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 with

Arnold Kling

and 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

• Rates are up

• M2 is contracting¹

• Fed is delevering, i.e. QT²

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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

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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?)

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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?

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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

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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

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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

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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.

  

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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

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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

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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

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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

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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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1. M2 is contracting

2. Fed’s % of Public Debt is shrinking

3. Deficit is projected to compound

4. Interest costs as a % of revenue

5. Consumption has outpaced earnings:

6. Prices have risen more quickly than wages, until recently:

7. Real wages are going higher:

8. Card spend is flat

9. Delinquencies are low but rising:

But overall, still a drop in the pail

10. Unrealized losses

11. 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:

12. Risk premium is still pretty high, but not crazy:

13. No exits for PE