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A Conversation with Kling
Random Walk at Night: A Zoom with Prof. Kling on macro and the "state of the economy."
Earlier this week, Random Walk recorded a live discussion withand his subscribers on the "state of the economy."
It was a lot of fun, and, I think, interesting.
The video is here, and the high-level outline+charts that I prepared are below:
I need to do a better job of looking at the camera . . . I break eye contact when I’m thinking. It’s a bad habit.
Thanks again to Prof. Kling for inviting me to the show, and thanks again to the folks who dialed in to listen and participate.
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The State of the Economy with Prof. Kling and co.
I. Fed’s Fight Against Inflation v. Uncle Sam’s Fight Against Deflation
Fed is tightening
Uncle Sam is expanding
Uncle Sam is in a vicious expansionary debt cycle3
The cost of borrowing is now driving the deficit wider, leading to more borrowing, a wider deficit and more borrowing, etc.4
If the Fed won’t lend to Uncle Sam, then investors have to fill the void.
The void is growing—watch the Treasury markets
If Uncle Sam gets all the capital it needs, will anything be leftover for private firms (and at what cost?)
What’s the end game?
Cut spending/raise revenue
Fed intervenes/Money Printer Goes Brrrrr (“inflate away the debt”)—>but who will lend?
Default—>but who will lend?
II. Can the Almighty Consumer keep it up?
We had a preemptive bailout
Stimulus kept real consumption on trend, but the stimulus is nearly gone for most people (and perhaps gone for everyone, if you exclude asset prices)5
To keep it up, we’re now going to have to earn it—wages must grow faster than prices.
For most of the pandemic, prices grew faster than wages, but recently that has reversed.6
Wage growth is slowing (and so is inflation), but 4% wage growth is not consistent with 2% inflation.7
Everything is fine, but getting worse
Consumer spending is moderating, but still strong8
Unemployment is low, but rising
Delinquencies (auto and credit card) are low, but rising9
Savings rate is low, interest-expense as a % of income is rising, and cash balances are flat-to-down
Back to normal isn’t good enough
Even we go “back to normal,” we now have a much larger debt burden to pay for, and capital is much more expensive.
Aging and Energy (maybe) are also secular headwinds
We’ll need to do more with less, e.g. more healthcare to provide, and fewer providers to do it.
III. Why haven’t rising rates broken everything yet? or The Asset Prices are Too Damn High
Three magic words: “Extend and Pretend” (or perhaps I’m just wrong)
Fed has bailed out the banking system
Huge “unrealized losses” on low interest, long duration loans, e.g. Treasuries and Real Estate10
Fed initiated BTFP to lend against assets at Hold to Maturity (i.e. face value), rather than Mark-to-Market prices.
Pretend the losses aren’t there, and hope no one suddenly needs liquidity
Banks’ losses, are businesses (and consumers) gains
Businesses and consumers locked-in low interest debt
Homeowners won't default on their mortgages, but they couldn't afford their own house (at the price they think it's worth)11
The public markets are being held up by the “Magnificent Seven” (Google, Apple, Meta, Tesla, Nvidia, Amazon, Microsoft)—>these companies are performing well.12
For now, we wait, but cracks are showing
Industries most dependent on cheap credit: Real Estate, Auto, VC, Private Equity
Capital raises and liquidity events are at a nadir13
Businesses and RE projects that once made sense, no longer “pencil,” but they have a enough cash to play out the string (for now).
Estimated 60% of B- borrowers will have an interest coverage ratio < 1 by the end of the year (Moody’s)
Defaults, stress and bankruptcies are starting to rise, especially for the riskiest businesses
Extend and pretend
Lenders, investors and operators are all heavily incentivized to pretend like everything is ok
Asset prices stay miraculously high, mostly because no one is selling or buying (and hasn’t needed to yet)
Lots of financial engineering (e.g. PIK and NAV loans “leverage on leverage”)
Lots of restructuring, especially on the real estate side
The Wall of Maturities is Coming
Eventually companies and funds will have to raise new money
If they have assets to sell, they will, and finally assets will reprice (which will trigger margin calls, and more selling, etc.)
Best Case: equity is wiped out, but the losses stay right there
Worst Case: major “unexpected” credit event causes a broader run and liquidity “crunch”
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M2 is contracting
Fed’s % of Public Debt is shrinking
Deficit is projected to compound
Interest costs as a % of revenue
Consumption has outpaced earnings:
Prices have risen more quickly than wages, until recently:
Real wages are going higher:
Card spend is flat
Delinquencies are low but rising:
But overall, still a drop in the pail
Incomes would have to rise ~70% for people to afford their own homes:
The story is “low supply” but the reality is closer to “Bid-Ask Spreads are too wide.” Discounts are however starting to creep up:
Risk premium is still pretty high, but not crazy:
No exits for PE