Fiscal and Monetary High-wire Act

August 11, 2020

Bankrupt Balance sheets

The US National debt has now soared to 130% of GDP; that $26.6 trillion equates to around 1,000% of Federal revenue. Our government will add $4 trillion to that dung pile this year alone, which is an incredible 20% of GDP. The Wuhan virus has completely destroyed the balance sheet of the US Treasury. If not for the Fed’s promise to purchase an unlimited amount of sovereign bonds, the bond market would have already collapsed.

State and Local government balance sheets are suffering greatly as well. Revenues are plunging just as expenses are soaring, with a huge number of businesses closing their doors and 10’s of millions of people getting laid off. Indeed, many states are projected to lose between 20-25% of revenue. The Center on Budget and Policy Priorities reported that in just the last four months, state and local governments have furloughed or laid off 1.5 million workers— twice as many as in all of the Great Recession. And now, state budget shortfalls expected from COVID-19’s economic fallout will be a cumulative $555 billion over state fiscal years 2020-2022, according to Federal Reserve and CBO data. In addition, major US cities, such as New York, L.A., and Chicago, were already on thin fiscal ice prior to the pandemic. The Wuhan virus has now melted all that the support away.

Corporate balance sheets are not faring any better. The first half of 2020 saw the most retail sector bankruptcies on record, according to Bloomberg. There have been 75 filings among all companies with liabilities of at least $50 million in the last three months, matching the same period of 2009—making it the second-worst quarter ever. Business debt was already at a record high as a percentage of GDP before the Wuhan crisis broke out. And now, Non-financial business debt has reached an incredible $17 trillion—surging at a further 24.27% annual pace in the first quarter. Hence, corporate and government balance sheets are thoroughly saturated in debt.

Now for the good news. Consumer balance sheets are in much better shape in comparison. But this is solely thanks to Washington’s efforts to offset the consumption crash from COVID-19 by further exacerbating its own fiscal imbalances. Lawmakers approved back in late March the distribution of Helicopter Money for most Americans; to the tune of $1,200 per each adult making less than $198k married filing jointly, and $500 per dependent child under age 17—even if you did not lose your job. And, for those that did become unemployed, enhanced unemployment insurance paid you on average about $1,000 per week, which in most cases was more than their previous income derived from being employed.

So, this is where the rubber meets the road: since the government’s balance sheet is already utterly destroyed, its ability to keep borrowing and printing money with impunity is almost over. Therefore, in order to keep consumption habits in place, the Wuhan virus needs to cease being an issue within the next few months. Otherwise, the consumption-driven economy will collapse. Also, there must be a place for consumers to regain employment once the danger finally ebbs.

However, as I’ve thoroughly laid out in the past few communiques, this, unfortunately, should not be the case. The announcement of FDA approval of a COVID-19 vaccine does not at all equate to automatic sterilization immunity. What it does mark, though, is the time when the real challenges could begin: How long will it take to distribute the vaccine across the globe? Will it be a one-shot deal or will there need to be multiple doses given? What percentage of the population rushes off to take a vaccine that was developed at “warp speed”? And, of course, how effective is the inoculation, and how long does the immunity last?

This is where the MSFM gets it wrong. They are promulgating the false notion that the worst economic contraction in US history is all about the virus and has nothing to do with the economics behind a typical economic contraction. But the fact is, the path towards recession was already firmly in progress well prior to 2020. Hence, the reason why the Fed had already cut rates three times and was re-engaged with QE before the pandemic struck. The Wuhan virus served to severely weaken balance sheets that were already very much in disarray. So, what we have now is an abnormally severe recession that features the very normal component of an overleveraged economy.

What happens next is crucial. Will consumer balance sheets become debt-disabled just like those in the corporate and government sectors? The answer is probably yes because government’s willingness and ability to further support the private sector is ending.

Let’s be clear. The consumer wasn’t in terrific shape prior to the health crisis. Household debt was already at a record $16 trillion prior to the Wuhan outbreak. However, this figure is much lower as a percentage of GDP than it was leading up to the Great Recession. But now, with 30 million people still unemployed and one more round of government assistance on its way, the household balance sheet should start to crumble in the next few months just like the other sectors. That is, once the Helicopters bearing government transfer payments become grounded.

To sum up the situation: our government will not be able to continue borrowing $4 trillion deficits per annum. Neither can our Nation’s debt to GDP ratio leap past 130%, and then just continue soaring upwards from that level without dire consequences. And, the Fed cannot assent to expanding its balance sheet at a rate that has seen its asset holdings surge by 75% in the last six months alone. These trillions of dollars in debt were monetized for the purpose of suppressing borrowing costs and inflating asset bubbles into even more rarified air. But how much longer can it continue at this pace without destroying the purchasing power of the dollar?

The hope is that science can kill the virus in the next few months with treatments and vaccines that are now in development. Then, consumers will immediately head back to being fully employed. But how realistic is this scenario? Well, Yelp—a company that offers a platform for businesses and consumers to engage and transact–reported that 132,440 businesses who listed on their site had closed their doors since the outbreak. And of that number, 72,842 have closed their doors permanently. Of course, the data from Yelp provides only a partial glimpse of the full damage report.

What condition will the nation be in whenever the virus is finally subdued, and some semblance of normalcy returns? The catalyst towards “Normalcy” (a vaccine) may also bring about the end of government’s fiscal and monetary high-wire act without a net. After all, it is an untenable position that the Treasury’s lotto-for-life windfall for most Americans—all of which is monetized by the Fed—can last much longer without destroying the dollar and bond market.

We must look to history for answers, …and the verdict is clear. The longevity of viruses (especially those of the corona variety) tends to last much longer than those nations that seek to engender prosperity through the printing press can remain solvent.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”