The Big Picture

“Neither a short-term borrower nor a long-term lender be.” -Polonius

Debt! When you hear the word do you just cringe? Most believe debt is outright bad. And in many cases that would be accurate. However, did you know that the debt market is nearly twice the size of the equity market? Noteworthy business is being done in lending. We know having too much debt is not a place you want to be. In today’s economy is it possible to go through life without ever haven taken on debt? Arguably it is, but that would be a path less chosen.

Utilizing debt to purchase a home is generally not a bad thing. Real estate is an appreciating asset. Going into debt to gain an education is also mostly positive. Returns from education can be quite good. Unfortunately we have witnessed a colossal rise in student loan debt along with education costs (an issue I can address in a post of its own). The point is there is such a thing as good debt and bad debt. Debt, like many financial instruments, must be managed.

Have a Plan and a Process!

From the Trenches

“The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default.” -Alan Greenspan

Can you believe he said that!? He did! Greenspan made this statement in an interview in 2011 on Meet the Press. The gentlemen sitting next to him had a somewhat troubled reaction at the comment (you can find it easily on YouTube). This statement is typical of some of the dogmatic thinking by central bankers. While it is true that government debt is not the same as corporate or personal debt; the above statement, is simply not true. Abusing currency by printing whatever is needed, so the U.S. “can pay any debt”, has dire consequences (See “Money” post from July 2017). There are several examples of this in modern history. Apparently Mr. Greenspan believes the U.S. to be immune. Not likely…

We just hit a major milestone. However not one that warrants a celebration. The U.S. has surpassed $20 Trillion in national debt. If you are curious how big that number is try counting to it! The debt has grown substantially from roughly 58% of Gross Domestic Product (GDP) in 2000 to 103% today (Federal Reserve). The increase in debt-to-GDP began in the early 80’s and has continued in an upward trend ever since. How much government debt is too much?

This is the million dollar, or should I say Trillion dollar, question isn’t it? There is no easy answer here. There are however, many theories and opinions. You know what they say about opinions? Furthermore, size is relative. Remember Albert Einstein? I know, I know, here we go down the rabbit hole. I am simply stating that when compared to GDP, the debt has grown materially. But if we look at the cost of the debt to GDP, it has come down. Rates are still quite low. Is high debt a motivation for the government to keep rates low? I would bet that it is! There are multiple ways to look at this issue. That said, there is a concern that we may have “crossed the Rubicon” with debt. We’ll see… down the rabbit hole we go.

Last point on the debts of governments. I often hear things such as; “China is going to call their debt and the U.S will go bankrupt.” Or something along the lines of “China is going to stop lending to the U.S.!” Et Cetera. I can understand the hype that this has created. China is the largest foreign holder of U.S. debt. Only replacing Japan which held the title for some time prior. In the 80’s the hype was; “Japan is going to own the United States!” It is important to understand that U.S. Treasury debt does not work that way. Have you ever wondered why China and Japan hold so much U.S. debt? In short, we are their largest customer. We buy a lot of goods from them. They end up with a lot of U.S. dollars. What to do with those… Buy U.S. Treasury securities because it is a very large, safe, and secure place to keep those funds. It isn’t so much that China is helping us out as it is China supporting the economic relationship that in turn supports Chinese exports! One thing I would bet on; China is very concerned with continuing its exports to the U.S.!

We do know that continuing along the path of more and more debt will lead us to a place I like to call; Nowhere Good!

Bottom line: There are only a few ways to bring down government debt. Spend less, grow more (i.e. higher tax revenues), inflate or monetize (has its downsides to currency), or increase taxes. Oh no you didn’t just say increase taxes!

The Weeds

“If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem!” – J. Paul Getty

I have always loved that quote! It is a great point. Once a company or a person gets too far into debt, there is really only one way out for them. Bankruptcy. It now becomes a problem for the bank! Notice I did not include country, that is a different process.

What is going on with corporate debt today? There has been a steady and material rise in corporate debt for some time as well. What gives? I suppose some of the increase makes sense as the cost of money has never been lower in history. Might as well take advantage. There is also a higher motivation for financial managers to increase liquidity given the experiences of the financial crisis in 2008.

Why do you care?

All in all, this is a fairly significant structural change in the makeup of corporate financing. Corporations are increasing their leverage, which increases risk! It may have an effect on how we value these companies at some point.

Even more peculiar is while debt issuance has increased, equity issuance has declined significantly. Corporations are buying back shares and funding the buy-backs by issuing debt. This leads us to another controversial subject. Why would a company want to buy back their own shares?

The only good explanation is to take advantage of an undervaluation in its own stock. However, valuations are arguably fairly rich at present. Another, more sinister, explanation is it helps the company report better results through improving earnings per share, or EPS. EPS is the primary measure of a company’s results. If you reduce the “S” by taking shares out of the market, the “E”, or earnings, holds more weight and the measure goes up. Viola! A bit of accounting magic one-o-one.

Bottom Line: Debt is a deep rabbit-hole subject. One worth keeping an eye on. To better understand the impact of debt in the financial markets and on your portfolio, you know where to find me.