Whether the wind is at your back, or face matters a great deal in life, metaphorically speaking. Over the last 5 years, certainly the winds of finance have been in the world’s collective face. In my blog post on July 17, 2012 I have written of a secular trend of what is occurring in the US and other countries, in terms of our “Solvency Curve”.
I have reproduced our Solvency Curve of the United States from the Flow of Funds data produced by the Federal Reserve Board.
I also highlighted in my blog, it’s the dynamic of what is happening along this curve that is worthy of consideration. The left hand of the “Solvency Curve” is the US Federal Government, with a “Solvency Ratio” of 0.135. The US federal government sits on the threshold of what we call the 3rd Order of Solvency. Yes, this sounds ominous however I do point out the Treasury Department is managing this ratio, rather intended or not, since I highly doubt they are following our work. Nevertheless, irrespective of the Treasury’s manipulation the US Federal debt continues to increase at a substantial rate.
As the US Federal government continues to dig a deeper hole on the left side of our “Solvency Curve”, the other segments of the economy continue to slide down the right side of the curve. As Dan Steinhart, of Casey Research points out US nonfinancial corporations are sitting on more cash than at any point since World War 2. Dan includes this chart as part of his analysis.
This Stockpile of Cash is the Raw Material for the Next Bull Market
Dan’s work highlights that nonfinancial corporations hold $1.4 trillion of cash. In absolute terms, that’s the most ever. In relative terms, it’s the most since World War II. Dan’s chart highlights where this cash currently resides.
So hopefully you can picture what is occurring in the US economy, the Federal government sliding down the left hand side of our “Solvency Curve” and the other categories of the economy, namely individuals, nonfinancial corporations, financial corporations and state and local governments sliding down the right side of the curve. This is the financial head wind I alluded to in my opening sentence of this blog. As the right side of our curve continues to stockpile cash and/or pay down debt or deleverage, economic activity will be weak.
Enter the “Fiscal Cliff”
After the national US election, you will hear a lot about the “Fiscal Cliff”. Yes, the “Fiscal Cliff” sounds scary, but is it really? Simplistically stated if the U.S. President and Congress do nothing, under current law, the “Fiscal Cliff” refers to a large predicted reduction in the budget deficit. Does this sound scary to you? Not to me! In other words, going over this “Fiscal Cliff” means the left side of our “Solvency Curve” – US Federal government – slows down from going insolvent or stays in the position that they are already in or constant. If the “Fiscal Cliff” were enacted the deficit for 2013 is projected to be reduced by roughly half, with the cumulative deficit over the next ten years to be lowered by as much as $7.1 trillion. This would be welcome relief to the current annual $1 trillion deficit the US seems to be on currently. As the US federal government stabilizes and signals fiscal prudence on the left side of our “Solvency Curve”, entities on the right side of the curve will feel more confidence on their overall financial health. Why would I say this? Ultimately the right side of our “Solvency Curve” has to pay for the left side in increased taxes and or reduced services. Currently this is a question mark because of the red ink for the federal government as far as the eye can see.
The New Bull Market
Dan Steinhart, of Casey Research concludes his presentation by stating, Corporations aren’t going to sit on their cash forever. Eventually conditions will be such that they’ll either want to or have to invest in new projects. Companies are ready to invest and grow. They just need an economic and political environment conducive to doing so.
The key is the reversal, on a secular basis, of the participants along our “Solvency Curve”. All participants must start moving up along the curve denoting more efficient balance sheets producing dynamic economic activity over the next 5 to 10 years. The economic pieces are in place for this secular change to occur, the US needs the political will to let it happen.
In my first update of my original blog, Martin Wolf of the Financial Times does ask the central question. Which I reproduce here,
The question is, of course, how the government should respond to its sudden shift into massive deficits. That depends on how the economy best adjusts to balance-sheet adjustments in the private sector. If the government is to move back into balance, by cutting spending and raising taxes, how would the private sector respond to being forced [sic] back into balance? Would it spend more, because of a sudden surge in confidence about fiscal prospects? Or would it cut back more, so driving the economy into depression, thereby at least partially defeating the effort to improve the fiscal position?
After the US federal election in November the president, whoever this maybe, will have an important economic choice as stated by Mr. Wolf. The math of solvency and the economic future rests full square on which path the US follows. Continue to slide down our “Solvency Curve” or reverse course and have the “Solvency Ratios” start moving up the curve. Let’s hope it’s the latter.
Read two prior posts on this subject