FRA: Hi welcome to FRA’s Roundtable Insight .. Today we have Dr. Lacy Hunt. He’s an internationally recognized Economist, the executive V.P. and Chief Economist of Hoisington Investment Management Company. It’s a firm that manages over 3.8 billion for pension funds and its insurance companies and others. He also served in the past as Senior Economist for the Federal Reserve Bank of Dallas, where he was a member of the Federal Reserve System Committee on Financial Analysis. Welcome. Dr. Hunt.
Dr. Lacy Hunt: Nice to be with you, Richard.
FRA: Great. I thought we’d have a discussion on a variety of topics relating to the economy and the financial markets. You recently mentioned that you thought this was the worst economic expansion recovery in U.S. history since 1790. Wow. Can you elaborate?
Dr. Lacy Hunt: Well if you calculate the average growth rate in the expansions in 1790, this is the slowest. It’s a long-running expansion, but it’s the slowest and in the last 10 years the household sector is very very poorly. The rate of growth in real disposable household income per capita is only 0.9 percent per year. And in the last 12 months, we’re only up 0.6 percent per year. So it’s a long-running expansion but it’s been a poor expansion. Certainly some of the earlier data, there are certain problems with it, but this is clearly slowest expansion since the end of WWII in our households. The main problem they’ve not kept up.
FRA: And do you point a finger for this cause as primarily on the Federal Reserve or do you see structural changes happening to the economy.
Dr. Lacy Hunt: I think that the main element that has oppressed the growth has been that the U.S. economy is so heavily leveraged. We have few much public and private debt and the debt, unfortunately, does not generate an income stream for the aggregate economy. And as a result of the prolonged higher indebtedness, which is on the verge of going much higher because of the problems in the governmental sector, the economy is now experiencing very poor demographics. We have a baby bust, a household formation bust, the birth rate is the lowest since 1937 and this is exacerbating the problems because we have too much of the wrong type of debt. And because we have too much of the wrong type of debt velocity of money falling and in fact velocity this year will be the lowest since 1949, only 1.3. And the debt creates a situation where monetary policy capabilities are asymmetric. A lot of action to sort of stimulate the economy has a very muted impact on economic activity, whereas a little bit of tightening goes a long way in depressing economic activity. So what the root cause of this underperformance is the extreme.
FRA: And what about the Federal Reserve? How has it undermined the economy’s ability to grow, you have recently observed it?
Dr. Lacy Hunt: Well the Federal Reserve, the most serious mistakes were really made in the 1990s and 2006, which allowed the private sector to become so extremely over-indebted with the wrong type of debt. And I think that the quantitative easing has, in essence, created more problems for the economy that is solved by saying that they want higher stock prices. It’s caused the corporate executives to switch funds from real capital investments into financial investments, paying higher dividends, buying shares, their own company back buying shares of others. And while this type of action does produce a higher stock market it doesn’t generate a higher standard of living. And so for reserve policy I think has not served the economy well overall. Although it certainly has served components of the economy extremely well.
FRA: And due to that do you think that there’s been too much financial investment versus real economy investment in terms of diverting the economic financial resources away from the real economy.
Dr. Lacy Hunt: I think that’s the principal problem. Business debt last year reached a record relative to GDP. And as I said it’s created a higher stock market, but it has not generated a higher standard of living. That’s the basic problem. And I think when the Reserve undertook quantitative easing it was sort of a signal to the corporate executives that we prefer financial investments and we’ll do what we can to protect financial investments. But that meant that financial asset was preferred over real side investment. And so it’s intermingling with the growth of pressing effects of too much debt. And unfortunately, the debt levels are getting ready to move substantially higher in the U.S. governmental sector. Government debt is already approaching 106 percent of GDP. It’s a brief period during World War II. It’s a record and by 2030 federal debt will be approximately 125 percent GDP. We’ve known about the problem, the demographic problems, for a long time that would inflate the entitlements, but there is also an increasing likelihood that the new federal programs that production’s expenditure increases will further accelerate the growth in federal debt. And I think there is very clear evidence that increases in federal debt at these very high levels relative to GDP over any measurable length of time it reduces economic activity. There is a negative multiplier, not a positive multiplier, to see exactly what David Ricardo hypothesized in 1821 and I think that’s confirmed. I, myself, have looked at the relationship between per capita changes in real GDP and per capita percent changes in government debt per capita and the relationship is negative, not positive. And so that’s that’s basically the problem we’re trying to solve indebtedness problem by taking on more debt. You can get intermittent spurts of economic activity and inflation, but ultimately the debt is a millstone around the economy’s neck.
FRA: So would you say that we have migrated to a sort of flattening natural economy?
Dr. Lacy Hunt: Yeah and let me give you a couple of examples. There’s so much liquidity in the financial markets. The stock market that a lot of the economic news is this is interpreted very constructively even when it’s not constructive. Meaning virtually the whole world believes that the United States is experiencing large job gains and that it really isn’t in question. But the rate of growth in payroll employment on a 12-month basis peaked at 2.4 percent in early 2015. In the last 12 months we’re down to 1.4 percent for the last 12 months. But what’s what is critical, if you look at just the expansions, don’t include the recessions since 1968, the average growth in employment in an expansion year was 1.9 percent. And in the last 12 months we are half a percentage point under that. Yes there is a perception that the employment gains are strong. And this of course undermines the the improvement of the standard of living. Perception is that the job gains are strong when in fact they are not. And there because of the liquidity and the need of some investors to fully participate in the rising stock market they tend to overlook other important developments. If we go back to the 12 months ending November of 2015, real average hourly earnings were up about 2.5 percent for the 12 months ending. And in the latest 12 months it looks like a real average hourly earnings are actually negative for the last 12 months. So there is the liquidity tends to push the focus away from the more realistic interpretation of the economy for certain types of assets. However, the weak performance overall and the deceleration and some of the indicators that I just referred to is not being unnoticed by the bond market. So we have this dichotomy, where the stock market is up strongly, but the long-term bond yields are down. Now the short-term yields are up because they are under the control or heavy influence of the reserve is the process of raising the short-term rates and they are also winding their portfolio. They made 20 billion dollars of government agency securities in October and November. And so that is pushing up the short-term rates with the long-term rates looking at some of these more important fundamentals are actually declining and another element that is not in the public at all because the fed reserve no longer does monetary analysis is that we are seeing a very sharp slowdown in the rate of growth in money supply and bank loans and an important credit aggregates. The last year, the M2 money supply was up 7 percent. It’s decelerated to less than four and a half percent in the latest 12 months and the rate of growth in bank loans and commercial paper which topped out on a 12- month basis about 9 percent is now under 4 percent. So the Fed’s raising of the short-term rates reducing the monetary base is causing a tightening in the financial side of the economy and enough investors see that. It’s not in the general psyche because monetary analysis is no longer very common. The yield curve is as flattening very dramatically. And when the yield curve flattens in the way that it is today, it’s first of all a symptom that monetary restraint is beginning to bite. Now the slowdown in money supply growth bank credit flattening of the yield curve these occur well before there is any noticeable impact on a broad array of economic and long lags in monetary policy. But when the yield curve starts flattening, that intensifies the effect of the monetary tightening because it takes away and greatly reduces the profitability of the banks and all those that act like banks. Banks make a profit by borrowing short lending long term. When those spreads come down bank profitability is hurt, particularly for the higher risk year types of bank loans. Not enough spread there to cover the risk premium. So the banks begin to pull back and this really further intensifies the restraint that’s emanating on the economy. So we have an economy that that the vast majority of people, vast majority of investors think is doing very well, but in fact there are elements right beneath the surface that suggest very strongly to me at least, that the outlook for 2018 is considerably more guarded than the conventional wisdom.
FRA: And do you see the potential for an inverted yield curve in the near future?
Dr. Lacy Hunt: I’m not sure that we will have to invert because the economy is so heavily indebted and the velocity of money is lower than any time since 1949. Now a number of people have pointed out that we typically invert before a recession and that historically has been the case most of the time not all of the time if you go that far enough, but see this is not a normal economy. For example, money supply growth since nineteen hundred has averaged about 7 percent, whereas currently, the rate of growth in M2 is about 36 percent below longer marriage, is a very weak rate of growth and money. And the velocity of money is lower than all of the years since 1942 with the exception of seven years and the economy has never been this heavily indebted. And so I’m thinking that what we might see is that the yield curve could possibly approach inversion, but it may or may not go through it but it will stay there very long because at that stage of the game the flattening of the yield curve will greatly intensify all these other effects. The reduction in the reserve aggregates, the monetary aggregates, the credit aggregates and the weakness in velocity. And when this becomes apparent the Federal Reserve will not be able to reverse gears quickly enough to ameliorate the impact that this will produce in terms of future economic growth.
FRA: So do you still see a secular low in bond yields on the long into the yield curve remaining in the future sometime?
Dr. Lacy Hunt: Yeah I think the long and lows have not been seen. It will be extremely volatile as we have been and we will have episodes in which the long yields rise. My attitude is that the loan yields can go up over the short run for any one of a number of causes. There are so many elements work out in the long end, but that they cannot stay up because when the yields go up and especially now that the yield curve is flattening. This intensifies monetary restraint, which puts downward pressure on commodities we’re going to see some of that. It puts upward pressure on the value of the dollar and it cuts back on the lending operations. One one of the things I think has been sort of overlooked, in general euphoria over the strength of thought, is the fact that commercial and industrial loans for all of the banks are now only up one-tenth of one percent last 12 months. There are forward-looking elements that have been very important historically that are signaling that change is ahead. They don’t tell us the timing. Timing is always difficult, but they are flashing signal should be observed.
FRA: And as this plays out, do you see monetary policy and fiscal policy is changing, like will we get fiscal policy stimulus. Will there be a change in monetary policy and how will that look like?
Dr. Lacy Hunt: Well with regard to the funding, the new federal initiatives, whether they’re tax cuts or infrastructure or what have you. Will not provide a boost to the economy if it is funded with increases in debt. That’s where we’re at. And by the way, it’s been that way for some time if you go back to 2009 we had a one-trillion-dollar stimulus package that was said to be inflationary and boost economic growth. But yet we still had this very poor expansion and inflation except for intermittent bouts here and there, largely and highly priced any lasting goods. The inflation rate has trended lower and so the basic. For example, when President Reagan cut taxes, government debt was 31 percent of GDP and now that’s 106 on its way to 120-125. And so if you go back and if you read David Ricardo’s great article in 1821 he was asked whether it made a difference; as to whether the Napoleonic wars were financed by taxes or by borrowing and Ricardo said that theoretically saying either way you’re going to suppress private sector activity and now we have a lot of evidence including some that are operatives that the government multiplier is negative not positive over a three-year period. May work for a very short while, but not on balance. And you see in these if the tax cuts were revenue neutral and they were financed by reductions in government expenditures that would be positive. Because what the evidence shows that the tax multipliers are more favorable than the expenditure multipliers. It is greater efficiency for private sector spending and government spending. And so there’s also evidence that you would lower the cost of capital, but that’s not what we’re talking about is it. We’re talking about a debt-financed tax cut and we’re not talking about a revenue-neutral infrastructure plan, just as we were not talking about revenue neutral in 2009. We’re talking about the debt-financed and at this stage of the game, those options will work for us. They’re going to make us more vulnerable. Except for a few fleeting instance. I will say this when you have a debt-financed infrastructure program or tax cut there will be pockets within the economy that will benefit, but the aggregate economic performance will not benefit and so fiscal policy as I see it is not really going to be helpful. The risk is that the debt builds up will add to the problems. There is very serious academic research that shows that when government debt rises above 90 percent of GDP for more than five years you lose a third of the economy’s growth rate from trend. Well actually we’re not 106 and there’s some evidence these higher levels of debt of the effect is non-linear, other words we use growth at a faster pace and there’s a lot of evidence. Just look at the data that we’re losing a half of our growth rate from trend. GDP rose 2.1 percent per capita since 1790. The latest 10 years where at 1.0. And so we should have lost only seven-tenths. We should come down at 1.3 over one and it looks like that is a consequence that we have to deal with. We’re not in a position to ignore the debt levels. So fiscal policy can be talked about, we can debate about it, and we can proclaim its benefits, but I don’t see them in the current environment. Just as I didn’t see them in 2009. I would change my alternative if they were revenue neutral really, but that’s not the issue here. And as guard to monetary policy, I think monetary policy is really all center. To me inflation is a money-price-wage spiral not a wage-price spiral, that’s the Phillips Curve. The way inflation gets started if you have an acceleration in money supply growth, that’s not offset by weakness and velocity, and that shifts the aggregate demand curve inward. Remember the aggregate demand curve is equal to money times velocity by algebraic substitution that’s true in all the leading textbooks macroeconomics. So you have a money supply decline, velocity declines, so the aggregate demand curve over time is going to shift downward. Which gives you a lower price level, lower level real GDP, doesn’t happen every quarter or even every year. That’s that’s the basic trend. And so monetary policy is in the process of not of accelerating money supply, but they are decelerating money supply grow very significantly. And if the Fed hears to their schedule of quantitative tightening I calculate that M2 to grow by the end of the first quarter. It’s currently running around four and a half percent the year over year growth rate will be down to less than 3 percent. And so monetary policy is taking steps to lower the reserve monetary and credit aggregates. And these actions, by the way, will further flatten the curve because they can press the short rates up, but the long-term investors I think will understand that the inflationary prospects on a fundamental basis are getting weaker, not stronger.
FRA: And do you see these trends as being exacerbated by the emerging government pension fund crisis, like could there be more debt used to solve that like for bailouts? Do you see that potentially happening?
Dr. Lacy Hunt: Well the main problem with government debt is that we’re going to have approximately 1 million folks a year reach age 70 for the next 14 or 15 years. And we’ve made a lot of promises under Social Security Medicare and the Affordable Care Act and we’ve known that this was coming, but we didn’t prepare for it. And so government debt will have to be used to fund the entitlement benefits and I don’t see any other way around it. And another problem that I think is being overlooked is that the actual federal fiscal situation is much worse than the numbers appear on the surface. For example, in the last three years, the budget deficit got worse each year. If you sum the budget deficits for or for 2015, 2016 and 2017 the sum is 1.2 trillion, but a lot of what was previously called outlays have been moved off budget, we call them investments through something else, student loans they get it and there are others. The actual increase in federal debt in the last three year is 3.2 trillion. So the budget deficit is actually greatly understating what is happening to the level of federal debt. They didn’t always use to be the case. And by the way that was worsened by a Bipartisan deal between one party that controlled Congress and another party that can control the White House in 2015. And neither party is blameless they both agree on it, but they didn’t change the fact that the federal situation is deteriorating and much worse than the deficit numbers themselves indicate.
FRA: And what about like for state and local jurisdiction locales, in terms of their government pension funds. Could there be federal level bailouts at that level?
Dr. Lacy Hunt: Here again what are they going to bail them out with. You’re going to have to sell Federal Securities. And one of the multipliers on new sales of Federal debt, they’re negative, not positive. Forget what was taught you in your macroeconomic class 20 years ago or 30 years ago or even 15 years ago. When I was in graduate school I was taught that the government multiplier was somewhere between four and five. That’s not the case it looks like it is at best zero and possibly slightly negative.
FRA: Yes. And finally your thoughts on Cryptocurrencies and Bitcoin and any thoughts that you have. Like in terms of what’s the behavior of the pricing action or the future of Cryptocurrencies?
Dr. Lacy Hunt: Well we’re fixed income investors. We manage about four and a half billion dollars for institutional accounts. And one of our rules of our approach over the years is that we only make recommendations in our asset category. We’re not experts in the Cryptocurrencies or golds or stocks. We observe the trends, but that’s not our area of expertise. We have enough trouble staying in the confines of the fixed income market and the Treasury sector of the fixed income market.
FRA: Yes. No worries that is a great insight as always. How can our listeners learn more about your work Dr. Hunt?
Dr. Lacy Hunt: Well we put out a quarterly letter, which they can write to us at hoisingtonmgt.com and when you send us your contact information and we’ll provide your quarterly letter as a public service. Please do that, no one will contact you. You know market letter; we make it available to anyone that has an interest.
FRA: Okay great thank you very much for being on the Program Show, Dr. Hunt. Thank you.
Dr. Lacy Hunt: My pleasure Richard nice to be with you.
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