"The debt they ran up in the first year of the Obama administration is bigger than the last four years of Bush combined." - Mitch McConnell
In a follow on from last week's blog I want to explore the idea that consensus when it comes to the outlook for higher interest rates and inflation and lower levels of real debt may be completely off target. While a lot of my analysis will focus on Japan I will once again note that there are a lot of differences between Japan and the United States both structurally and socially. Although there is definitely a different mind set in Japan in terms of savings and investments as well as in politics and economic size the most striking difference is that Japan has a current account surplus even while it is running massive budget deficits. In the United States we have neither and both are worsening each year.
First we will look at the level of debt in Japan.
As you can clearly see Japanese debt as a percent of GDP is above 200 percent and climbing. This is far in excess of where the United States is but even with this level of debt there is still a large demand for Japanese bonds both locally and from abroad. Furthermore Japanese yields have been effectively zero for decades and yet investors continue to buy them. Regardless of this effort to stimulate the economy through increase the debt level and keeping interest rates low the country continues to be mired in a deflationary spiral.
The effect of this on Japanese stocks is marked.
As you can see Japanese stocks have been mired in a downward spiral for decades. As the Japanese government tried to kick start the economy by printing money the debt level grew. This has crowded out private enterprise creating a drag on GDP growth and has kept a lid on Japanese stocks. If there is no growth or if growth is muted by government crowding out stocks will languish and this is the case in Japan.
There is another issue bubbling in Japan however and that is the aging of the Japanese population. As in the United States, Japan faces a huge burden from the aging population. A large portion of this demographic holds investments in the Government Pension Fund which in turn invests 63 percent of its assets in Japanese bonds. They are going to have to start selling these to meet obligations and this may be what breaks the low interest rate environment in Japan. The effect of this could be catastrophic for Japanese industry and may actually drive stocks lower. Furthermore the interest on the debt paid by the government is being kept to a minimal level due to the low interest rates. Should interest rates spike higher it would not take long for the Japanese government to find itself in a worse predicament than Greece. There is one caveat though, they will be able to depreciate their currency!
Turning to the United States you can see that the debt levels, while not nearly as high as the Japanese, are spiralling higher at an alarming rate. Furthermore as it has now crossed over 100 percent of GDP the drag on economic growth is being and will be felt for years to come.
The amazing thing is that the psychology of the US investor is stuck on stock investments.
One key though is the little chart at the bottom of the US stock chart. This shows the volume levels for the S&P 500. As you can see while the market continues higher the volumes are steadily dropping. Now for stocks to fall all you need is no volume while the opposite is true for stocks to rise. So the question is why are stocks in the United States rising when the debt level is spiralling and the volumes are dropping?
To me it is back to the market psychology in the United States. As far as most investors and investment gurus are concerned you have to be invested in stocks. This thought is teleported straight to you through numerous television channels and shows as well as through legions of financial planners. I would argue that this is nonsense and that you should shun it as an investment unless you trade it professionally or have a massive investment portfolio for the simple reason that the chips are heavily skewed against you.
A book written by Buchanan called "Ubiquity: Why Catastrophes Happen" highlights some interesting data. Effectively the argument goes that in the markets stability and complacency breads instability. Just like a child throwing buckets of sand onto a pile of sand at some point the sand pile collapses. Now not all of it may collapse and sometimes the slide is small but other times it is drastic, you just never know when it will happen and how large the issue will be you just know that it is only a matter of time. The same thing happens in the markets. As things appear stable more and more risk is taken (as it is perceived that the equilibrium level will remain the same forever) until eventually everything collapses. At the time the collapse happens most people are bullish but once the pile crashes down people become risk averse as they have been burned. In fact the opposite should be true. Be risk averse when the pile gets too high and buy whatever you like when the pile collapses as the risk has been removed.
My hypothesis is then that the United States interest rates just as they did in Japan can and will continue to remain low and even potentially fall further for a significant period of time even while the Federal Reserve prints money hand over fist. Why? Because there is nowhere else to invest that offers the supposed safety of the Untied States. This debt level will create a massive drag on GDP growth for years to come (as it has in Japan) and will come at the expense of the stock market and its upside. Remain patient and wait for your time as when the opportunity presents itself those with the cash will be able to scoop up what they want for pennies on the dollar and that is worth waiting for!
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