Worms in the Woodwork

BY JAMES RICKARDS

Political news in the U.S. and wars abroad have pushed most economic news out of the headlines. Yet the economic news is more important than ever and will have a huge impact on stock and bond markets in the months ahead.

Here’s a summary of recent critical developments:

On the economy as a whole, headline numbers continue to look good. The Q42023 GDP was 3.3% (annualized). That put full-year 2023 GDP at 2.5% over 2022, a substantial increase in a year when many forecasters predicted a recession.

By itself, this growth trend suggests strong growth ahead, which would seem to support high stock market valuations. But there are worms in the woodwork.

GDP has gone up, yes, but so has the national debt. The national debt today is $34.2 trillion. GDP today is approximately $28 trillion. This puts the debt-to-GDP ratio at 122%, the highest in U.S. history. The debt-to-GDP ratio was about 120% at the end of World War II.

At least then, the U.S. and its Allies won the war, and the U.S. was an economic and political hegemon. Today, respect for the U.S. is in sharp decline around the world and our military ventures in Iraq, Yemen, Syria and Afghanistan have all been failures despite killing some individual terrorist leaders.
Phony Growth

The point is that GDP growth is not being powered by economic fundamentals. It’s being powered by deficit spending. And the debt is growing faster than the economy itself. That’s unsustainable on its face. Worse yet, the amount of growth we get for each dollar of deficit spending keeps dropping and is now about $0.67.

At debt-to-GDP ratios below 90%, it is possible to get more than one dollar of growth for one dollar of new debt assuming the spending is done on growth-oriented projects including infrastructure. Once the debt-to-GDP ratio goes above 90%, the so-called “multiplier” drops below $1.00. This means that debt grows faster than the economy and the debt-to-GDP ratio gets worse. You can’t borrow your way out of a debt trap, but it seems that’s what the U.S. is trying to do.

The unemployment headlines also look positive but, again, there is bad news behind the headlines. The current unemployment rate is 3.7%, which is near long-term lows. Job creation as measured by the employer survey has also been strong. But the good news stops there.

The Labor Department has two measures of job creation — the employer survey and the household survey. The employer survey has shown good job creation, but the household survey has shown the opposite — quite large job losses.

Both surveys show that the jobs created have been more part-time than full-time. They also show that total hours worked are declining and real hourly wages are falling. This means that while more people may have jobs, they work fewer hours and receive lower real incomes. That’s not a recipe for strong consumer spending.

It’s also the case that labor force participation (total number of employed individuals divided by the total workforce) has been declining and total job openings are falling. Finally, the unemployment rate is a lagging indicator, not a leading one. By the time unemployment finally starts to rise, the recession will already be here.
The Irrelevant Fed

The Federal Reserve has maneuvered itself into irrelevance and will not be able to offer any kind of “stimulus.” There was no change in the policy rate at the Jan. 31 meeting and the Fed has already signaled that there will be no rate cut at their March meeting either. The Fed has no plans for near-term rate cuts, especially after this week’s inflation numbers.


The main reason the Fed will not cut rates soon is that they are losing the battle against inflation. Headline CPI (the kind Americans actually pay, not constructs like “core” and “super-core”) was 3.1% in January.

That compares to 3.1% in November and 3.0% last June. In other words, inflation has not gone down like the Fed hoped and will stay elevated in part due to higher oil prices lately driven by geopolitical concerns.

The Fed will not raise rates soon, but they will not be quick to cut them given continued inflation. To put current inflation in perspective, 3.4% inflation cuts the value of a dollar in half in 21 years, and half again in another 21 years. That’s a 75% dollar devaluation in just 42 years or the course of a typical career from age 23 to age 65. The Fed’s goal is 2.0% inflation, and they are far from it right now.

Other recessionary signs include the fact that swap spreads are negative, which suggests banks and dealers are tightening credit conditions. Yield curves are still inverted, which suggests recession, but they are flattening lately, which suggests the recession may already be here.

These technical indicators come against a global backdrop of recession in Germany, slowing growth in China and near-recession conditions in Japan and the U.K. These indicators are highly technical, but they have a better track record of forecasting economic conditions than Wall Street economists or the Fed.
Add in Stage 2 of the Banking Crisis

On top of these debt and employment concerns, the economy may be facing a new stage in the banking crisis that began in March 2023 with the sequential failures of Silvergate Bank, Silicon Valley Bank, Signature Bank, Credit Suisse and First Republic Bank. The banking crisis seemed to calm down after that, but it was only hibernating. A new crisis is emerging.

Two weeks ago, the New York Community Bank (NYCB) announced huge write-offs on two commercial real estate (CRE) loans. NYCB’s stock crashed, and investors started looking for the next shoe to drop. NYCB is still under investor scrutiny (and has been downgraded by the rating agencies).

Other banks in Japan and Germany have recently reported large CRE write-downs and are also in financial distress. Analysts expect that there are huge CRE price declines that are not being reported by the banks because they are holding the assets and extending the maturities on loans. However, once forced sales begin, these assets will have to be written down across the board and a selling panic may begin.

The bottom line is that there’s a lot of trouble hiding behind the good headlines. Growth is being driven by unsustainable debt, not by fundamentals. Low unemployment is being driven by part-time jobs, fewer hours and lower real wages. The Fed is losing the battle against inflation.

There will be no “soft landing” in the economy; there’s no such thing. And a new stage of the banking panic may be right around the corner due to CRE price collapses and forced selling.

It’s time to lighten up on tech stocks and financials. Investors should increase allocations to cash, Treasury notes and gold. Stock portfolios should be directed toward big energy companies, agricultural firms, mining and defense. That’s a diversified portfolio that will see you through the coming storm.