On first reflection, the US economy appears to be in relatively healthy shape. Unemployment levels are back near long-run averages, business confidence appears buoyant and GDP has grown significantly during 2021 to recoup many of the losses following the global shock of the coronavirus crisis. However, under the surface all is not as rosy as it seems.
Growing US debt levels
Though GDP has grown strongly, so too has US Federal debt and at a much faster rate. Whilst this would not always pose an immediate problem, we need to consider the relationship between the two. Debt to GDP [1] reached levels of 130% in Q2 2020 and this in itself is a notable milestone. Over the past two centuries, 51 of the 52 countries that reached sovereign debt levels of 130% of GDP ended up “defaulting” within the next 15 years, either through devaluation, inflation, restructuring or outright nominal default.
US Federal net outlays currently outweigh their receipts by a considerable margin. Importantly, it is either impossible or politically difficult to reduce a large portion of these outlays immediately. The US now finds itself in a similar position to the German government post the first world war, where compulsory war reparations hampered their ability to control government spending. Nevertheless, this spending has to be financed somehow. Historically, foreign central banks bought large amounts of US Treasuries. However, of the $10trillion increase since 2014, only $1.2trillion was purchased by overseas investors. Several key domestic parties have therefore had to bridge the financing gap.
Increasing burden on Federal Reserve
Recent regulatory changes focusing on liquidity ratios encouraged US banks and Money Market Funds to purchase Treasuries and the holdings of each have now reached all-time highs. Unfortunately, they are reaching their upper limits from a regulatory point of view and are now being incentivised to push away deposits through reverse repo arrangements in search of higher yield. The remainder of the new issues were purchased by the Federal Reserve, who have almost doubled their holdings over the past 12 months. Without any other major buyers on the horizon, it looks like they will have to continue to do so for the foreseeable future.
This cannot continue indefinitely. At some point the market will have concerns about the US defaulting on their obligations. Therefore, debt needs to be brought back to a level below GDP where monetary policy can be effectively implemented again. As it appears that there are no obvious routes for cutting debt, GDP will have to grow at a rate faster than the 9% per annum debt averaged over the last 20 years.
Long-term inflationary pressure
For a developed economy these are significant numbers and as a result, actively seeking inflation may be the only sensible solution. The recent softening of language over how ‘transitory’ inflation expectations are in the US perhaps hints at such a case. If the US pursued the strategy of (hyper)inflation then the US dollar is likely to fall substantially and the effect on markets would be widespread.
Notably, this potential strategy of ‘financial repression’ already seems to be underway. Real yields are very negative and will need to remain so for some time. On a positive note, it seems to have played a role in reducing debt to GDP from its high of 136% down to 125%. However, this will need to continue for another 4-5 years in order to de-lever the government’s balance sheet sufficiently. Can this strategy be sustained for that long and how negative might real rates get in the interim period?
Relationship between macroeconomic fundamentals and systematic strategies
One might ask why a systematic manager needs to keep track of the wider macroeconomic climate. This is because each systematic strategy is based upon a set of underlying assumptions. Many are designed to work in certain environments and rely upon markets behaving as expected. If long-run relationships no longer hold, then the ‘rules of the game’ may have changed to the extent that market movements are no longer predictable and the strategies may not perform as well as expected.
Understanding the macro environment is central to the deployment of systematic strategies. When we at Paravene undertake research into the performance and suitability of any strategy, we need to be aware of the current economic regime which we are in. Therefore, like the market, our portfolio evolves through time, aiming to be optimally positioned for our investors’ capital.
Paravene Capital is a multi-strategy Investment Manager, that marries proven systematic trading strategies with downside protection structures to deliver uncorrelated, stable return streams. To find out more about us please visit our website: https://www.paravenecapital.com/.
[1] Source: Fred, Federal Reserve Bank of St. Louis.