US Financial Risk Going Forward

I decided to evaluate risk of a US shock for the 0–12 month period, because there is much talk about a looming crash. The most severe recessions and depressions always follow macro financial imbalances that reach a point of rupture. Lets go look into what is happening and what markets could cause problems going forward…

Macro-financial background

Most major macro shocks that degenerate into major crises are often of the same general structure. After going through many crises of the last 100 years and combing through the literature, here is what I find as variables that are of particular interest:

1. Total debt.
2. Corporate debt buildup and ratio to GDP.
3. Household debt relative to income.
4. Government debt-to-GDP.
5. Price-to-earnings ratio.
6. Inflation and inflation expectations.
7. 10-year government bond yield.
8. Net external debt relative to GDP.
9. Federal bond market depth.
10. Yield spreads as a proxy for risk taking.
11. Large financial institution balance sheet duration gap.

Note that there is domestic political risk such as internal tensions as well as geo-political tensions, both of which can cause severe shocks. But these types of risks are not easily predictable or measurable, so I am leaving them out entirely to focus on the data-driven and measurable sources of financial fragility.

Note that debt-to-income and debt-to-GDP ratios are NOT necessarily problematic, since they can simply represent asset price increases that provide higher collateral.

Understanding the dynamics of booms and busts

A boom period arises when a large portion of the population is confident they will have good job and income prospects in the future and will be able to pay the debts they take on today. These debts can be productive debt (student loans, housing) or unproductive debt (credit debt due to overspending on trips, parties, restaurants, and unnecessary luxuries).

When a shock hits, the severity of the consequences depends on the trust that “things will return to what they were and continue improving” after the shock has passed. If large portions of the corporate sector, household sector, and/or foreigners start to doubt the future, THEN you have a crack in “fortress of trust” and can lead to problems. This is one of the reasons federal authorities intervene so aggressively to restaure trust that things will soon return to “business as usual.”

Federal authorities such as the central bank or the political party in power launch “stimulus packages” to boost aggregate demand, which supports employment and profits in the short and medium run, which then support trust in the future of jobs, profits, pensions, and income.

The government can launch “spending programs” which seek to boost spending on such things as infrastructure. This type of intervention is “centralized”, because it calls for political decisions as to which projects are launched and where, which is the opposite of decentralized stimulus such as tax cuts or monetary stimulus (cutting interest rates and printing money to buy financial assets).

Monetary stimulus causes a drop in credit interest rates and a rise in financial asset (and housing) prices, which boosts “wealth effects” and makes people feel more confident about the future.

As long as inflation is contained, central banks can print extra money to buy assets, which in turn have increasing prices and associated “wealth effects.” If inflation starts rising above-target, then this starts to put a limit on the freedom with which the central bank can print-and-stimulate.

Debt and financial asset variables

These are important because they tell us if financial asset prices seem “over extended” relative to their historical levels. This is always a tricky business, because it is impossible to know WHEN and IF a market is really over extended, since many moving parts can cause price fluctuations.

That said, we can at least analyze the overall situation to know if things seem maxed out or not. To complete the picture, you can add other variables, but most information about the major labour market indicators such as the employment rate, the participation rate, and the unemployment rate are “priced in” financial asset prices. One particularly pertinent variable is the 10-year government bond yield, as it serves as a benchmark for most capital costs in financial markets.

Now financial markets can be “maxed out” seemingly everywhere, yet nothing happens. This is because you need ONE important ingredient to precipitate an asset price “correction”, and that ingredient is inflation and inflation expectations. Failing to take into account these is why many “doomsday analysts” fail miserably with their timing and call a crash every year for 10 years without anything actually happening. They forget about inflation and interest rates.

Foreign asset holdings are more volatile

Since foreign holdings of domestic assets are exposed to currency risk, these tend to be more volatile. This is why it is pertinent to take into account the net international investment position as % of total income to get an idea of the possibility of an asset selloff coming from foreign holders, thus causing “rollover” stress in various credit markets.

However, the foreign holding can be large, but if domestic bond and stock markets are large relative to other countries, they are automatically more stable, because market depth implies better stability, all else equal. So this must also be taken into account when evaluating risk.

Furthermore, the actual foreign holders of domestic assets must also be looked into, because large government holders may have less volatile holding than private sector asset holders such as mutual funds and hedge funds, for example.

Selloff dynamics

If enough asset holders start to panic for whatever reason and start to sell their assets to bring them into the cash money market, then all non-money-market markets get a negative price shock, which triggers margin calls and liquidity squeezing, which exacerbates the downward spiral.

The last resort asset price supporter can always step in: the central bank! This is ALSO a very important variable that must be factored into a risk scenario. If there is no inflation, any financial asset selloff will be stopped cold by massive central bank purchases. I don’t necessarily agree with this, by the way. But such is reality today: central banks stand ready to buy everything in sight, so “free markets” and price signals and all that are pretty much out the door. We are in a monetary global economy and world order.

The data

Here is the data. I discuss further below…

Total private debt as % of GDP:

Total corporate debt as % of GDP:

Household debt as % of GDP:

US government debt as % of GDP (including projections):

S&P500 Cyclically-Adjusted Price-To-Earnings Ratio:

Inflation and inflation expectations:

Net international investment position as % of GDP:

10-year federal government bond yield:

Spread for risk proxy:

My 2 cents

Bank and large financial institutions have their duration gaps under control and a normal capital cushion. Looking at the data, what do we see?

1. Households will NOT be the source of any problems going forward.
2. Stocks are maxed out and corporate credit is high.
3. Government debt is high and rising.
4. Foreign holdings of US assets is larger than ever, which exposes the USA to a foreign selloff and USD currency risk, which can cause an interest rate shock.
5. Inflation and inflation expectations are still quite low and contained, so there is little risk of a major shock for the next 12 months.

This tells me that the next crisis will come from the federal debt market and/or the corporate debt market, and will start with a first-gradual-then-fast drop of trust of foreign holders of US assets.

This crisis will only start to show up once inflation and inflation expectations rise more convincingly, thus forcing the government to eventually convincingly and clearly cut spending and/or increase taxes, thus causing domestic political and social tensions. It will be visible in the 10-year bond yield, which would typically bust above 4%… we are far from that now!

This crisis could likely be very short-lived, since the Fed will simply step in and buy everything in sight to support asset prices. This will be possible as long as 1) inflation is low or is falling and 2) the USD is not totally crashing. If inflation is too high or the USD is crashing, then the Fed would have less wiggle room and might be forced to stand aside and let the asset price crash happen… we will see which way it goes. Clap clap clap! Thanks for reading to the end.

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