September 08 2023

Turning Off the Tap

Last week I was asking whether one could gradually wean off QE and an era of abundant and cheap money. Why is it important? the economy has been on steroid support since the great financial crisis in 2007, and since then in 2012 and 2020 again. There seemed to have been no coming back, and once the liquidity taps were opened, they proved difficult to close. Yet, something singular has been happening post covid: the return of higher inflation.

Symptomatic from a heated economy, inflation further stretches social disparities as asset prices go through the roof and affordability wanes. It therefore prompted the Fed to start meaningfully raising rates for the first time in ~15 years in 1Q22, and downsize the federal balance sheet.

From the inception of the great financial crisis in 2007 to now, these 3 categories of support expanded:

  1. Government spending through stimulus packages
  2. Expansion of Fed’s balance sheet
  3. Accommodative monetary policies, typically low rates

Government spending as % of GDP had been hovering around 20% since WWII until it shot up to 25% during the GFC, normalized again from 2014 to 2019, then reached a peak of 31% during the covid pandemic. In 2022, it was still standing at 25%, and spending from Oct22 to July23 was $5.3TN, trending at 10% higher than the previous year, far outpacing US GDP growth. It is likely that the % will stay high in 2023, meaning that the Government contribution to economic growth is still in exceptional territory. The $400bn Inflation Reduction Act is only the latest case in point.

Inexorably, national debt as % of GDP increased from 64% in 1Q18 to 120% in 2Q23. Interests now represent about 2% of annual GDP.

Concomitantly, Federal balance sheets swelled to absorb excess supply of government debt, from under $1tn in Jun08 to $8tn in Sept23. We are certainly past recent peak, but a long way from even 3 years ago.

Well, is that a problem ? In a sense, not so much as long as the world runs on USD, and US economic growth keeps ticking along. At a 5% rate, investing into arguably the safest assets on earth makes for a nice risk-return, so much so that foreign countries hold 23% of US debt, or $7.6tn. I voluntarily save the debate of the US waning global influence, along with de-globalization for another time.

So, at what point national debt becomes too much? Like with everything, it is only a question of liquidity. As long as you can find lenders, you can kick the can down the road, almost with no regards to decaying financials. Some US households or corporates might not be so lucky. As high rates start to bite into refinancing walls, I hear a lot of reluctance from investors and banks to lend to lower credit quality.

Yet again, there might just be another pressing occasion for the US Government to crank up the support. Markets seem hooked up on this idea that support will come again, as forward interest rates suggest. There remains that the coming 12 months would be a lot more stressful for families and companies who don’t have the luxury of a good credit standing.

Stay safe out there !

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360 Advisory LLC is a Boston-based RIA managing investments