This month we will explore a new way to look at economic reality. It has been the proper way to understand economic and market dynamics since the 1990s. And we will dip into why understanding this new perspective is so important.
First, the old paradigm. Traditional economic theory has for years promoted the business cycle as an accepted and fundamental reality. The business cycle theory postulates that economic activity may be understood as a series of peaks and troughs with each succeeding peak higher than the previous. The business cycle moves through three main phases: contraction—or movement from a peak to a trough, recovery—the period of time as the economy begins to move up and out of a trough, and prosperity—the final run up of the expansion, which with the fullness of time falls into contraction.
Now, the paradigm shift. Peter Boockvar of the Bleakley Group, recently offered up an alternative perspective. I think he is onto something. He recently wrote:
“We have credit cycles that ebb and flow with monetary policy. After all, when the Fed cuts rates to extremes, its only function is to encourage the rest of us to borrow a lot of money and we seem to have been very good at that. Thus, in reverse, when rates are being raised, when liquidity rolls away, it discourages us from taking on more debt. We don’t save enough.”
Previously businesses would borrow money in response to the recovery phase of the business cycle. They borrowed to invest in material and capacity to capitalize on the expanding economy and the potential for additional profits. The business cycle drove the acquisition of credit.
Historically, borrowed money has been dear. You pay for the privilege of additional cash and businesses borrowed only when expanding economic activity provided a high likelihood of gains far greater than the accumulated costs of expansion including the price of additional money (interest). The point is they only borrowed when it was profitable. And healthy profit translates into robust economic expansion.
Since the 1990s and the Alan Greenspan Federal Reserve, things have changed. Under Greenspan the Fed dumped money into the economy beyond the cash needed to sustain economic growth. They responded to the market turmoil of 1998, they jumped out in front of concerns of a Year 2000 (Y2K) universal computer meltdown and the threat of a linked economic meltdown, and they left (now probably) excess amounts of credit floating around the economy.
In the next decade a new Federal Reserve Chairman, Ben Bernanke, followed suit and over-inflated the economy with (again probably) excess amounts of credit that lead to an historic housing bubble and ultimately the great recession.
The net result has been a shift in perspective. Credit, once considered by people and businesses to be a tool for judicious use, has become the equivalent of an economic narcotic, a substance that replaces reality. And everyone seems to want it.
And here’s the rub. Debt fueled investment provides smaller and smaller returns as the debt grows larger and larger. In economic terms, there is an inversely correlated return as debt expands. Whether it is personal debt, business debt or the aggregate debt in the national or world economy, if allowed to expand uncontrolled, the borrower will eventually discover a tipping point where debt controls the outcome. That outcome is usually bankruptcy. Along the way, the closer the borrower gets to that catastrophic failure, the more the return on debt curve bends downward and the value of borrowing diminishes. That’s a long way of saying; the more debt consumed, the less return the debt will provide. Shorter still, at some point debt stops stimulating growth.
This set of realities is part of why you have heard so much from us at Arkenstone Financial about the Federal Reserve. The easy money policies of the Fed have settled into the roll of primary driver of the economy.
Given the powerful influence of credit over the economic cycle understanding the tools and measures that help us understand where we are in the credit cycle and the likely impact that positioning will have on the credit markets and equity markets becomes very useful.
Next month we’ll take a look at the yield curve and how relating short term bond rates to long term bond rates may help us better understand when the economy may be tipping over into recession.
So, at Arkenstone Financial we remain vigilant. We consistently research and routinely update our trend following strategies designed to participate in positive market moves and at the same time manage risk. And, we keep you informed.
If you’ve got questions or want to expand on this conversation give me a shout.
- Inside the Bubble in Washington D.C. - August 22, 2018
- Paul’s Perspective – Through the Looking Glass of New Economics - June 21, 2018
- Paul’s Perspective – Will the Retirement Boom Be a Bust for Equities? - May 23, 2018
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