Trump’s Greatest Challenge

…will be restoring the American economic machine to its former glory. To the extent he is able to achieve this, a lot of ills that may crop up elsewhere may be forgiven. Trump’s economic progress will be especially important from a political sense given the fact that Trump is the ‘change’ candidate. He ran, and was elected on a promise to shift away from the status quo in all aspects. Should the Trump economic doctrine fail, it will poison the anti-status quo rhetoric which won him the presidency for decades to come. It will potentially open the door for a complete and total return to power for the ‘establishment’ forces in a way that may be more damaging than if Hillary Clinton had won instead. That underscores how important it is for Trump to get the economics right.

As I write this, we are in the midst of a post-election victory haze which has seen the stock market make new highs virtually on a daily basis. Stock in commodities and manufacturing have risen by upwards of 50%. Trump himself has lauded the reaction in stocks since November 8 as a validation of his election.

In some ways he is correct. Should he enact his policies, especially the cutting of corporate taxes and reducing regulations, the business environment in this country will improve, which will lead to greater profitability and thus higher stock valuations.

The issue is that the market correctly assigning higher stock valuations to publicly traded companies is happening in an environment in which these valuations were already in the realm of the absurd. Indeed, Trump himself lamented the fact that the stock market was in a giant bubble on the campaign trail, calling it a ‘false’ stock market. Now that he has won, and stock prices have rocketed even higher, Trump is being inconsistent in his praise for what can only be described as the bubble getting even more absurd.

What has driven this bubble to its current heights has been the torrent of debt unleashed on the economy over the last 7+ years. This debt, in turn was facilitated by the depressing of interest rates to levels not seen in the history of the developed world, for nearly a decade, without interruption. Sticking with the United States, the Federal Reserve quintupled the size of its balance sheet, which enabled the totality of credit outstanding to continue to expand, in the manner it has done for the better part of four decades.

The result has been the restoration of the 2008 bubble, the popping of which led to so much destruction. What is important to note is that this bubble, like all bubbles, will pop. The only question is the needle which pricks it. It very well might be the Federal Reserve, which is set to raise interest rates at its meeting next week. It might be the plunging of the economy into a full blown recession, which is a natural part of economic cycles, but truly devastating when a bubble has been the foundation of the preceding period of growth.

Regardless of how it starts, the fact is that one peach of a smash is inevitable. This is because of the fact that as it currently stands, the US economy employs a debt driven consumer spending model as its method for achieving economic growth. This sort of model relies on constantly expanding debt, and constantly rising prices. These are two facets which are unable to endure indefinitely, much in the same way it is impossible for a human being to naturally propel oneself through the air indefinitely without gravity asserting itself at some point. From an earlier piece I wrote on the subject:

At some point, markets can’t support prices at the high levels producers need to set, which in turn leads to prices falling, profits falling, trouble servicing debts, liquidations, and layoffs. Yet, the solution presented by mainstream economics is to guide prices higher again.

All actors in the economy, from the government, to households to business are currently over-indebted.

As a result we are getting closer to the point when there will be no one left to take on the new debt required to push prices ever higher, in order to keep the ‘growth’ going. As this become more and more apparent, prices will start to fall, loans will become bad, bankruptcies will rise, and all the rest of it. Then the political game truly begins.

The economic carnage will be universally blamed on Trump, and it will not be a difficult story to sell. The surface level thinking will show that the economy was ‘fine’ under Obama, with rising stock prices, rising GDP, home prices and employment levels, a reduction in the deficit and so on. The fact that these metrics are superficial, and easily gamed by the cheap money which will have evaporated in the downturn will be overlooked.

It is at this point that the most pivotal moment in Trump’s presidency will arrive. He will have to choose between attempts at reflating the burst bubble, and allowing market forces to play out, and then rebuilding on the new landscape that forms thereafter.

The standard politician has always taken the former route. It is the route of political expedience, the route of slavish devotion to abstract metrics such as GDP. The last two administrations have done exactly that. In the wake of burst Internet and Housing bubbles, the Bush and Obama administrations respectively, in conjunction with the Greenspan and Bernanke Federal Reserves ‘stimulated’ the economy via a lowering of interest rates and dramatic increases of debt. The debt taken on under the Bush administration equaled that of the cumulative debt of every president prior to him. Eight years on, President Obama matched that dubious achievement.

The consequence of allowing market forces to run their course would have been catastrophic, in fairness. This is largely because the multi decade advance of asset prices was also the savings vehicle for many in the Baby Boom generation. For decades, they had not had to build real, legitimate savings because asset prices were always rising. When the time came to retire, conventional wisdom held, it was simply a matter of selling the assets and living happily ever after. That all changed when the bubbles burst, particularly in 2008. For many Boomers, their retirement nest egg had been wiped away, or at least severely diminished, just at the very moment they needed it.

The actions of world governments and central banks in attempt to reflate the bubble was in some sense a refusal by the Boomer generation to accept their mistake, demanding that economic gravity be defied indefinitely until they were made whole again.

These actions were able to ‘fix’ the problem in the short run, but are fundamentally inadequate for the long term. Indeed there has been positive talk about home prices which are nominally flirting with 2008 bubble levels. At some point there will again be ‘too much debt,’ and the whole system will be under pressure once more. The fact that asset prices have been engineered higher for the benefit of Boomers means that these very assets will be increasingly out of reach for a younger generation which itself is overburdened by student debt the Boomers never dealt with when they were young.

This will necessitate still further debt and money printing to enable the younger generation to purchase assets from Boomers at these stratospheric levels, in order for them to retire.

This paradigm is the equivalent of fixing the negative symptoms of a drug withdrawal with a higher dose of the drug. I sets in motion a cycle in which the only conclusion is either an overdose or the mother of all withdrawals.

The correct solution is to endure the withdrawals, no matter how bad they are, because they will still be better than a certain overdose. In the context of the current economic situation, that means allowing the gaggle of bad debt which hangs around the neck of the economy like an albatross, to be purged from the system.

Trump should understand this scenario well – for it mirrors the situation he was in personally during the early 1990s. Having overextended himself in the late 80s, he was in a fair bit of trouble, to put it mildly, when the market turned. This is all well documented, but Trump’s Comeback would not have been possible without a renegotiation with his creditors. This allowed Trump to survive without having to sell the assets which he had accumulated to that point, and set the stage for him to grow his empire not only to far greater heights, but with a far greater foundation which offered a substantial margin of safety.

The United States as a whole is need of something similar happening. I suspect, on some level, Trump is aware of the nastiness which might be involved. Back in May, he revealed as much when he suggested that the United States could simply renegotiate its debt to alleviate its problems. This set off a firestorm in the media, which posited that Trump would be threatening the pristine credit history of the US government, which had always honored its debts.

That is patently untrue, but the real cause for alarm comes from the fact that the bond market, and in turn all markets, rest on the fundamental idea that it is true. That is, US government debt is a 100% certainty to be paid on time and in full. As such, for Trump to suggest that the debt could be ‘renegotiated’ would upend world markets.

The premise from which this potential turmoil originates from is faulty however. The US does pay its debts on time, but owing to money printing exercises, it has not necessarily been paying them in full. Paying debts with printed money is to pay in a currency that is worth less than when it was borrowed. In theory, the interest rate should square the difference, but given that interest rates have been held artificially low by the Federal Reserve, a real case can be made that America’s creditors have already had involuntary renegotiations with America, which has been implicitly defaulting on its debt for years now.

What Trump mentioned in May was an explicit default. In that event, the tumult would be extraordinary, with interest rates rising precipitously, prices falling precipitously, and a temporary state of near depression ensuing, perhaps worldwide. Yet it would be the right thing to do.

The current game of kicking the can down the road and hoping for economic miracles has not worked. Consider that in the last two presidencies, each has had to double the national debt and keep interest rates at historic lows merely to maintain a period of growth with had nothing to show for it but stratospheric asset prices and a war torn planet. In the meantime wages have stagnated, home ownership has dropped, labor force participation has dropped, high paying manufacturing jobs have been replaced by low paying service sector jobs, and only those over the age of 55 have seen a net increase in employment.

This is the paradigm which the Keynesian academics, global central bankers and short term-ist politicians believe justifies the doubling the debt every 8 years to preserve.

In rejecting that prescription, Trump would put America in the position he himself was in in those early 1990s days, when he would tell himself repeatedly, ‘survive til 95. Survive til 95.’ It was at that point he figured that he would be able to have a proper foundation to work from, and that sustainable growth could begin.

The short term carnage which would result would no doubt be pounced on by a leftist media which will have been constantly begging for him to fail. There would be no end of horror stories describing the bankruptcies, foreclosures, layoffs, business closings and so on that would descend upon an a economy ridding itself of bad debts. These unfortunate occurrences would then be used to bolster the leftist line that Trumpism generally, with its America Fist, anti-globalist bent is a proven failure, with a view to then restoring the globalist, politically correct politics it was after all along.

Trump’s messaging  in the face of such an onslaught will have to involve the explicit illustration of our bubble-crash-new bubble cycle, and the framing of our choices as I’ve outlined.

It will be a truly Herculean task, merely because the size of the bubble is such that even the most modest worker will be involved owing to the fact he or she probably has a 401K. It will be difficult for the truism that all long term gains require short term sacrifice to gain traction when that sacrifice comes in the shape of a declining 401K or home price.

Indeed, we live in a culture which has been conditioned to crave instant gratification. The idea of saving and investing, and not seeing the fruits of that saving until years in the future is increasingly an alien concept. To impose a necessary, but painful economic downturn will be potentially suicidal to Trump’s political career, but a necessary component to a sustainable, longer term recovery.

It is because of this that there will be a strong temptation for Trump to do as his predecessors did, and to try and restart the bubble machine. However, as I’ve made clear here, it is the wrong answer. As I’ve mentioned before, I suspect that Trump does know the right answer. Indeed, his campaign was centered on having the ‘right answers’ in other areas such as immigration and foreign policy.

In these arenas his anti-status quo approach is correct. The same is true of the economy, and more specifically the debt driven consumer spending model of growth that currently drives it. That is the status quo. That has led to failure. That needs to go. Trump’s task, if he really is to go down as a great president, will be to destroy the bubble-crash-bubble paradigm and free an US economic machine, now running on savings and investment instead of cheap credit, to start once again, all the while holding the hand of a skittish public through the transition.

The Great Unmasking

Last month, Donald Trump caused a stir in the economic world, with his analysis of the Federal Reserve and its monetary policy during an interview he did with CNBC.

In it, he was adamant that the zero interest rate policy of the Federal Reserve had created a ‘false stock market.’ This was after last week, in which he had said that the interest rate policy had created a ‘false economy.’ His reasoning for both was that the decisions were political in nature.

According to Trump, Janet Yellen, the Federal Reserve Chair, was embarking on these policies in order to help President Obama, in order to make sure he ends his term with a positive economy.

Politics aside, the administration, and most left leaning economists have quick to point to the job numbers as a sign of the recovering health of the economy. The fact that the stock market has made fresh all time highs in 2016 has been used to tout the strength of the business community and commerce. Indeed, at a campaign rally last month, President Obama vociferously patted himself on the back for an economic job well done:

Janet Yellen, during her remarks explaining the Federal Reserve’s interest rate decision on September 21, painted a rosy picture of the economy, repeatedly citing the employment figures along with household income increases as evidence.

It is my view that these data points – mainly the employment data, and the performance of the broad stock markets – are merely masks which give the perception of strength and improvement, while concealing a deteriorating reality underneath.

The Labor Market Mask

Let’s look at the employment data.

While it is true that the unemployment rate has come down to 5%, from about 10%:

Part of that is because the labor force participation rate has declined throughout President Obama’s tenure and is at multi-decade lows:

labor-force-participation-rate

With a ‘normal’ labor force participation,  the unemployment rate would be much higher, at least 10%.

The problem isn’t just with the totality of the workforce and the employment rate, but with the types of jobs which are being created in this economy, and who is filling them. Even a cursory look at the below surface trend reveals some problems.

The following is a breakdown of the labor force participation rate by age group: (Credit to the excellent Doug Short, who is a tremendous resource with his charting)

labor-force-participation-by-age

The following chart shows the breakdown in cumulative job gains for prime age workers versus those over 55, from 2007 through August 2016:

jobs-old-vs-young

The following chart shows the cumulative gains in the food and hospitality industry versus manufacturing:

water-bartender-mfg-workers

These charts show that the labor force is getting older, and the jobs that are being created are mostly of lower quality, in terms of goods producing. The bartenders vs manufacturing chart is somewhat tongue in cheek, but it does highlight the fact that most of the jobs that are being created are in the service sector, which are less paying jobs. The jobs that are being lost are the higher paying goods producing jobs.

Also concerning is he fact that the jobs data for September 2016 showed an increase in part time jobs of 430,000, compared to a loss in full time jobs of 5,000. In addition, there was a spike in the amount of individuals who hold multiple jobs of roughly 300,000, from 7.5 million to 7.8 million. The following two charts highlight these developments:

part-vs-full multiple-oct

Put it all together, and what we have is an economy which appears to be creating low paying jobs, which are being filled by people who may already have jobs, but need second and third jobs. Or, individuals who were laid off from a full time job, and are replacing it with multiple part time jobs, at lower pay.

Regardless, these are not signs of a robust economy, and those who point to headlines touting ‘X million jobs created since the recovery’ are being duped by an attractive mask that hides a horror show.

The Asset Price Mask

But what about the stock market? Isn’t it at all time highs?

It is, but masks are present here as well. Namely, the Federal Reserve. For nearly 8 years, the Federal Reserve has been engaged in unprecedented levels of monetary accommodation, with the Federal Funds rate resting at 0% until the most modest of raises in December 2015.

That raise was supposed to be the start of an easing cycle, which many experts predicted would result in four rate hikes for 2016. However, the stock market subsequently began 2016 with the worst start in the history of the stock market. This prompted an abrupt about face from the Fed, and then the ‘experts,’ with respect to the rate hiking schedule. Four rate hikes became two, and two became one, and as of this writing there is talk that there will be none at all.

That 12% stock market sell off in the first three weeks of 2016, on the back of the Fed raising rates for the first time in 7 years, from 0% to a negligible 0.25%, is indicative of the whole story: This market lives by the Fed and dies by the Fed. Some, myself among them, would call that a bubble.

The Fed’s persistence in keeping interest rates as low as possible is ultimately rooted in its flawed belief that elevated asset prices are the key to prosperity. Consider Ben Bernanke’s 2010 explanation of accommodative monetary policy and its intended result, the ignition of the ‘wealth effect.’

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

This is a description of an economic growth model that starts with the Fed lowering interest rates, pumping money into the economy, continues with various actors in the economy increasing their borrowing, and ends in them buying assets, which increase their prices, emboldening the owners of those assets to further spend or take on more debt as a result of their increased ‘collateral.’

The hope Bernanke and all Keynesian influenced central bankers had, and still have, is that this process continues and feeds on itself, a phenomenon known as the ‘virtuous cycle.’

Indeed, the Federal Reserve has accomplished this, expanding its balance sheet from roughly $800 billion in 2008 to roughly $4.5 trillion today:

fredgraph-2

Which has led to skyrocketing corporate debt:

fredgraph-3

Which has, in part, led to a substantial rise in the S&P 500, which I will use as a proxy for ‘asset prices’:

fredgraph-4

The problem with this, the Fed’s preferred model for growth, is that continued asset price increases rely on ever expanding debt, to provide the impetus to buy. It is a simple fact that debt cannot expand in perpetuity. It is limited by the ability to service that debt, which is in turn limited by the productive capacity of the borrower in question.

With respect to corporate borrowers, that productive capacity is seen in earnings. If corporates can produce increasing earnings, they can sustain larger debt loads, which justifies the higher debt-induced prices. The following chart, of the S&P 500 index compared with earnings of the companies in that index, tells an interesting tale:

spx-earnings-vs-stock-index-price-1

In short, the continued rise in stock prices are not justified based on the diminishing productive capacity of the companies themselves. A reason for this diminished capacity is general weakness in the economy itself, evidenced by the labor market situation which was discussed earlier.

An economy in which more and more people are working multiple lower paying part time service jobs instead of higher paying full time goods producing jobs is going to be an economy in which fewer and fewer people have incomes which allow them to spend freely. These household budgets are further constricted when taking into account the fact that the Fed is trying to engineer prices higher, so as to kick start the ‘virtuous cycle’ of the ‘wealth effect.’

The math just doesn’t work. Rigid incomes lead to constrained household budgets, which do not lend themselves to increased spending at higher price points, nor do they lend themselves to increasing borrowing to spend at higher price points.

Despite this roadblock, share prices continue to remain elevated, because the continued low interest rate environment established by the Fed enables corporates to take up the burden of spending. They can borrow at record low rates, and buy back stock. Or, other investors, banks, foreign central banks and others can borrow at low rates, in order to buy elevated stock prices. The rationale here is less a belief in a prospective restoration of business fundamentals, and more in a belief that buyers will buy for the sake of buying, rendering elevated prices becoming even more elevated.

Even the Fed is worried about the developments they have created:

In the minutes of the Fed’s September meeting, released this week,some officials “expressed concern that the protracted period of very low interest rates might be encouraging excessive borrowing and increased leverage in the nonfinancial corporate sector.”

 

Despite these worries, investors continue to demand corporate debt, helping fuel a years-long rip-roaring rally in corporate credit that shows few signs of stopping. Corporate bond issuance this year is set to total $1.5 trillion, nudging past last year’s tally, according to the credit strategists at HSBC, led by Edward Marrinan. Issuance of high-grade debt is expect hit [sic] another record high this year.

 

It’s all a sign that, in the words of the bank’s strategists, “Market participants seem to be downplaying—or looking past—the risks associated with the steady deterioration in the credit fundamentals of the US corporate sector,” such as rising leverage, contracting earnings, and stressed revenues.

 

After the financial crisis, many companies focused on rebuilding their balance sheets to withstand another shock. But as the prolonged period of low interest rates continued, cheap borrowing costs prompted, well, more borrowing. Much of that went to fund shareholder-friendly activities like dividend increases and share buybacks. It also funded big mergers and acqusitions.

Emphasis mine. The preponderance of ‘shareholder-friendly activities,’ not least of which being the explosion of asset prices themselves, looks very good on the surface. Indeed, many law makers, academics, and market cheerleaders (such as President Obama) have been in a celebratory mood over the last few years, boldly declaring that the Federal Reserve’s actions had worked.

However, the divergence described by the WSJ – that the Fed itself worries about – between elevated asset prices and the fundamental deterioration of those prices is real, and cannot persist in perpetuity.

Removing the Mask

Deteriorating fundamentals cannot support the further debt burdens that are required to keep asset prices rising even further beyond these levels. And the Fed knows it. This is why they abandoned the original plan for multiple rate hikes in 2016, as that would have slowed down borrowing and thus slowed down the impetus for asset price increases.

In this manner, the market going from four expected rate hikes to now one or zero rate hikes is an effective rate cut. This is what the Fed has been relegated to, sitting on its hands and hoping a miracle happens. If they are proactive in doing anything more accommodative, such as another round of QE, they will put themselves in an untenable position. They can’t on one hand tout the robustness of the economy  yet embark on further emergency policies, such as QE would be. The situation would be exposed for all but the most die-hard believers in the Fed.

Regardless of their games, or ‘forward guidance’ as they would call it, reality will assert itself at some stage. The mask will eventually come off. How exactly it will happen is uncertain. But this situation has happened several times before in financial history. There is no escaping a scenario in which too much debt has been taken on relative to the ability to service it. All the Federal Reserve (and central banking in general) can accomplish is to push the date of reckoning out into the future. But even that does damage.

The current boom/bust episode is merely the latest in a 40 plus year credit binge following the ending of the gold standard in 1971. This has eventually led to constantly rising asset prices, which fooled the majority of the public into eschewing the idea of accumulating real savings.

Most used their home or 401k as their savings account. This was fine as long as the stock and housing markets kept rising, which they did, temporary bear market corrections notwithstanding. That all changed in 2008, when the bubble burst in earnest, and asset prices crashed.

This resulted in mass layoffs, but more importantly, many who had counted on elevated real estate and stock prices for retirement were now out in the cold, just at the moment they were ready to retire. This meant they were forced to return to the labor market, because they had built up no real savings over the preceding decades. This explains the surge in labor force participation for the over 55 segment, discussed earlier.

The under 55s have struggled to regain a foothold during this latest ‘recovery,’ still being several million jobs underwater from where they began the Great Recession. Some of this is down to competition from the over 55 workers, who flooded the market. Many of them, closed off from their former occupations, went into parts of the market usually populated by younger workers. Hence the proverbial ‘Wal-Mart Greeter.’

That position really should be filled by a 16 year old kid, working his first job and acquiring the basic skills involved with employment. Instead, the position is filled by a 60 year old who is working one of his last jobs because he didn’t accumulate savings during most of his productive years.

This phenomenon doesn’t bode well for the economy as a whole going forward. When you have an economy which is severely under-employing those who are in their peak earning years, not only is the economy not going to be moving as robustly as it should, but in the future, as those workers persist with decades of under-employment, they too will have to encroach on future younger generations as they try to get their careers off the ground. Multiple generations impaired at once.

And therein lies one of the ultimate problems with central banking, played out over decades. It, like most of government, prioritizes political expedience over longer term sustainability, papering over the cracks instead of repairing them, thus consigning the ultimate costs to be dealt with in the future.

In this greater sense, reality will assert itself here as well. The exponential increase in debt and increases in money supply papering over business cycle after business cycle can only end in a currency crisis, as it has done many times in the past. One can only hope we correct course before such an event occurs.