INDEBTED SERVITUDE?

The stock market surged to new all-time highs in the first quarter but the rally was largely confined to the month of February. The Dow Jones Industrial Average posted a price gain of 4.6% for the period, but, as of January 19, the venerable index was down for the year in very choppy trading that continued into early February. A short-term low, however, on Ground Hog Day was followed by a sprint to the aforementioned record highs on March 1 as the market registered gains in fifteen out of eighteen trading sessions.

In fact, there were twelve consecutive up days from February 9th to February 27th – one of the longest such streaks on record. Alas, the high on March 1 was followed by a correction that included a streak of eight consecutive down days, likewise one of the longest such streaks on record. The market giveth and the market taketh away….

Despite another increase in the federal funds rate on March 15, yields on ten-year Treasury notes actually fell about five basis points during the quarter. We have long opined that the sport known as “Fed Watching” is largely a waste of time. Why spend hours parsing the speeches of members of the Fed’s Open Market Committee or the minutes of that august body’s meetings when the market itself tips the Fed’s hand long before the actual announcement? Mister Market – a sobriquet coined many years ago by Jim Grant – sees all and knows all. Speaking of which, the decline in ten-year yields is a sign that Mister Market may be anticipating that the Fed is getting a bit ahead of itself. More on that subject anon.

Meanwhile, commodity prices parted company with stocks by tumbling 3.4% during the period as measured by the Commodity Research Bureau’s composite index. The rout in that sector was largely led by crude oil, which pulled back after a sharp rally last year that resulted from an OPEC agreement on production cuts. We shall be keeping an eye on commodity prices in the weeks ahead as they have a history of being a leading indicator for risk asset prices as well as the economy in general.

On the economic front, GDP turned in yet another lackluster performance during last year’s fourth quarter as the annualized growth rate came in at 2.0%. With initial claims for state unemployment insurance benefits recently at the lowest levels in decades, one would hope that first quarter growth will be reported to have been at higher levels. The manufacturing sector, however, has not been helping out very much as industrial production (a statistic compiled by the Fed’s staff) was reported to have been down slightly in January and unchanged in February. Housing activity, moreover, has been relatively good, but, here too, this sector is not really helping to fire gains in overall final demand. Finally, personal income growth in January and February was reported to have grown at a healthy annual rate near 5%; yet personal spending grew only 0.2% and 0.1% in those months, respectively.

We sense that there is a thread that links this disappointing data and that thread is the four-letter word, “debt.” It has been our opinion for years now that lackluster global growth and the deflationary pressures attendant thereto can be largely attributed to the enormous amount of debt that has accumulated at virtually every level of society from student loans to the obligations of sovereign states.

The fact that strong growth in personal income has not been accompanied by a strong increase in personal spending could be an indication that consumers need the funds for purposes other than consumption. We contend that debt service requirements are siphoning away a significant part of income gains in the current environment. This also helps explain why a stronger jobs market has not led to strong housing demand. Many prospective home buyers are simply not in a position to take on additional debt service.

Over the years these pages have described the machinations of the ”virtuous cycle” of economic activity that typically begins near the bottom of a recession when the Fed aspires to stimulate growth by loosening the monetary spigot. The hope is that the increased wherewithal in the system props up risk asset prices, thereby lifting animal spirits of investors, business people and consumers. Lower interest rates and more readily available credit help to stimulate housing activity and business spending. These, in turn, lead to a better jobs market and increases in disposable income. Income gains lead to higher consumer spending, which is followed by additional increases in production and the cycle eventually becomes self-sustaining.

The momentum typically continues until stopped by something. Sometimes that “something” is an exogenous event that creates fear amongst investors, consumers and/or the business community. More often, however, the “something” is Fed tightening – the proverbial taking away of the punch bowl when the party gets going too good.

One might think that we are currently some distance from the party being so good that the Fed needs to clamp down but, beginning in late 2015, the central bank made the first of three small increases in the federal funds rate. In an historical context, seventy-five basis points doesn’t look like much of a “tightening” at all. One must consider, however, that never before in our nation’s history have interest rates been as low as they have been in recent years.

We suspect that the “virtuous cycle” has not been hitting on all cylinders in this recovery because of the enormous worldwide debt service burden. While seventy-five basis points is nominally a relatively small increase by historical standards, it represents a quadrupling from where the program began. Over the past twelve months, ten-year treasury yields have increased by sixty basis points. Once again, that doesn’t sound like much in nominal terms but it is a 33% increase.

Hence, even what appear to be relatively small increases in interest rates are having a substantial impact on the debt service requirements for debtors with adjustable rate loans.

The bottom line is that the economy’s sensitivity to rising interest rates is as high as it has ever been due to the substantial impact on debt service costs in a debt-laden world. Unless inflation were to accelerate and thereby make servicing the debt somewhat less painful, it should not take much tightening to have a profound impact on the economic cycle.                                                                                                                  

Weaver C. Barksdale, CFA