The Dividend Cafe - Debt and Everything Else

Episode Date: June 18, 2021

We had an interesting week in financial markets … The Fed did exactly what they were expected to by any reasonable person – nothing more, nothing less. They acknowledged the economy is improving, they said they were “talking about talking about” slowing down their quantitative easing. And they indicated two years from now as a time where the fed funds rate may be 50 basis points higher than it is now (may it be so). And that was it. No actions, policies, or steps. No commitments, promises, or assurances. Just loose language around some policy measures that are (a) Brutally obvious, (b) Not remotely hawkish, and (c) Not nearly enough if the conditions people are saying they are worried about are actually present. So how did people respond? After three months of people saying “inflation is here” and the “Fed must act” – what happened? Commodities got hammered, and the yield curve flattened more than it has in ages. You can’t make this stuff up. But rather than re-hash what I think the Fed will do, or what they should do, or what is going on in the inflation ad nauseum discussions, I think this week’s Dividend Cafe needs to better unpack what the real, actual, accurate under-current is to all of this. More or less, every single topic being discussed right now has as its true foundation the reality of debt. The accumulation of debt. Concerns about debt. Plans for more debt. Questions about servicing of debt. The promise of debt. The fear of debt. The cost of debt. For a four-letter word where 25% of its letters are actually silent, this is a pretty potent word in 2021 economics. And it is the subject of this week’s Dividend Cafe. Let’s dive in. DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello, welcome to another week's edition of the Dividend Cafe, both you all listening on the podcast and those of you watching the video. I hope that you all will have a wonderful Father's Day weekend. You may be able to tell watching the video, I'm out here at our Hamptons house, the whole family, and looking forward to a nice weekend. And the reality is it's been a pretty exciting week in markets. And there's a few things that need to be talked about.

And there's a few things that need to be talked about. And yet, I want to talk about today in a way that I think really captures the heart of the matter. And there's all these kind of symptoms, I guess, is a word you could use. There's a lot of tentacles coming out of a foundational issue. And there's a lot of attention on the tentacles. There's a lot of discussion for pretty good reason on inflation, on the Fed, on what to expect from quantitative easing, on expectations of economic growth, expectations for economic recovery. So you have all these kinds of things that we talk about that are going on that really, in my opinion, really do matter. that really, in my opinion, really do matter. And yet I think that what everything comes down to in a certain way, and I'm going to spend our time together today to define that way, define what this means.

It really does come down to the subject of debt. It comes down to the subject of corporate debt, of various debt ratios, of the cost of debt, of national debt, governmental debt, all of these things that are going on at once. And I think that the way, by the end of this podcast, hopefully what I'll have done is kind of laid out how all these other things I talk about that I describe as tentacles or symptoms or what have you are really manifestations of the debt issue and how we've kind of gotten into this position. So if there were ever a dividend cafe that could not be relied upon just on podcasts for video, it is this one because at dividendcafe.com, there are a number of charts

that I think are really vital. And I guess if you just take the numbers as I give them here and don't need a visual reinforcement, that's fine. But the charts that I put at Dividend Cafe are meant to show visually the objective yet graphic reality of the debt debt issue and i don't know if everyone knows this but at the turn of the millennium so we're talking about a little over 20 years in a 20 years ago now the united states had over uh five trillion dollars of debt and that was a lot of debt um but you know we particularly on a relative basis, we had been at about a trillion 10 years earlier. So we, you know, debt had gone up. But then you obviously had a ton of economic growth, you had balanced budget, there are a lot of good financial metrics,

believe it or not, 20 years ago, 21 years ago. But the debt represented about 55% of GDP. And we right now are a few bucks away from $27 trillion of debt. And that represents very, very close to 130% of GDP. And so I make the argument in Dividend Cafe today that I think should be intuitive to all of you, which is that the absolute level of debt is a data point. It matters. We hear it. You can hear we were at $5 trillion and now we're at $27 trillion. That ought to scare you. I don't know why it wouldn't be at all somewhat daunting to hear. But then if we said $5 trillion represented 55% of GDP, but $27 trillion only represents 40% of GDP, meaning that even though the debt had grown that much, the economy had grown that much more, it's not that I think it might be a different subject. It really would be a different subject for very good reason. The analogy I always like to use, recognizing it's not totally perfect,

but it's pretty good, is a household. Because I think we all can understand the idea of a household with $50,000 of debt and $100,000 of assets is one thing, but a household with $250,000 of debt, so five times the debt level, but a million dollars of assets, 10 times the asset level is very different. And most people rather be in the position of having $250,000 of debt with a million of assets versus the other hypothetical of $50,000 of debt, but with only $100,000 of assets. And I don't think that's controversial or challenging. And yet I bring it up to make the point that the debt to GDP is sort of the real metric by which we can measure the feasibility of the debt, the risk level of the debt, the cost

of servicing the debt, the resources and assets that we have that the debt functions within as a society. And I think that you have to really look at this right now in a number of different ways, not just the reality of governmental debt, where both the absolute level and the ratio of debt to GDP is growing and growing fast. The chart of the debt level shows that what you have was basically debt that went way up in the first 10 years of this new century behind a couple of pretty expensive wars and then the financial crisis where revenues both collapsed and obviously a lot of debt was thrown at the problem. Then you had significant level of debt increase even as revenues were picking back up, then you get five or six years well past the financial crisis. And at that point, revenues are flowing. And yet debt is growing even

higher, for reasons that I think are highly mysterious. Then you get to COVID. And at COVID, of course, you had an explosion of debt over this last year and a half. But what I think matters is to look at this both from the governmental standpoint and then the corporate standpoint for me to be able to explain why all of this maloo comes down to the topics at hand of growth expectations, of rate policy, of monetary policy. So, you know, that growth expectation story becomes very important. The corporate levels of debt are very interesting because on one hand, you know, the $1.7 trillion of new bond borrowing last year was somewhat surreal. But the cost of the debt as a percentage of total debt is at record lows. you more or less have about a 46% increase from corporate America in what the interest expense has been in the S&P 500 of their debt, yet their earnings are up 215% from their bottom, and they're up well over 100% over the last 10 years. And so the earnings in this sense of a company have grown faster than the debt level. And so when you take that fact and combine it with a decreasing cost

of the debt, a lot of people could look at it and say it's benign. And I'm in the camp of saying, yeah, but no. And what I mean by that is, yeah, corporate America has been very well capable of servicing this debt. And some of those financial metrics are better than they were, not worse. The problem is when you look at the higher level of debt divided by the higher level, much higher level earnings, is that earnings can go down. And that the cost of the debt, which has also helped serve a lower interest expense for income statements and across the economy, the cost of the debt can go up. So you just kind of have this situation where I think circumstances have been fine and I have no prediction to offer about them all of a sudden turning. But it is tautologically true that we have built up more risk in the system because the cost now of earnings coming down, the cost of interest rates going higher is much more severe.

And this is the heart of the matter. Whether you want to apply it to the governmental side or the corporate side is what Nassim Taleb refers to the anti-fragility of the system, things that get stronger when they are stressed. We have a very fragile system that is very vulnerable to shocks to the system, even if it feels manageable. And that speaks to the very essence of investor anxiety, because investors are fine with returns going up. And, you know, you get all the different concerns that might come up for a stock portfolio. But what really matters at the end of the day to an investor is avoiding those things that can be really, really dramatic.

is avoiding those things that can be really, really dramatic, right? And I believe that there is a number of incentives in the system right now to artificially avoid the dramatic because of the risk that has come from excessive indebtedness. Now, I do believe, as I think any reasonable person, left-wing, right-wing, most people would believe that there's excessive indebtedness in the governmental sector. And they could blame different things for that. They could blame different presidents or different congresses or what have you. But I think that at least the underlying conclusion is usually pretty agreeable. On the corporate side, I make the distinction between productive use of debt and unproductive use. I think that you get a really

good multiplier effect from productive use of debt from the corporate economy. These are generally really good operators, really efficient allocators of capital, really good allocators of resources. And there is a certain return that comes from low cost of debt and ample access to debt and the other side of the equation of credit that is then deployed into an equity growth. And that is the system working in a really good way. The problem is that there's a side effect to a low cost of capital that is used productively by some. A, the some go away at some point. They're not available anymore. They've levered up enough. They've found the good opportunities. They found the great projects. They've pushed

their ratios up to the limit, and then they're kind of done. And you're then left with, okay, well, who's the next best level of corporate operators? Who's the next best level below them? And you start going down the quality tree, which is pushing up risk and pushing down results. But then the other thing is the passive beneficiaries of the policies, the passive beneficiaries of the circumstances that good operators are making good use of. And those passive beneficiaries are what we would call zombie companies. But basically, companies otherwise would go away. They have not been able to get their earnings power back up above the cost of capital. But back up above the cost of capital,

but because of a depressed cost of capital, their depressed return on capital is sort of facilitated. It is enabled. It is soothed in such a way in which companies that otherwise would kind of go away, sell off parts, re-optimize. They don't have to. And having these suboptimal companies function in the economy is obviously a very poor use of resources and is nonproductive and suboptimal. Therefore, pushes growth rates down. So the diminishing return of the opportunity set of debt in corporate America at whatever point it's reached, and it doesn't just hit a bang, right?

It's kind of a process over time. And then that combined with the sort of side effect of zombie companies, there's these risk levels that exist and these incentives to alter the way we would think about monetary policy, about fiscal policy, et cetera. You combine that then with the governmental debt side to keep the world turning. You have to pay your transfer payments. The society is not going to put up with Medicare and social security not being paid. There is some degree of a very substantial need for funding national defense, military. Everyone can debate where they want to set those knobs. My point is, once you get these levels where they are, there is very little room to give. And that society that gets above its means, in my opinion, has a very difficult time getting within their means. But

when I say that, I don't know of historical precedent when a society does get within its means. It is ahistorical to think of an economy, let alone an economy our size, that can all of a sudden right-size the expense part of their P&L. And yet the costs are all that much higher just in the last few years, let alone 10 years, let alone 20 years, let alone much longer than that. And so you have this built up risk level in the corporate side of the economy and the governmental side of the economy, all the while people more or less taking for granted that it can keep functioning this way. What is my bottom line conclusion?

This is why the Fed has become the great actor in the economy. The stakes are exponentially higher than they were because of the rising level of debt and the rising level of debt divided by GDP. The ability for the government to fund its debts is not merely a matter of treasuries selling at an auction. As the world's reserve currency, and with countries like China who own over a trillion of our debt, Japan that owns over a trillion of our debt, and American investors that require a high degree of quality collateral that own many trillions of dollars of our debt. Quite frankly, 9.5 trillion is US investors. That's more than double the portion of our debt owned by the Federal Reserve. It's one of the reasons I push back so hard.

Sometimes I'm on TV and somebody on the panel or the other anchor might say, well, the Fed is the reason that they're able to go sell all this debt. Look, the Fed owns $4 trillion, a little over $4.3 trillion of U.S. Treasury debt. That's a lot. But as a percentage of the total debt, it's really not 20%. And you look at the amount that is owned by just regular American investors and American companies, there is this high demand for the security of the governmental debt. The printing presses, the military, the dollar, all of those things matter. The printing presses, the military, the dollar, all of those things matter. But over time, my point is, I think, somewhat indisputable, which is that you get into a point where any increase in interest rate policy might be a really needed prescription to provide a policy tool, a risk management policy tool to a central banker, near zero bound monetary rate landscape by the debt levels that the governmental and corporate sector function within, you've put yourself into a corner.

And I believe that is where we are now. So therefore, the utterly preposterous postgame commentary every time the Fed speaks becomes obsessed upon for the very reason that it is a much more significant dynamic in the economy than it otherwise would be. that was in the 50% to 60% range, nobody would be talking about it the same way. If you had a normalized rate environment and people could make economic decisions without concern as to where these things were going to go, what is the debt profile going to look like? What is the rate profile going to look like? You eliminated so much price discovery that it is so difficult for long-term economic actors to go produce, to go do what they actually do, and misproduces that long-term fragility that investors now have to deal with, that investors that are rightly thinking incorporate into their asset allocation, incorporate into the quality of the holdings they seek to own, and use it to frame accurately what a risk and reward profile

in a portfolio actually looks like. You notice, by the way, that for all this talk about debt today, and it being the key subject that we're focused on, I didn't bring up household sector debt. And there's a lot I could say about it. But the debt levels of American households, which are much higher than they were the financial crisis, their ratios are way down. Now, part of that begs the question, because the debt divided by the assets is so much lower because the assets of their houses and their stock portfolios are so much higher. But my point is that when you look at the debt to assets that we were pre or during crisis compared to now, there was a lot of deleveraging. There was a lot of liquidating of assets. There was a lot of moving assets that didn't belong in one hand to another hand where they did belong, that could more afford it, that could service the cash flow, that it would fit within the balance sheet in a healthier context of a given household.

the day, I believe that those types of simplistic notions that just come in and say, we got to go reduce all this debt, move trillions of dollars off the government P&L, all that stuff. I think it's fine to say it as long as everyone knows it's not going to and can't and won't happen. I mean, if we just simply want to talk in that idealistic way, I don't mind it because I certainly believe that the government spends trillions of dollars more than it should. It's just that it isn't going to happen. And the voters aren't going to let it happen. The voters don't want it to happen. This is one of those things.

Everybody hates Congress, but very few people hate their congressman or congresswoman. Everybody hates government spending, but nobody has something in the P&L they actually really want to cut. Everybody hates government spending, but nobody has something in the P&L they actually really want to cut. I guess you could say I'm saying it critically, but my point is not so much criticism as it is description. This is the lay of the land. Given the fact that debt level won't be cut easily, I think you have an environment in which lower growth expectations become, over time, more and more accepted as the base reality that they are. And then from there, it puts a premium on those who can transcend those lower growth expectations. And it puts a real premium on those that are able to grow cash flows with pricing power. It puts a real premium on balance sheet strength.

pricing power. It puts a real premium on balance sheet strength. And what it ought to do to avoid malinvestment is reward those who seek healthier debt ratios and avoid poor allocation of capital. Now, this begs the question, because you don't always know ahead of time, you know, in hindsight, what was poor allocation of capital. But when I look at where a lot of what we call the non-bank debt that is built up in the economy, there's middle markets lending, private credit, a lot of the debt that is used to fund some of the private equity acquisitions. You know, is this risk free? Of course not. God, no. But do you believe that there are good allocators of capital in there that are going to make the most use of that debt? Well, the answer is I do, but does that work? I don't think it happens without underwriting. And so it puts a

premium on quality allocators of capital. I guess you could have had to listen through the last, whatever it's been, 20 minutes or so, just to get to these final couple sentences. On the private sector side and within one's investment portfolio, in an overly indebted society with fragile debt profiles, finding efficient allocators of capital is extremely important. And wasteful allocators of capital get to hide. They get to be perceived in a positive way for a period of time until they're not. And when that sort of proverbial tide goes out, I think that people end up seeing where there was efficient use of capital and not. All of this is a byproduct heightened in a high debt environment, high governmental debt, high corporate debt that makes the Fed, that makes the interest rate, that makes monetary policy, that makes liquidity. I sit back and look at this quantitative easing discussion with almost amusement if it wasn't so serious, because nobody is making an argument that it is creating a material economic benefit to the society.

Why is quantitative easing happening when it is not being used to manipulate or control or help the interest rate? not being used to manipulate or control or help the interest rate. And there is no evidence of there being any increase in loan activity because of a buildup in excess bank reserves that quantitative easing does. Why are they doing it? They're doing it to further lubricate these financial markets, these credit markets, as they find their way into financial assets. Why is that important? Because we've built up a lot of debt. Now, I don't think anyone's going to say that. And by the way, I don't expect them to say it. I wouldn't say it if I were them, but I do know it's true. I do know that's what they're thinking. And so the idea of the federal funds rate being up half a point in two years, who didn't believe that was what they're supposed to say.

Will they end up doing it, by the way? I don't know, but I don't care. I sure hope so. I know they didn't do it after a financial crisis for years and years. Maybe this time it'll be different. But this is the trade-off issue that we're stuck with, is on one hand, you have to get the natural rate higher. It is unnatural at 0%. Trust me, that's not natural. And it has no embedded policy tool efficacy now. They can't go use the rate to lower it to provide a further economic benefit at a time of crisis. We've lost that risk management. They have to get the rate higher, yet now getting the rate higher is done in the fragile system of greater corporate indebtedness

and greater governmental debt. This is the world we're living in. This is what we're living in for 10 years. This is why I have that Japanification thesis. This is why I favor dividend growth as a way of getting rising cash flows in a world that is going to be addicted to low rates. This is why I favor quality control in the way we allocate capital, avoiding bubbles and booms and hysterias, because I think that now the stakes are higher. All right. It's very difficult to fully extract everything I want to say out of these basic principles, but I hope I've moved from the setup of the world we're living in to the takeaways that I care about as an investment manager in a limited amount of time I have here. Reach out with any additional questions you may have.

Please do read DividendCafe.com. I really can't imagine a better way to spend your Father's Day weekend than listening to me talk about government debt. Thank you so much as always for listening to and watching the Dividend Cafe. We really want to hear your feedback. Write a review at Apple Podcast or Stitcher or wherever you listen. Giving those stars, writing that review really helps us. It gives us feedback, but it also pushes us in the ratings in a way that helps you and helps us. It gives us feedback, but it also pushes us in the ratings in a way that helps you and helps us. And so thank you for that. We look forward to talking to you again next week in the Dividend Cafe. Securities LLC, member FINRA and SIPC, with Hightower Advisors LLC, a registered investment

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