To better understand the current economic environment we find ourselves in, it helps to better understand how we ended up here.
And few have as detailed an understanding as today's guest, who has been a true insider in both Washington DC and Wall Street for his extremely long & accomplished career.
We're fortunate today to speak with former Congressman, economic policymaker & financier, David Stockman.
David represented Southern Michigan in the U.S. House of Representatives from 1976 to 1981, and later served as the Director of the Office of Management and Budget in the Reagan Administration and was the youngest Cabinet member of the twentieth century. Since then he has held executive positions in many of the most influential banking, buyout and private equity firms, including The Blackstone Group and Salomon Brothers.
He warns that "everything is overpriced" that it will be "damn near impossible" to continue the current high levels of deficit spending without re-stoking inflation.
It would not surprise him to see a 30-50% downwards correction in financial asset prices begin next year.
Here are my key takeaways from the interview:
David points out that the U.S. government is locked into a structural deficit, spending around 25% of GDP while tax revenues only account for about 17-18%. This imbalance leads to a deficit of 6-7% of GDP each year, adding approximately $2.5 trillion annually to the national debt, which is currently around $36 trillion. David predicts that under current policies, an additional $25 trillion could be added over the next decade, pushing the debt load to unsustainable levels. Both major political parties, despite differences in rhetoric, have proposed significant spending and tax cuts that ignore the existing debt burden, with potential new additions of $7.5 trillion (Democrats) and $10 trillion (Republicans).
The era of debt monetization that began with Alan Greenspan in 1987 appears to be over. From then until 2022, the Fed enabled massive government borrowing by keeping interest rates artificially low, buying Treasury bonds, and expanding its balance sheet from $200 billion to a peak of nearly $9 trillion. This 36-fold increase in the Fed's balance sheet allowed the government to run large deficits without crowding out private investment or spiking interest rates. However, with inflation reaching a 40-year high, the Fed has been forced to reverse this policy, making it more challenging for the government to finance its debt without spiking yields.
With inflation remaining above target, David predicts that interest rates may stabilize at around 5% for the 10-year Treasury bond, significantly higher than in recent decades. He notes that historically, interest rates must offer a "real yield" of 2% above inflation, and with inflation around 3%, this would necessitate a 5% yield. Rising rates will lead to higher borrowing costs across the board, impacting everything from federal debt servicing to consumer credit, mortgage rates, and corporate financing. This rate increase, David argues, will also negatively impact high-growth sectors like tech, where valuations rely on lower discount rates.
David suggests that “smart money” investors in the bond market may soon react to the Fed’s inability to continue supporting the debt. As inflation persists and the Fed steps back from purchasing bonds, large investors may start selling bonds to avoid losses from rising yields and falling prices. He believes this shift could catalyze a broad repricing across asset classes as the bond market adjusts to higher interest rates. He warns that a rapid increase in bond yields would cause ripple effects, impacting stocks, real estate, and other asset valuations.
Both corporations and the government will soon face substantial debt refinancing at much higher interest rates, which could significantly strain balance sheets. Many corporations took advantage of low rates to refinance, but a large wave of this debt is set to mature in the coming years, with refinancing costs likely double or more than current levels. For the government, rolling over short-term debt at higher yields could double interest payments from $1 trillion annually to $2 trillion, further worsening the deficit. This refinancing risk could contribute to liquidity pressures, driving borrowing costs even higher.
David advises investors to minimize exposure to long-term bonds and real estate, both of which are vulnerable to repricing in a rising-rate environment. Instead, he recommends short-term government securities, which currently yield around 4-5%, as a safer option with low risk to principal. For inflation protection, he suggests Treasury Inflation-Protected Securities (TIPS) and a modest allocation to precious metals like gold, which could retain value as real money during inflationary periods. He cautions against speculative positions, especially in sectors like technology and real estate that are heavily reliant on low interest rates to justify high valuations.
David highlights that the U.S. is in a net-negative savings position, which will exacerbate liquidity issues as borrowing needs increase. Analyst Michael Howe’s model shows net liquidity has been rising since late 2022, supporting current asset prices, but this is expected to peak within a year. Furthermore, corporate refinancings at higher rates will act as a “liquidity sponge,” absorbing capital that would otherwise support market prices. This tightening liquidity situation could strain asset prices and investment returns across multiple markets.
David warns against recency bias which is assuming recent history will continue into the future. Investors may be overly reliant on past decades of Fed-fueled asset inflation and easy monetary policy, which led to strong returns across asset classes. However, David argues that those conditions are ending, and the market may face a prolonged period of lower or even negative returns. He stresses the importance of a cautious, long-term perspective that avoids over-optimism and focuses on stability and preservation in an environment where central banks are likely unable to intervene as forcefully as they have in the past.
For the full interview with David Stockman, watch the video below:
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