones can be read in our April 26th note What Do We Do Now?
We then spoke about the ripple effects of this new policy regime. Most recently, in our May 31st note The Ripple Effects… Accelerated.
Layoffs are on the rise… especially in the technology sector.
Netflix, Peloton, Tesla, Robinhood, Playtika, Carvana, Klarna, Latch and hundreds of public and private companies have laid off workers this year.
Hiring freezes have been implemented at Amazon, Microsoft, Coinbase, etc…
This is just the beginning.
And it’s the catch-22 of the Federal Reserve.
Raise interest rates to curb inflation… but put millions of people out of work.
Both cause recession. It’s just a matter of what type of recession we’ll get.
Every recession is different. But the pain is all the same.
However, these recessions bring once-in-a-decade buying opportunities.
Ones we’re starting to see. And ready to pounce on. But we’re only at the tip of the iceberg. And we think there’s likely more downside left because we won’t know how far the Fed will go.
The point is to prepare for the opportunity. Not to predict it.
The Fed got us into this mess. Now they’re trying to get us out of it.
No decision they make is the right one. Meaning we’re going to see more pain before things get better.
Don’t get caught flat-footed. Or try to play hero by catching the falling knife.
Spend, save, and invest wisely.
Good investing,
Lance
P.S. Our Mighty Portfolio was built on three pillars: Disruptors, Trophy Assets, and Income/Hedges.
A three-legged stool can’t stand without all three legs. Take one out, and the stool falls.
These three pillars give us the ability to extend our time horizon for years...
We’d love to have you join Mighty and let us help you navigate these markets. Reply back and let us know if you’d like to set up a call.