A good friend of mine, who is the one I bounce ideas the most with, asked if it was possible to do a guest post. Without this guest, my discussions and investment ideas over these years would not have been the same. So I’m very happy to present some Macro thoughts from my friend – the first guest poster!
Has the US debt cycle come to an end?
Until this week, the equity market has been holding up fairly well despite the trade war, slowing demand in China and Brexit. But there is something on the horizon that suggests we should sell
equities and wait for a better entry point – the debt cycle in the US seems to have come to an end. A rate cut from the FED during the second half of 2019 would confirm that theory and should be a negative catalyst for equities.
I’m sure many of you have read and heard about Ray Dalio, founder and co-CIO of Bridgewater, one of the largest hedge funds in the world. He describes how the “economic machine works” through the debt cycle. Simply described; both companies and households spending consist of two factors; Income and Credit. Income tends to be fairly stable, growing a few percentage points per year, and is the base of a households´ and companies spending. Credit on the other hand tends to vary over time, perhaps you use credit to buy a new, larger house, or a new car while a company might use it to expand manufacturing capacity. Thus spending can increase faster than income by using credit.
A person’s spending is another person’s income – an important aspect in a debt cycle. This means if you are using credit to consume, another person’s income will increase. With increased income the second person can increase their credit thereby expanding their spending power. This chain of events can continue for years, until the debt cycle stops i.e. when households and companies stop expanding their borrowing. As the cycle turns and less is being spent due to lower credit growth, it means another person’s income is falling. That person will therefore not be able not borrow as much since their income is falling thus decreasing their spending power. The chain of events goes both ways creating the debt cycle. You will find a great summary of Ray Dalio’s theory of How the Economic Machine works here:
I’ve thought a lot about this and tried to quantify the debt cycle with the help of the 3m US treasury yield. We start with the simple assumption that if the demand for credit is high, the price of credit i.e. the interest rate, will rise. When demand for credit slows the interest rate goes down. The reason I’m looking at the 3 month yield is that it says a lot more about the credit demand right now compared to for instance the 10 year yield which factors in a lot of expectations about future inflation and economic growth.
By looking at the y-o-y change in the 3m UST yields we can see how the demand for credit has changed over the last year. This is what we typically do when looking at a company`s specific data, we compare the order book, revenue and EBIT with the same quarter last year to see if it’s gotten better or worse. The chart below tells us that the 3m UST yields are about 50bps higher than a year ago, meaning demand for credit has gone up.
S&P500 vs 3m UST y-o-y (bps)
US Corporate Debt growth y-o-y (%) vs 3m UST y-o-y (bps)
A general thinking when looking at Capital Goods companies is that when the second derivative in organic order growth turns negative it’s usually a good time to sell the stock. It tells us demand is about to stabilize i.e. order growth will go towards 0%. In the same way a positive second derivative, when organic order intake is negative, would be seen as a sign that order growth is about to
improve.
Applying the same methodology on the 3m UST yields a negative second derivative would tell us that the demand for credit is slowing, a strong indicator the debt cycle is coming to an end. The y-o-y change in the 3m UST started to stabilize by mid 2018 and has recently started to go down as a result of the lack of rate hikes from the FED. The Fed Funds futures market indicates we will have at least one cut from the FED during the second half of 2019 and another one in 2020. A cut in interest rates from the FED in the second half of 2019 would confirm the end of the debt cycle which would mean the start of a bear market.
FED FUNDS Future Aug19-Dec19
S&P500 vs 3m UST y-o-y (bps) including a rate cut in October
Btw, seems as the debt for automobile credit is also piling up and getting unsustainable… :-s In materials science, systems under stress crack (fail) at their weakest link. I wonder which will be the weakest link in the global economy now.
What data are you referring to and in which countries?
must be US auto credit…
https://www.theguardian.com/business/2019/jun/22/investors-demand-dividends-push-us-to-disaster-corporate-borrowing
Dangerous practices… https://www.theguardian.com/business/2019/jun/22/investors-demand-dividends-push-us-to-disaster-corporate-borrowing
Yes that is interesting. Something I’m looking into currently and to me is a big concern is the amount of money, especially pension money, that has been allocated into Private Equity. Private Equity owned company are leveraging up, typically using the leveraged loan market, loans that is later bought by Collaterized Loan Obligations (CLOs). Not surprisingly Private Equity is also active in managing CLOs. Those two articles summarises it well. This is one of my main concerns with “the US debt cycle coming to an end” as it’s a sector with low transparency, high risk asset class and a asset class institutional investors have significantly increased their allocations to over the past few years.
https://www.economist.com/briefing/2019/03/14/should-the-world-worry-about-americas-corporate-debt-mountain
https://www.bloomberg.com/graphics/2018-collateralized-loan-obligations/
Thank you for sharing your opinions.
I would argue against some statements made:
1. “A rate cut from the FED during the second half of 2019 would confirm that theory and should be a negative catalyst for equities.” <— I would argue that a rate cut would be a positive catalyst for equities because interest rates are to stock prices what gravity is to matter.
2. "We start with the simple assumption that if the demand for credit is high, the price of credit i.e. the interest rate, will rise. When demand for credit slows the interest rate goes down." <— This makes sense in theory if money supply isn't controlled by the Fed (or other monetary 'authority'). However, because the powers that be depict the interest rate (by setting the federal funds target rate), I would argue that it's the case of the tail wagging the dog (interest rate levels determining borrowing demand), not the dog wagging the tail (borrowing demand determining interest rates)
I conclude:
There are always unintended and unexpected consequences for every economic action, so no predictions can be 100% certain (if an economist can successfully predict 2 cycles he wouldn't had to have a job and we wouldn't be reading his predictions). You may be right and I may be wrong, but as Warren Buffett said, "Predicting rain doesn’t count. Building arks does." Building arks means to say being prepared; to have more drypowder—some 15-25% of portfolio in cash as the market starts to get tumultuous. I personally wouldn't be fully invested nor be fully disinvested as the author suggests ("we should sell equities and wait for a better entry point") because in the case of the latter, you would be missing out earning 8-9% return on equity per year (assuming your portfolio of companies make on average 8-9% return on equity) by staying on the sidelines.
Thanks for your thoughts.
1. I believe many market participants share your view and it’s exactly the view I’m trying to challenge. I think a more relevant topic to discuss is why they have to cut, which I share my view of in the post.
2. Here is where our views separate. I believe Central banks globally closely monitor market pricing and are willing to follow what the market tells them. This is what the FED has done for many years now. The U-turn from the FED at the beginning of the year was clearly a move based on the reaction of equity markets showing that they were not prepared for more hikes. In my mind central banks control supply of credit, not demand. I’m suggesting the y-o-y change in 3m UST is a good indicator of demand, and history tells us one cut has never been enough to change that trend in the same way as a capital goods company never been able to change its demand just by cutting prices by 5%.
I fully agree we can’t be 100% certain with any prediction. I also agree that no one should be fully divested, but right now it makes sense to “sell equities” / hedge tail-risk/take down risk (or whatever you want to call it) and wait for a better entry point.
The next question is where capital allocation has been inefficient, but I leave that for another blog post.
Thanks again for your thoughts.
1. Exactly right, the eurodollar futures already imply at least one cut until Dec, so that’s what the market thinks. The question is however, what this implies for the equity markets. Is a cut priced in erroneously? Is it priced in at all? Very hard to judge.
2. The FED indeed monitors a range of economic and financial indicators including employment data, credit spreads, yields, the yield curve, etc.
But the FED does not control the amount of money at the moment. They operate a floor system with as much reserves as the banks demand in contrast to a pre crisis corridor system where the amount of reserves was daily tightly managed. The “floor” is the IOER, interest on excess reserves.
To the author, very interesting post and approach, thank you. I would just add that the 3m UST can not only indicate credit demand but also supply, for example the treasury has predominantly issued short term bills to finance its fiscal deficit unter the Trump administration.
Brilliant!!! First time seen that. Great innovation in the format !!!! Bravoooo !!!