Market Watch - January 11, 2019
Because of recent volatility in the stock market surrounding the election, it is fitting to look strictly at business statistics to help us draw intelligent economic conclusions. The American Institute for Economic Research (www.AIER.org), from a recent issue, provides post election insight: “Mixed results from business cycle indicators suggest continued economic expansion though signs of soft spots are developing. Due to increasing interest costs, and rising prices, the housing market continues to weaken. For now, the outlook is positive, but federal debt and worsening deficits remain a significant risk.”
Public debt is, and has been for thirty years, the greatest risk to our economy. The private sector is in the best shape in the history of the United States, save the pending student loan crisis. The federal government, however, is so debt laden, and deficit dependent, that continuation of this behavior is bound to create a major financial catastrophe at some point.
Question: How can we tell if either the public or private sector is doing well, or not; is solvent, or not?
Answer: The federal government has debt of $21.5 trillion, as compared to a GDP of $20.5 trillion. Debt is 105% of GDP. Every economy in history, with a debt to GDP ratio over 100%, has failed.
On the other hand, the private sector shows U.S. net worth of $107 trillion, net of $16 trillion of debt (65% of which is mortgages). Private sector debt is only 15% of the country’s net worth.
Question: With an increase in both interest rates and the deficit, what is the effect on the government’s current expenditures?
Answer: In 2018, the federal government spent $459 billion on interest payments. That represents interest costs to the federal government of 2.2% on the $21.5 trillion of debt currently existing. Coincidentally, the Fed’s current discount rate is 3%. Over the years the Fed has increased the discount rate to 6.5%, on average, to dampen increases in inflation. From that 6.5%, the Fed has then cut rates an average of 4%. If rates double from their current base, interest costs alone on the federal deficit would be $1 trillion. Should rates get to that 6.5% benchmark, the current cost of carrying existing government debt will exceed $1.4 trillion. This would be a difficult situation for the economy.
Question: At this moment we are forecasting a revised federal deficit exceeding $985 billion this year. The deficit appears a greater problem than China when one considers that what we purchased from China last year only amounted to $505 billion. Could the deficit really be twice the amount of our business with China this fiscal year?
Answer: The answer is yes. This fiscal year has already started badly with the government’s first month showing a $100 billion shortfall. Most economists believe the federal budget will exceed the $985 billion revised federal deficit forecasted. Currently, at the rate expenditures are exceeding the budget, the deficit will probably end up double the amount of trade we did with China last year.
Question: It is well known that steel production is essential to military strength. Ditto intelligence. China makes 50% of the world’s steel. Can China’s dominance in steel production hurt us, and how do the Chinese steal our intelligence?
Answer: China’s production of 50% of the world’s steel, coupled with the U.S. importing 30% of their steel, puts us at a military disadvantage. That could be quickly ameliorated because we are already seeing huge investments in steel in this country as a result of the tariffs. U.S. steel just announced $750 million to modernize facilities in Gary, Indiana. Other producers have announced large capital investments.
As to stealing our intellectual property (IP), it was learned a few months ago that China had installed a chip in a processor that allowed them to spy on thirty U.S. high tech companies. China makes 75% of the world’s mobile phones and 90% of its PCs. Chips had been inserted during the manufacturing process. Coincidently, two officials from the People’s Liberation Army were supervisors. The U.S. takes a dim view of this behavior.
National security advisor John Bolton warned China on November 13th against further machinations in the South China Sea. Interestingly, this came right before a well-publicized, and well-known, Trump meeting with the Chinese president, supposedly about tariffs. Underneath the table is the real issue, and it’s the Chinese military, and Chinese lying, cheating and hacking.
Question: Oil is falling fast. Why is this, and how will it effect our economic situation?
Answer: The world uses 80 million barrels of oil daily. The U.S., Saudi Arabia and Russia are the three biggest producers with the U.S. producing just over 11 million barrels a day, Russia at about 11 million and Saudi Arabia just under 11 million. The next four largest producers harvest 4 million barrels daily; and they are Iraq, Iran, China and Canada in order of production, all of which are out-produced by Texas. Anticipation of sanctions on Iraq caused other producers to ratchet up production, which glutted the market with excess supply. The good news is that the lowering of the cost of fuel helps offset increases in both interest costs and any increased tariffs we pay on imports.
Interestingly, Saudi Arabia is threatening to withdraw from OPEC. Enemies surround them, with whom they are constantly at war, and with whom continued OPEC cooperation may no longer be in the Saudi’s best interest.
Question: The financial press have published articles lately about program trading and the potential for large market crashes. Is there credibility to this fear?
Answer: There is credibility to the fear that program trading can help create large swings in the market. However, because more than 70% of trading is program trading, governing authorities recognize potential for disaster and have therefore put stops on downward prices. A security can only drop so much and then the market closes in that security. These have been used in various forms in the past, called Market Circuit Breakers. If there has been any success, it is because trading calms down after the market is closed and emotions get sorted out. In past crashes, the market reverses itself when it becomes obvious that economic conditions are brighter than the market’s reflection of those conditions. Those are usually called “buying opportunities”, which some analysts are calling this market.
The most notable of analysts works for J.P. Morgan Chase. They express concern that great selloffs will create a liquidity crisis because investors who purchased stock by using a lot of debt will not be able to pay either their debts or the interest on the debt. They postulate that should such an event occur, the Fed, as has happened in other countries by other central banks, would step in and purchase stocks to stabilize the market.
Like the “Y2K” scare, this has been game-planned so many times, and thought through so thoroughly, that it’s unlikely to occur. One step to help prevent such a disaster is increasing interest rates. Most of the program traders are operating with a lot of debt. Profit margins for traders become more difficult as interest rates increase, because profits to begin with are very thin. They make money on volume. If interest rates go up, volume goes down and traders slow down. Hence, speculation is reduced, and that is always good.
Summary:
Statistical evidence indicates the economy will continue to thrive. Among great economic news: there have been 99 consecutive months of job growth; wages are up 3.1% the last 12-months; December posted record job gains of 312,000; and the Fed has indicated there may not be the rate increases this year that had been previously discussed.
Americans have doubled their savings since 2007. Corporations continue to report record earnings. The U.S. consumer purchased a whopping 16% of the entire world’s goods and services last year, representing $14 trillion of U.S. GDP. Most importantly, the U.S. consumer, who every country in the world is courting, has the fattest savings accounts in history, and U.S. job openings exceed workers looking for jobs for the first time in 17 years.
Times are good. It is too early to tell if the market sell-off recently was because of the political situation, or because of the economy. It appears that the political disruption was the major reason for the market’s recent decline; however, corporate earnings will soon start to be released for 2018. These results, plus the first and 2nd quarters of this year, will probably dictate the direction of the market. Right now is a good time for the cautious investor to be wary, sit on the sidelines, and see what happens.
George Rauch
January 11, 2019
