Economic data have been phenomenal lately, lifting the U.S. stock market to new highs as investors celebrate an end in sight to the global nightmare of the past year.
And so it’s an awkward time to be a killjoy, even if just hypothetically.
The fiercest debate among market participants this year has revolved around inflation—will it or won’t it be more than transitory—and the Federal Reserve—will it or won’t it find itself behind the curve? But what if that framing is wrong? What if the bigger question is whether growth is transitory, and if it is, then what?
For its part, the Fed has acknowledged better-than-expected economic improvement while hammering the message that any corresponding rise in inflation will be fleeting and a full recovery distant. “Most participants indicated that the pandemic continued to pose considerable risks to the economic outlook,” including risks stemming from more-contagious virus strains and social-distancing fatigue, the Fed’s rate-setting arm said in its March meeting minutes published on Wednesday.
As many economists and investors dismiss such trepidation and revel in a Roaring ’20s repeat, some warn that the recovery so far is flimsy, built on massive fiscal and monetary stimulus and astronomical leverage that present the mirage of a fast-improving economy.
“Everything we’re seeing is temporary,” says David Rosenberg, chief economist at Rosenberg Research. He predicts a growth slowdown by the fourth quarter that he says may not start to worry investors until August.
Set aside, for now, the strong jobs report, purchasing managers indexes, and consumer confidence readings over recent weeks, and even the hot producer-price index reported on Friday. Take a step back and it’s clear just how linked consumer spending— which represents about two-thirds of gross domestic product—has become to what is supposed to be emergency fiscal aid. Monthly retail sales figures tell the story of spending, which has become reliant on household checks that started last year, ebbing markedly between rounds.
Then, consider the consumer credit report released on Wednesday that showed a much bigger-than-anticipated $27.6 billion boom in February. That surge in credit, the biggest one-month increase since November 2017, comes as loans worth $2 trillion entered forbearance during the pandemic, allowing more than 60 million borrowers to miss $70 billion on their debt payments by the end of the first quarter of 2021, according to a group of economists led by Stanford University’s Susan Cherry.
In one sign of trouble, recent reports say 1 in 10 subprime auto loan borrowers are now more than 60 days’ delinquent, the highest on record. In another sign of excess, margin lending is exploding. Investors as of late February borrowed a record $814 billion against their portfolios, the fastest annual clip since 2007 and up 49% from a year earlier, data from the Financial Industry Regulatory show. And in yet another sign, buy-now-pay-later company
(ticker: AFRM) in its most recent quarter reported 4.5 million active customers and $2.1 billion in gross merchandise volume—up 52% and 55%, respectively, from a year earlier.
The consumer piece of the overall debt picture is, of course, just the tip of the iceberg. “Everybody’s focused on the reopening party,” Rosenberg says. “My mind goes back to the Fed not being able to raise rates because of leverage,” he says, referring to corporate debt and the Fed’s inability to lift interest rates above 2.5% during its last tightening cycle, only to immediately follow with rate cuts leading up to the pandemic. “And now that leverage is on steroids.”
In a recent investor report, economists at Citigroup flagged global debt-to-GDP ratios that are surpassing World War II peaks for advanced economies and hitting new highs for emerging market economies. As for the U.S., Fitch Ratings said in March that federal debt will approach 109% of GDP this year, while general government debt will reach 127% of GDP in 2021, before surpassing 130% by 2023. Analysts there wrote that very low interest rates, which have held down debt-service costs, will eventually rise despite the Fed’s commitment to an extended period of extremely accommodative monetary policy.
Catherine Mann, Citi’s global chief economist, warns of such a feedback loop. She says that as long as the rate of economic growth exceeds real, or inflation-adjusted, interest rates, investors shouldn’t be overly concerned with high debt-to-GDP ratios. That’s currently the case. But the problem is that you don’t know when markets will start to signal that debt is on an unsustainable path and require higher rates, she says.
Therein lies the conundrum. In the context of the feedback loop Mann describes, where the cost of servicing debt becomes much heftier, the Fed could decide to wait longer to raise rates in order to avoid exacerbating the situation. That would presumably help facilitate the assumption of even more debt, and it begs this question: If the Fed’s ability to lift rates is more constrained than investors appreciate, then what?
To Rosenberg, a so-called debt jubilee is the inevitable outcome. Under this scenario—effectively a default through hyperinflation—the U.S. Treasury would put a large sum on the Fed’s balance sheet and the Fed would then print the money. Behind Rosenberg’s logic is the idea that the Fed has become increasingly aggressive with its tools, probing the outer limits of monetary policy with each cycle and raising concerns over how it will fight the next downturn with rates at zero and so many unconventional measures already deployed.
Regardless of whether something as extraordinary as a debt jubilee is in America’s future, one thing is clear: The growth necessary for the U.S. to get out of a precarious debt-to-GDP situation is far from guaranteed. The “right” kind of spending and debt that juice things like productivity and capital investment will help fortify the economy. Spending and debt that isn’t so strategic, however, will erode the growth required to keep high debt levels sustainable.
For now, it might serve investors well to shift some focus from the inflation side of the economy to the growth side. While economic growth looks excellent on the surface, the very things driving it appear a bit toxic.
Write to Lisa Beilfuss at [email protected]