Could the Brexit Be the Tipping Point for Stocks?

By June 27, 2016 Blog No Comments

Thanks to Great Britain, the stock market recently experienced its worst 2-day slide since last August. And unless you’ve been living under a rock for the past couple of weeks, the word “Brexit” has probably made its way into one or two of your conversations.

This is not the first—nor will it be the last—hurdle for the European Union (EU). In fact, in the summer of 2011, the buzzwords for euro-zone fragmentation were “Grexit” and “contagion.” In other words, the possibility of the EU breaking apart has been in the news for quite some time.

Keep in mind, the sinister threats to the world economy as well as financial markets are not exclusive to the United Kingdom’s recent referendum. In fact, the dangers trace their origin back to something so simple – something so obvious and prevalent – it’s a shame that the mainstream media have swept the risks under the rug.

What am I talking about? I am referring to “Peak Debt.”

Coming from a very modest upbringing in the Bronx, my grandfather (Papa) was proud of many things. Being debt-free was most definitely one of them. He often boasted that he didn’t owe any man a red cent. As far as Papa was concerned, “debt” served as a literal four-letter word as well as a figurative one.

My grandfather’s attitude towards debt was not uncommon for his generation. I remember shooting darts with him and a few of his buddies at the Elks Lodge one time, and I brought up the topic of home prices in California. They all proceeded to tell me how much they paid for their homes back in the 50s, 60s and 70s. Inflation aside, I was stunned at the modest dollar amounts. Equally compelling? Each of these men were blue-collar to the core – a retired painter, plumber and mechanic. Not only could they afford homes in Orange County, California, but they paid 100% cash for them!

They then proceeded to tell me personal stories. Each had witnessed family members and friends get into trouble with debt. The blue-collar group spoke of these debtors as if they were wayward souls, spending the rest of their days in hiding or shackled to the wall of a debtor’s dungeon.

Clearly, that old school thinking has changed over the course of a few generations. In fact, following my first legitimate paycheck, I remember my father telling me that I needed to apply for a credit card and that he would cosign for me. We did so for a credit line with a 15% APR; we did it with the sole purpose of establishing credit-worthiness – a rite of passage of sorts. After all, Equifax, Experian and TransUnion won’t even acknowledge your existence without you having a credit file.

Then came “No-Doc” and “Neg-Am” home loans. These were the types of mortgages that allowed people to place themselves deep into the debt abyss. It helped stoke one of the most epic real estate frenzies in history (and the eventual collapse beginning in late 2007.) My own family and friends were chastising me for not buying into the madness. Heck, I can recall a professor, in a college of finance nonetheless, telling me to beg, borrow and steal my way into real estate ownership.

That school of thought, in turn, has given rise to a culture that is all-too-familiar with phrases like “strategic default” and “short sale.” Even Congress has gotten into the mix by passing acts such as the Home Affordable Foreclosure Alternative Program (HAFA). Indeed, a host of alphabet soup legislation inspired by the consequences of 2008-2009 have come down the pike.

Unfortunately, all signs point to the grim reality that debt has not only become the means to a version of the American dream, debt is now an American lifestyle. No longer is debt the thing of nightmares, like how my grandfather used to speak of it. (Papa passed away in 2006.) Still, if he were around to witness it, my grandfather would’ve had a thing or three to say about individuals, corporations and governments living so far above their means. He’d have an opinion on how everyone would surely crumple under the weight of the fatal obligations.

Perhaps ironically, the epic meltdown of the global financial system may seem like it occurred eons ago. Indeed, most of us have tried to forget about real estate prices falling 40% or more from their high-water marks and the S&P 500 plummeting more than 50% in less than 18 months. Paper wealth was being vaporized six ways to Sunday.

Yet, here we are. The apocalyptic dust cloud of the Great Recession has seemingly settled. Home prices across most of the U.S. have recouped most of their former glory. Likewise, the S&P 500 has recouped losses and gone on for 30% more in paper wealth beyond the highs reached in 2007.

So why do I even bring up painful memories and insightful analogies? Because the wealth effect that has occurred over the past seven years has been built upon the same faulty foundation as in the Great Recession. And that foundation is unsustainable debt levels.

“But haven’t individuals learned their lesson?” you ask. “Haven’t they become more responsible and repaired their personal balance sheets?” That would depend on how you look at it.

Granted, household debt servicing as a percent of disposable personal income is remarkably low. In the chart below, we see that households are able to afford their lifestyles because debt servicing is as favorable as the mid-80s and mid-90s.

untitled-1Source: Federal Reserve Bank of St. Louis.

Yet, you cannot make this observation without noting that the Federal Reserve has pushed borrowing costs to some of the lowest levels in history. (See the next chart below.) By taking overnight lending rates down to zero – and by manipulating other key lending rates to record lows – households may never be able to afford their lifestyles in the absence of permanently low borrowing costs. In other words, to the extent households keep borrowing and to the extent their total debt rises, there is virtually no room left to lower existing debt servicing in the future. (And may the gods help us if borrowing rates themselves were ever to move higher!)

untitled-2Source: Federal Reserve Bank of St. Louis.

Whether it’s “same as cash financing” for our appliances, furniture and vehicles, or 30-year fixed mortgages at 3.5%, the Fed’s zero percent interest rate policy (ZIRP) may be as close to the limit on how low they may actually go. It is true that central banks around the globe have already entered the theoretical realm of negative rate policy (NIRP), but so far, negative rate policy has failed to stimulate business or consumer lending abroad. And that means, the world is only getting closer and closer to “Peak Debt.”

untitled-3Source: Federal Reserve Bank of St. Louis.

Data does support the notion that American households did make a brief effort to clean up their balance sheets after the Great Recession. Whether it was by choice or by “Chapter 11,” the chart above shows how household debt (blue line) took a modest dip following the 2008 peak of $14.6 trillion. Barely a drop in the bucket, $1 trillion was all American families managed to shed from their balance sheet. Household debt has been slowly climbing ever since.

Corporate debt (red line), on the other hand, barely even skipped a beat. Corporations took only a very brief hiatus from borrowing in late 2009. Since then, corporate America has doubled down on its borrowing. And why not? Having the means to access such affordable credit, corporations have refinanced their old obligations as well as gone on to use the money for acquiring shares of company stock (a.k.a. “stock buybacks”).

Now let’s look at the level of borrowing that has gone on at the federal level. After all, nobody teaches us how to spend beyond our means better than the U.S. government.

untitled-4Source: Federal Reserve Bank of St. Louis.

Unabated by the Great Recession, public debt (in the chart above) has continued to grow exponentially. More than 40 years of data look more like an Evil Knievel launch ramp.

Paradoxically, past and present Fed officials have argued that the Federal government has not done enough. They complain that the Federal government should spend even more.

The notion that more federal spending might be beneficial to the economy clearly depends on perspective. For one thing, total public debt grew by more than $8 trillion since the stock market lows in March of 2009, up 73% in a little more than seven years. To put that pace into perspective, it took 20 years for total public debt to grow by $8 trillion prior to that, from December of 1989 to March of 2009. In essence, the pace of Federal borrowing nearly tripled following the worst credit (borrowing) crisis since the Great Depression!

Even with the speed at which society’s debt has grown in the last seven years, it’s relatively innocuous when you consider the extraordinary pace at which the Fed has expanded its own balance sheet. Our central bank has gobbled up U.S. Treasury bonds and mortgage-backed securities (a.k.a. quantitative easing or “QE”) to help keep interest rates suppressed.

untitled-5Source: Federal Reserve Bank of St. Louis.

Let me try to make this more real for you. For every $1 of that $8 trillion in debt issued to finance the public sector during the Fed’s controversial series of bond buying QE experiments, $0.52 of it was purchased by the Fed with money it created out of thin air. Now, when a bond gets scarcer, its price goes higher. And as the price goes higher, the yield goes lower. Ergo, savers who rely on higher yields are punished, while spenders who cherish lower and lower yields get to spend.

While public debt grew by 73%, the Fed’s balance sheet swelled by a staggering 674%. When you consider the fact that the Fed ended its QE spending splurge back in December of 2014, you are talking about a 37% annualized rate over a little less than six years!

So why bring up the Fed balance sheet at all? If the stock market is up more than 200% since the lows of 2009, and real estate prices have recouped as well, someone must be doing something right, yes?

Unfortunately, excess debt spreads its tentacles out into all corners of society. The solution to a subprime bad debt crisis became, well, a whole lot more debt!

It follows that we may all begin to see the consequences of the Fed entering the ZIRP/QE rabbit hole. If they cut off the ultra-cheap credit lines, the economy and the stock market are likely to implode. Keep rates suppressed indefinitely, and the Everest-sized debt could reach the elevation of Olympus Mons! (Google it!)

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As the chart above shows, stock market growth over the past seven years has been very closely tied to the Fed’s quantitative easing programs. When the Fed expanded its balance sheet, the stock market grew. When the Fed halted its balance sheet expansion, the stock market moved sideways.

“But correlation does not imply causation!”

Yes, I know. However, when you are talking about something as supposedly random as the stock market, a correlation coefficient greater than 90% is a statistical relationship that cannot be so easily dismissed as circumstantial. Markets move for a reason. And over the past 7 years, there has been no better single explanation than Fed policy.

What we have seen in the last 18 months is more or less a “go nowhere” Fed. It follows that since the end of the Fed’s controversial QE program back in December of 2014, the stock market has pretty much gone nowhere as well.

The unfortunate fact about debt is it eventually needs to be paid back; otherwise, the whole system collapses in on itself. And if households, corporations and governments are only interested in adding on more debt in this already abnormally low interest rate environment, what happens down the road when rates cannot actually move any lower?

Japan and parts of Europe are already experimenting with negative interest rates. Try to wrap your head around that for a moment. It is equivalent to a lender paying the borrower to take out a loan. In other words, in a negative interest rate environment, you would (willingly) loan out your money just so you can get paid back less than what you loaned out. Is that really going to work in a rational society for any meaningful length of time?

Regrettably, the powers that be didn’t recognize the debt frenzy for what it was leading into 2008. We all ended up learning some pretty powerful lessons…some more painfully so than others. Yet, here we are again.

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Disclosure Statement: Pacific Park Financial, Inc. is a Registered Investment Adviser with the SEC. Pacific Park Financial, Inc. and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising on this website. StockHedgeIndex.com is created independently of any advertising relationship.

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