In his first testimony to Congress this week, new Federal Reserve Chair Jerome Powell argued that the U.S. economic outlook is positive. He cited “the robust job market” boosting consumer incomes and spending, strong growth in other countries helping U.S. exports, and the “stimulative” recent U.S. tax reform.
Not so fast. The recent return of volatility to markets should remind us we won’t be able to call the next economic crisis a “black swan” when it hits down the road, because the elements are already in plain sight: a dangerous cocktail of rising consumer, corporate, and sovereign debt scheduled for refinancing; rising interest rates; and increasing global competition for investors’ attention.
We can’t ignore the enduring problem of unemployment and underemployment. While the Bureau of Labor Statistics lists the unemployment rate at 4.1%—a 17-year low—the seasonally adjusted U6 unemployment rate, which takes into account eligible workers who can’t find full-time jobs and those who have given up trying altogether, stands at 8.2%. The fact is that automation and other technological innovations are accelerating job displacement, reducing costs, and increasing corporate margins and profits. This benefits investors with the liquidity available to participate in financial markets, but certainly not average families living from paycheck to paycheck, or without a paycheck at all.
While Fed policies helped household balance sheets to deleverage after the 2008 financial crisis, they did so by effectively transferring household debt to corporate and sovereign balance sheets, paving the way for higher interest rates. Outstanding non-mortgage consumer credit has risen by 45% since its previous peak in 2008, now approaching $4 trillion. Global nonfinancial corporate debt increased to 96% of global GDP between 2011 and 2017, with some 37% of global companies now deemed to be “highly leveraged,” (meaning they have a debt-to-earnings ratio above five-to-one) up from 32% in 2007, according to Standard & Poor’s. And the level of margin debt used to buy securities has doubled since 2011, to a new all-time high of $643 billion. Nearly one in five American companies now qualify as “zombies,” meaning that earnings before interest and taxes don’t cover interest expenses.
Assets under management in loan exchange-traded funds (ETF) are up by 42% over the past two years, from $110 billion to $156 billion. Bank loans are illiquid and slow to settle, while the ETFs that own them are immediately redeemable, a liquidity crisis in the making.
All of this suggests a new cycle of distressed corporate credit looks to be just around the corner, and recent tax reforms limiting corporate interest deductibility won’t help. Nor will the upward pressure on rates that will come about as the tech giants begin liquidating their $700 billion holdings of corporate debt to enjoy the tax benefit of repatriating cash to the U.S.
Then comes the Treasury market. The last global economic crisis hit when hundreds of billions of dollars of mortgage debt went bad on bank balance sheets, and governments bailed out the banks to save the financial system—effectively underwriting and nationalizing the debt. The next crisis might start with a loss of confidence in governments’ practice of printing money to service their own debt—a process gaining momentum as foreign government buyers of U.S. Treasuries shift to purchasing their own sovereign debt, and private sector institutions begin adopting cryptocurrencies, though the latter process is still in its early stages.
It’s a basic matter of supply and demand. The U.S. presently owes $20 trillion in outstanding Treasury debt, all of which is scheduled to be refinanced over the next eight years. And this doesn’t even take into consideration the recent tax reform’s projections of another $1 trillion increase in Treasury issuance in 2018, and likely the same for the following year. As our Federal Reserve finally starts unwinding its “extraordinary accommodations” it seems appropriate to wonder, “Who will be buying them?”
The Fed held $2.45 trillion of outstanding U.S. Treasury debt at the end of 2017, roughly five times more than the $500 billion it held before the financial crisis and before additional issuance contemplated by the Tax Cuts and Jobs Act. Foreign nations hold $6.3 trillion, almost half of which is in the sovereign hands of China, Japan, and Saudi Arabia. U.S. commercial banks now hold $2.5 trillion, up 127% from January 2008. In the past 15 years, global debt-to-GDP has risen by over $100 trillion to $217 trillion, or 327% of global GDP as of January 2017.
China and Japan’s central banks are increasingly refinancing their own debt. As China also bypasses the U.S. as the world’s largest oil importer, Saudi Arabia (a top 15 holder) is also being paid in yuan instead of dollars, and therefore has less reason to buy U.S. Treasuries. As the European Central Bank follows our Fed and normalizes policy rates, it stands to reason that euro issuance will compete with America’s in sovereign refinancing markets. Whether commercial banks will roll over their maturing debt is anyone’s guess, given the revenue headwinds those institutions are facing from financial technologies, and the likely availability of higher yields available to U.S. institutions from corporate lending opportunities.
While the U.S. dollar and Treasuries may still be, as bond investor Bill Gross used to say, “the cleanest dirty shirt” in the global monetary system, is it reasonable to assume that this will be good enough? The conclusion of leading policymakers, academics, and market economists at February’s annual Monetary Policy Forum sure implied that it won’t be: Their consensus was that we don’t really know whether “extraordinary” monetary policy did much, if anything, to help the economy over the past 10 years.
House Speaker Paul Ryan aptly declared in 2012, “In this generation, a defining responsibility of government is to steer our nation clear of a debt crisis while there is still time.” The next recession might be a whopper, with rising interest rates on historic debt levels. But just wait until the $100 trillion of as-yet-unfunded U.S. Medicare and Social Security obligations we’ve left for our children comes due.
Buckle up, because there’s even more debt in the global system than there was at the start of the 2008 financial crisis—only this time it’s corporates and sovereign governments that own it. Who will be left to bail them out when the bill comes due?
Daniel J. Arbess is the CEO of Xerion Investments, a co-founder of No Labels, and a lifetime member of the Council on Foreign Relations.
