Hoisington Quarterly Review And Outlook – 3Q15  by John Mauldin, Mauldin Economics

Lacy Hunt has a way of getting right to the point. Thus, in the opening paragraph of Hoisington Management’s 3Q “Review and Outlook,” today’s Outside the Box, Lacy nails the global economy to the wall:

Future business activity will reflect two economic realities: 1) the over-indebted state of the U.S. economy and the world; and 2) the inability of the Federal Reserve to initiate policies to promote growth in this environment.

If that’s not a pithy, spot-on summary of our sorry situation, I don’t know what is. And as usual, Lacy backs up his conclusions with plenty of solid analysis, drawing on the latest and best research. That’s why, quarter after quarter, I send Hoisington’s “Review and Outlook” your way – Lacy’s work is a cornerstone for my own thinking on the economy and markets.

Hoisington Investment Management Company (www.Hoisingtonmgt.com) is a registered investment advisor specializing in fixed-income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $5 billion under management and is the sub-adviser of the Wasatch-Hoisington US Treasury Fund (WHOSX).

I am in Portland at the Allison Resort and Spa, which is a fabulous place. My hosts, Aequitas Capital, couldn’t be kinder, and I have been able to find a few hours here and there to actually enjoy this wonderful spa. Dinner with my great friend Ed Easterling was just a special bonus.

The previous two days in the San Francisco Bay Area were simply mind-boggling. Every time I get around brilliant researchers who are at the very bleeding edge of the latest discoveries in the biotechnology world, I succumb to amazement and astoundment. Truly, we live in fascinating times. I am not going to say much here about what we experienced, as Patrick Cox and I intend to make a full report in our letters this week.

I’m going to hit the send button quickly, as the room below is full of people who are experts in various aspects of private credit and some really fascinating areas of alternative investing for income. I’m learning a great deal, and what I learn will end up having to become a special letter on its own. If Lacy is right (and I think he is), fixed-income investors are going to have to look outside the traditional markets in order to be able to get anything close to the returns they need from their portfolios. The 40-percent part of the typical 60/40 portfolio is going to be very challenged.

You have a great week. I will be flying back to Dallas tomorrow afternoon, changing my suitcase at home, and then jetting off to Jersey and eventually Manhattan. But it’s all good.

Your thinking about debt analyst,

John Mauldin, Editor
Outside the Box

[email protected]

Hoisington Quarterly Review and Outlook – 3Q2015

Economic Realities

Future business activity will reflect two economic realities: 1) the over-indebted state of the U.S. economy and the world; and 2) the inability of the Federal Reserve to initiate policies to promote growth in this environment.

The first reality has been widely acknowledged, as developed and developing countries both have debt-to-GDP ratios sufficiently large to argue for a slowing growth outlook (Chart 1).

Hoisington Management

U.S. government debt now stands at 103% of GDP. If private debt is included, the ratio climbs to about 370% of GDP. Scholarly studies indicate that real per capita GDP growth should slow by about one-quarter to one-third from the long-run trend when the total debt-to-GDP ratio rises into the range between 250% and 275%. Since surpassing this level in the late 1990s, real per capita GDP has grown just 1% per annum, much less than the 1.9% pace from 1790 to 1999.

These results indicate that the relationship between debt and economic growth is non-linear, or progressively negative, as debt advances to higher levels, a pattern confirmed by academic research (Chart 2). The latest information further supports this relationship. The current expansion began in 2009, and since then real per capita GDP growth has been 1.3%, less than half the 2.7% average growth in all expansions from 1790 to 1999.

Hoisington Management

The Bank of International Settlements released a report last month stating that total public and private debt relative to GDP for the entire global economy stands at 265%, up from 219% at the peak of the prior credit cycle. Additionally, the global rate of growth is decelerating significantly while debt levels are continuing to rise, indicating an increasing debt drag. Researcher Chris Martenson calculated that since 2008 total public and private debt rose by $60 trillion while GDP gained only $12 trillion.

The second economic reality is the failure of the Federal Reserve to produce economic progress despite years of wide-ranging efforts. The Fed’s zero interest rate policy (ZIRP) and quantitative easing (QE) have been ineffectual, if not a net negative, for the economy’s growth path.

Short-term interest rates in the U.S. have fallen to near zero, restraining the central bank’s ability to lower them further. None of the more powerful channels of monetary policy, including money growth, have been responsive to Fed actions. When the debt overhang is excessive, the Fed and other central banks cannot control money and velocity, real long-term interest rates or the Wicksell Effect. Over the summer, the Wicksell effect has become more adversarial to economic growth in the U.S. as nominal GDP growth has slowed, while the market rate of interest, as measured by the BAA corporate bond yield, has risen. Treasury bond yields, in real terms, have remained stubbornly unchanged since 1990 even though the nominal bond yield has dropped 600 basis points.

Despite the unprecedented increase in the Federal Reserve’s balance sheet, growth in M2 over the first nine months of this year fell below its average rate of growth over the past 115 years, a time when the growth in the monetary base was stable and quite modest (Chart 3). In addition, velocity of money, which is an equal partner to money in determining nominal GDP, has moved even further outside the Fed’s control. The drop in velocity to a six decade low is consistent with a misallocation of capital and an increase in debt used for either unproductive or counterproductive purposes.

Hoisington Management

The evidence speaks for itself: the Fed cannot print money. The Fed does not have the authority or the mechanism to print money. They have not, they are not and they will not print money under present laws.

The Fed, of course, has the authority to buy certain assets, including government bonds, in the open market, but that is where their authority starts and stops. They create excess reserves by buying securities in the open market, which are then owned by the depository institutions. However, the Fed does not have the direct capability to move these funds and therefore place them in the hands of households, businesses, and other nonbank sectors. It is this transaction that creates money. Keeping short-term interest rates low for an extended period of time will not change the trajectory of the economic growth path as long as the massive debt overhang persists.

Finally, policy

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