Shell Games

Much has been made about the deleveraging of the US consumer since the Great Recession. Most economists agree that consumers are now in much better financial condition thanks to a period of aggressive belt-tightening following that traumatic event. Indeed, there is some truth to that assertion. According to data from the Federal Reserve, aggregate consumer debt fell from 2007 to 2011 before resuming an upward trend in 2012. We are now back into record territory but not if we factor in the growth in the economy and growth in consumer incomes. Consumer debt as a percentage of Gross Domestic Product dropped from a high of 98.5% in 2007 to just 78.0% in 2017. Over the same time frame, consumer debt as a percentage of Personal Income fell from 119% to 92%. Without a doubt, these are encouraging numbers.

While it’s true that lower debt ratios are desirable, nobody seems to address how the deleveraging occurred. The first and most obvious source of debt reduction came from loan write-offs. A lot of consumer debt was wiped away as mortgage foreclosures and other loan defaults were charged off by banks and other consumer finance companies. Though the magnitude of the loan losses was far greater than any prior recession, the process of cleansing the system of bad debt was not unlike any other economic downturn. Investors in banks and other finance companies sustained big losses but the system emerged stronger as banks recognized their losses and fortified their balance sheets with additional capital. In other words, this portion of the deleveraging process represented a normal and healthy aspect of the business cycle, allowing for a fresh new business cycle to begin.

Unfortunately, not all of the slate was wiped clean. As a result of government largesse, huge budget deficits led to a big increase in the ratio of government debt to GDP just as the ratio of consumer debt to GDP was falling. Much of the consumer debt that was accumulated prior to the Financial Crisis was effectively assumed by the Federal government through fiscal stimulus (tax cuts and stimulus spending) and increased transfer payments (unemployment, disability, food stamps, Social Security, Medicare). You can see from the table below that the combination of household and federal government debt remains very close to record territory at about 163% of GDP. If you are like us and believe that US citizens will ultimately be on the hook to pay back that debt, then the consumer “deleveraging” we’ve heard so much about seems a lot less impressive.

Source: Federal Reserve
A similar shell game is going on now. Congress passed another large tax cut in 2017, followed by a generous spending bill in early 2018: a combination which will leave us running trillion-dollar deficits again very soon. If we take a look at the latest projections from the non-partisan Congressional Budget Office (CBO), the federal government’s budget deficit is now expected to rise from $665 billion in fiscal 2017 to $1.0 trillion in fiscal 2020 – an increase of over 50%. In the table below (CBO projections are shaded in peach), we show that the deficits resulting from the tax cuts and spending bill will total $575 billion from 2018 to 2020 as compared to a scenario whereby the deficit remains a constant percentage of GDP at 2017 levels (3.4%). In other words, the fiscal stimulus initiatives passed by Congress will increase the federal government’s debt by $575 billion over three years compared to the status quo.
Sources: Federal Reserve, Congressional Budget Office, and Farr, Miller & Washington
However, the CBO also expects economic growth to accelerate as a result of the tax cuts and spending increases. Real (inflation-adjusted) GDP growth is now expected to accelerate from 2.3% in 2017 (which is very close to the average of 2.2% since the end of the Great Recession) to 3.0% in 2018. The incremental growth in GDP translates to $137 billion of GDP in 2018, followed by $271 billion in 2019 and $242 billion in 2020. The sum of the incremental GDP rise from 2018 to 2020 comes to $650 billion. In other words, the tax cuts and spending bill are expected to generate total incremental economic activity of $650 billion from 2018-2020 compared to GDP growing at the trend rate of 2.2%.
You see where I’m going with this? Yes, economic growth is accelerating as a result of tax cuts and spending bill, but only at roughly a one-to-one ratio with the increase in federal deficits. It’s worth pointing out that the Federal Reserve is currently projecting real GDP growth of just 2.8% in 2018 and 2.4% in 2019, while the CBO’s projections are a much more optimistic 3.0 and 2.9%. Could GDP growth accelerate to the CBO’s projections or even more as a result of the stimulus? Perhaps, but there are significant headwinds – rising interest rates, rising energy prices, the threat of trade wars, weak labor productivity, a rising dollar, weak wage growth and low consumer savings rates – that will likely keep a lid on growth.
We’ve written about the dangers associated with running such high deficits at this point in the economic cycle when unemployment is already below the NAIRU (non-accelerating rate of unemployment). The need to finance rising deficits at a time when the Fed is raising rates and trying to reduce its balance sheet will be a very tricky high-wire act.

In bull markets, it is tempting and gratifying to embrace positive data that reinforce one’s positive, profitable ride. While it is our job to look beneath the headlines (as we have in this article) we are also mindful that the economy is currently sound and growing. With the Dow and S&P500 trading within 10% of their all-time highs, some volatility is to be expected. Yet, none of the downward trends have taken over the market narrative. We will continue to question headlines and feel secure in the research-driven investment posture we favor.