US Debt, China & Banks. Oh My!

The economic and investing landscapes are always in a state of flux, but lately the headlines seem to be coming especially fast and furious. In discussions with reporters, clients, and friends, I am asked a lot of questions that boil down to, “Does this make any sense?” This week, I wanted to share some of the questions I’ve been asked, and to take the time to share my thoughts and how they relate to our investing strategy and philosophy.

The national debt is on everyone’s mind lately as a potential debt-ceiling crisis approaches. Is the United States being crushed by debt? Will a conflict with China spell economic doom if the Chinese stop buying US Treasuries? Isn’t the debt going to create more inflation? 

First some background data. Currently, the US national debt is roughly 118% of GDP, a level we have only seen historically during and immediately after World War II. The total amount of US government debt outstanding currently sits very close to the current debt limit, which is $31.4 trillion.[1] US GDP for 2022 was $25.5 trillion, and the economy grew at an inflation-adjusted rate of 2.1% in 2022.[2] For the non-economists in the crowd, nominal GDP growth was 9.2% last year, but you subtract the 7.1% inflation rate to get the 2.1% inflation-adjust, or “real” growth rate.

Foreign countries currently hold about 24% of US debt. Japan is the largest holder at $1.1 trillion, and China is the second largest holder at $859 Billion.[3] This means that China owns 2.7% of the United States sovereign debt – certainly a significant amount. The Chinese economy is the second largest in the world, and deeply intertwined with the US economy, which is still the largest. With regard to commerce, we are as economically beholden to China as any business is to its largest customer. Of our four largest trading partners, China ranks first with 16.9% of the total; Canada is second with 14.8%, and Mexico is third with 14.2%.[4] So, I agree that any potential war with China, whether hot or cold, would both impede trade and add to the US’s cost of funding its deficits.

While China is very important to the global economy, the US is much more important. China’s economy was two-thirds the size of the US in 2022. As many international companies look to diversify supply chains in the post-COVID world, they are finding that building new factories and facilities outside of China is expensive and difficult, yet it can be done even if the time frame is years rather than months. The contributions of the US to the world economy – financial services, technological innovation, education & research – would be much harder to replace if the world decoupled from the US. Replacing American prowess would not take years, but decades or even generations.

I am concerned about tensions between the US and China, but I recognize the costs of conflict would be untenable for China and relatively much greater than the potential costs incurred by the US. I hope that cooler heads prevail, but I have faith that the American way of life and economic juggernaut will endure and ultimately thrive.

Rising interest rates is an issue that impacts almost everyone directly, and I have been asked many questions about the bigger picture. Will rising interest rates create a collapse in urban real estate that spirals out of control? How will the government finance deficits in a rising rate environment?

The urban office market is a significant headwind. The post-pandemic usage reduction for office space is estimated at about 30% prospectively.[5] As leases come up for renewal, a reduction in rents wrought by high vacancy rates will hamper landlords’ ability to pay their mortgages and cause credit problems for banks, insurance companies and other institutional lenders. This headwind looks to be with us for at least the next few years. This will keep commercial real estate lending tight and borrowing rates high, but losses related to commercial real estate will not come close to those sustained with residential real estate during the GFC. Banks, in the aggregate, have more than enough resources to manage through this correction, though there will clearly be some pain at individual lending institutions.

The interest on the US debt is an increasing concern, and we’re not alone. Any time a country is rapidly increasing its outstanding debt, as most countries have, as the cost of that debt is rising, things can get untenable in short order. The following chart is from the Peterson Institute. A study by economists Carmen Reinhart and Ken Rogoff from Harvard showed that when an economy’s debt exceeds GDP, the money used to service that debt curtails future economic growth.

Still, Congress and many presidential administrations have been universally unwilling to address this problem due to the political risks. I don’t see much cause for optimism going forward either. Eventually, and nobody knows when, our policymakers will be compelled into austerity by market and economic forces. Until then, we are likely to see debt levels continue to rise. This is an investor “tail” risk that is hard to quantify but is always in the back of my mind. 

Source: Peterson Foundation. As of May 2, 2023.

Related to rising interest rates, more and more concerns arise about the banking system. The most blunt of the questions are “Has the current Administration ruined the American banking system?” and more broadly, “How bad is the crisis in the banks?

I don’t believe the banking system is ruined by any stretch, though it is under considerable stress. While the current administration and Treasury Secretary Janet Yellen have certainly made missteps (as every administration dating back to Washington and Treasury Secretary Hamilton surely has), they did not create the current turmoil. Secretary Yellen happens to be at Treasury’s helm at a critical moment. She has not been an effective communicator, and that has hurt the banking system. But the problems are much larger than Secretary Yellen.

Banks are businesses and not part of the government. Like any business, banks should be allowed to fail if their management teams make a series of bad decisions that imperil the enterprise. During the Global Financial Crisis, though, the federal government (Treasury, FDIC, Fed, etc) made the decision to bail out banks and their investors because they determined that the alternative was the failure of the entire financial system and a second Great Depression. Those government’s decisions led to the notion that many big banks were “too big to fail,” because the authorities wouldn’t let them fail. And that sentiment endures today. 

Today’s bank crisis is much different, though I would argue that its genesis is the same. Like the GFC, today’s banks are suffering the consequences of years of ultra-loose monetary policy. For reasons I have trouble explaining (though most are likely political), the Fed and federal government never really stopped priming the economic pump after the GFC, with liquidity injections accelerating following the arrival of COVID. A lot of this liquidity ended up on bank balance sheets in the form of deposits. Now that the Fed has determined that the massive amounts of liquidity in the system must be drained in order to effectively combat inflation, the banks are seeing their business models come under assault. Customers are demanding higher rates on their deposits or leaving the banking system altogether in search of higher returns. And just as importantly, the value of bank assets, to include loans and bond portfolios, are losing value as interest rates rise. The combination of falling asset prices and soaring funding costs is wreaking havoc on an industry that had been viewed as relatively stodgy in the years since the GFC.

So, what to do about it? There are two things that will almost undoubtedly put an end to the turkey shoot that short-sellers are now enjoying with the regional banks. First, the Fed needs to make clear that its interest-rate hikes are over. We obviously didn’t get that explicit guidance from Chairman Powell yesterday, but I also think it’s clear that the Fed is now in pause mode. 

I also found it somewhat troubling that Powell was dismissive about a couple of things. First, when asked about the massive amounts of deposits that have been fleeing the regional banks, Powell opined that this was a normal consequence in any Fed tightening cycle (insert game show buzzer here). The loss of over $100 billion in deposits by one bank in just a few days is anything but normal. Second, Powell also dismissed the stark contrast between the Fed’s view of the economy and that of the fixed-income markets. The bond markets are clearly screaming, even louder now, that the Fed is making a big mistake by continuing its rate-hike campaign. The markets are saying the Fed has already done enough, and further hikes will have to be quickly reversed. Whatever metric you use – Fed Funds futures, breakeven inflation rates, or Treasuries with maturities greater than one year – they are all saying the same thing: it’s time for the Fed to relent. Does the Fed really believe it’s smarter than the collective judgement of trillions in investment dollars?

Second, the FDIC insurance caps need to be increased so that the implicit guarantee that’s been in place until now becomes more explicit. These deposit limits have not been lifted since 2010, and it’s clear that many small businesses need to maintain higher balances just to meet payroll. Furthermore, it seems clear to me that the bank regulators should be the ones to determine whether or not banks are operating in a safe and sound manner, not individual bank customers. What is the point of making people split up their deposits among several different banks?

I suspect that both of these criteria will need to be satisfied before this regional banking crisis is definitely put behind us. How long until that happens, though, is an open question. 

Finally, I do get asked the big questions that arise out of worries about the current turmoil, “So Farr, is everything so broken that I should just sell everything?”

Selling everything hasn’t ever been a good long-term plan, though Treasury Bills yielding 5.1% seem hard to beat for temporary insulation from risk. If the Republic survives, as it always has in the past, then corporate America will continue to grow and prosper well into our grandchildren’s and great grandchildren’s lifetimes. At the end of this century, investors will own shares of companies that were purchased decades before and that have increased in value several fold. As discouraging as today’s circumstances may be, America will survive and grow and prosper. It takes a good deal of willpower to remain optimistic, but most every very successful person I’ve ever known has found a way to believe that things will indeed be better at some point in the future.

[1] Source: CNBC. As of May 5, 2023.

[2] Source: BEA. As of May 5, 2023.

[3] Source: Investopedia. As of May 5, 2023.

[4] Source: US Census. As of May 5, 2023.

[5] Source: Business Wire. As of May 5, 2023.