Exploring The Great Divide at the Heart of the US Economy
Blain’s Morning Porridge, May 24th 2024: Exploring The Great Divide at the Heart of the US Economy
The Great Divide – V11 4.30.2023 (1)
“Trying to make some sense of it all, but I can see it makes no sense at all..”
The US economy looks strong, robust and resilient. Investors are pouring billions into stock trackers believing it’s all rosy upside ahead. Under the surface there is enormous stress as consumers, corporates, banks and the government struggle with debt and its consequences. If something snaps….
The first thing I read this morning was an upbeat forecast from an US investment bank – global growth to moderate but hold steady above 3%, solid outlook for risk assets, inflation beaten, limited trade war risks between the US and China (the proposed new tariffs are largely symbolic), and returning upside in Japan and Europe. Another investment bank is telling me to put money into “liquid” small caps to garner “outperformance”. Meanwhile, Nvidia’s numbers earlier this week beat expectations, and already analysts expect them to deliver an even better 2nd quarter on the back of rising data-centre growth. Buy, buy, buy…..
Such optimism is not uncommon in markets. There are always those who will tend to see a half-empty glass (typically bond traders) and those who perceive it half full and they tend to be stock pickers. The trick is to be agnostic: what are the facts and reality behind the directions stock markets take? Remember, markets are not clever – they are simply voting machines tallying the expectations of participants. Even more critically, markets have no memory – they make the same mistakes time and time again.
I try to be data driven, but also rely on my experience which, after markets have recoved and come back stronger from every crash I’ve experienced since 1985, leads me to my mantra: “things are never as bad as we fear, but seldom as good as we hope…”. Yet, this morning I find myself wondering for whom the investment banks are writing their overly rosy upside reports?
Sometimes a little balance is required.
One of the more insightful market comments I’ve read recently comes from Orchard Global, the Alternative Asset Manager. Orchard’s CEO, Paul Horvath is a chum, and his approach to the current economic reality is somewhat less frothy than the puff I regularly read from the banks. Orchard recently released Pauls comments on what he calls The Great Divide – we downloaded it into the Morning Porridge Website and comment this morning with Orchard’s permission. It’s one of the best reports I’ve read recently – and I stress what follows is my take-away from it.
The gist of the deck is quite simple – although the US economy appears to be robust, resilient and strong with solid employment numbers, moderating inflation and rising growth…. there are serious distortions and risks, not least in terms of rising wealth inequality, market concentration risks, the banking sector and the sheer quantum of unconstrained Global debt.
I’ve written many times about how consumers are being squeezed by declining personal finances. Savings may have been strong post pandemic, but are now depleted while saving rates have collapsed. More and more US consumers live one paycheck to the next. Rising mortgage and personal debt rates are emptying consumer wallets at unprecedented speed. Debt delinquencies are rising. Spending patterns have dramatically changed – food spending’s share of disposable income has risen dramatically.
The burdens of inflation, higher rates and rising utility costs fall heaviest on the least wealthy in society at a time when the US has become massively skewed in favour of the wealthiest in society. The top 5% of US earners now receive almost 25% of total US income! A fraction of their income goes on food – while the bottom 25% of the US population is now spending over 30% on avoiding hunger.
It’s no wonder the bottom half of the US electorate feels left behind, seeing their incomes depleted, their factories and jobs under threat and are prepared to believe a strong leader will protect them from imagined enemies like China stealing US jobs or immigrants driving crime waves. Rising inequality and relative poverty are prefect seed-beds for political populism – all it will take is 2 or 3 of the swing states to Vote for Trump, and he wins the election.
Things aren’t much better for US corporates. At present the headlines are all about what 10 largest stocks which definitionally are the ones the index trackers favour – the biggest names in the market who set the agenda and receive all the focus. The 100 largest firms represent 92% of US total profits. We’ve spent the past year following the ups and downs of the Magnificent 7 tech stocks, but missing the woods for the trees; the number of US firms genuinely struggling. The top 10 US stocks now account for over 75% of value – a concentration we haven’t seen since 1929!
The level of US mid-caps struggling with negative earnings and higher rates is on an upward trajectory, bankruptcy filings are rising towards levels last seen in 2008/09, and junk default rates are finally rising. While the junk bond optimists think defaults will fall back towards 5%, the pessimists reckon defaults could top 12% later this year representing the largest credit shock since the Global Financial Crisis.
Meanwhile, the canary in the proverbial coal mine for the US banking sector may be Commercial Real Estate. The papers are full of stories of property funds gating, or restricting drawdowns/redemptions because of fire-sale CRE prices. The threat is CRE could trigger significant contagion risk in banks as the current CRE refinancing wall could precipitate further cracks in confidence.
And to cap it all – I recently read a horror-headlines: US pays more in interest service than on defence. In FY 24 the US will spend $822 bln on defence, but interest on the national debt of $35 trillion will top $870 bln. The US debt/GDP is now 120% and rising – the kind of level previously only seen in wartime.
That’s the big picture – how the strong, robust, resilient US economy is actually under more pressure than we perceive. Does that mean we are still massively underestimating the risks of a significant “hard landing crash”? What could trigger such a macro event – possibly something fairly hidden – like the worryingly high default rates in multifamily dwellings or a succession of CRE and Corporate defaults triggering another round of regional bank weakness?
Paul concludes the current state of affairs is unsustainable: The US government can’t keep borrowing at such unprecedented levels, debt service levels are too high, and the majority of consumers, corporates and banks are under stress. He lists the following potential trigger points:
Defaults on credit cards, autos, mortgages and student loans exploding;
High yield corporate defaults exploding;
The tech-driven stock market rally exploding;
Regional commercial banks exploding;
The U.S. treasury market exploding;
The political or geopolitical situation exploding;
ANY OR ALL OF THE ABOVE
And on that happy note, have a great weekend. Out of time and back to the day job…
Bill Blain
Author of The Morning Porridge
Wind Shift Capital