True or false?: The U.S. economy is dangerously over-leveraged, and thus particularly vulnerable to any economic downturn.
Before I try to answer this question, I bet that most of you probably haven't even thought about it. That's because it's human nature, when the stock market is at or near all-time highs, to not focus on what could go wrong.
Just take 2007. The economy was about to go over a cliff because of an inability to service its debt, and yet few were worried. And I'm not just Monday morning quarterbacking for me to say that now: The U.S.A. Economic Policy Uncertainty Index, a comprehensive and objective measure of perceived economic uncertainty, reached its lowest reading ever in 2007.
Chalk up another win for contrarian analysis.
To be sure, the lack of widespread concern today doesn't guarantee that we're on the verge of another financial crisis. But the antidote to overconfidence is to periodically step back and ask where the economy's Achilles' Heel may be hidden.
A good place to start is reviewing the two major causes of the 2008 financial crisis: High levels of both household and financial sector debt. And on both scores, the recent news is encouraging. According to Ned Davis Research, household debt in the U.S. (as a percent of disposable personal income) has declined from a high of 133.8% in 2008 to its current level of 98.8%. And, as a percent of GDP, total domestic financial debt has fallen from a high of 125% during the financial crisis to its current 78.2%.
At least along these two dimensions, therefore, the economy appears to be significantly less vulnerable than it was prior to the 2008 financial crisis.
We shouldn't make too much of this improvement, however, since regulators are like the generals who always are focusing on how to fight the last war. It's not particularly surprising that there has been some improvement in those areas which we now know, in retrospect, were the source of the economy's downfall then.
One area where recent developments are potentially alarming is growth in non-financial business debt. Ned Davis Research reports that, as a percent of GDP, such debt has grown to be just shy of an all-time high. Other than federal government debt, which I will discuss in moment, this is the category of debt that has grown the fastest since the financial crisis.
In commenting on this, Davis notes that the increase wouldn't have had to be concerning, had it been used to invest in future growth. But he thinks this largely has not been the case, because companies appear to have instead used their debt to repurchase their shares. That in turn means that companies will not be in as strong a position as they otherwise would have been when it comes time to pay back their debt.
Furthermore, a lot of the non-financial sector business debt is either rated junk or close to junk. And an inordinate amount of that debt is coming due in the next several years -- $1.7 trillion over the next five years, according to George Putnam, editor of the Turnaround Letter: "Until recently, the debt markets were very forgiving, suggesting that much of the debt could be refinanced fairly easily."
But the market's volatility in the last quarter of 2018 showed that it doesn't take much to cause junk bond issuance to dry up almost completely.
Putnam writes, "Unless the debt markets return to the blissful, carefree ways of the last few years - which we think unlikely - many of the debt issues coming due in 2019 will not get refinanced and will end up defaulting. Should the Federal Reserve raise interest rates further or the economy soften, defaults and bankruptcies will pile up even faster." (Full disclosure: The Turnaround Letter is one of the services that pays a flat fee to have its performance audited by my performance-tracking firm.)
An early warning signal of trouble down the road will be a jump in the junk bond spread, which is the difference between the yield on junk bonds and on those of comparable Treasuries. Any significant increase indicates that investors are requiring more compensation for the risks they incur by holding such bonds. For the moment, though, this spread remains low, as you can see from the accompanying chart.
Another economic Achilles' Heel is federal government debt, which has mushroomed to over 100% of GDP, according to Ned Davis Research. That's double the ratio that prevailed less than two decades ago.
That's not an immediate cause for concern, since demand for U.S. Treasury securities remains high. But it's not out of the question that this could change, and change quickly. One relevant data point to pay attention to is the bid-to-cover ratio, which is the ratio of total demand for Treasuries relative to the total supply being offered. One early warning sign of trouble in this regard is that, for all of 2018, the debt to cover ratio was the lowest of any year since 2008.
A related concern about the huge amount of government red ink is that so much of it is held by foreign governments. In an escalating trade war, they could use their holdings as a weapon, threatening to dump a big chunk of their holdings, thereby forcing interest rates to skyrocket virtually overnight. Think China.
To be sure, such an act of economic warfare would exact costs on those foreign governments. But so do all trade wars, and yet governments engage in them anyway.
The bottom line? The U.S. economy today is not vulnerable in the same way it was in 2007. But that is of little solace, since it's quite vulnerable in other ways. Two warning signs to keep a close eye on are a widening of the credit spread and a reduction of Treasury auctions' bid-to-cover ratio.