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Goodfellas

By: Stephen Colavito Jr.
Chief Market Strategist, Lakeview Capital Partners, LLC

October 2019

Martin Scorsese’s 1990 masterpiece Goodfellas immortalized the hilarious, horrifying life of actual gangster Henry Hill (played by Ray Liotta), from his teen years on the streets of New York to his anonymous exile under the Witness Protection Program.  I, as the great-grandson of Italian immigrants and self-described mobster movie critic, believe that Goodfellas is on par with another iconic film, “The Godfather.”  Joe Pesci’s psycho improvisation of Mobster Tommy DeVito made Pesci a star.  Actors like Paul Sorvino, Robert De Niro, and Chuck Low had lines that (like Caddyshack) men like to quote at completely random times.

One of my favorite scenes is between Chuck Low (Morris Kessler), Ray Liotta (Henry Hill) and Robert De Niro (Jimmy Conway), mind you this is the PG-rated version:

Morrie: Henry, you’re a good kid, I’ve been good to you, you have been good to me.  But there’s something unreasonable going on here.  Jimmy’s being an unconscionable nut-cracker.  I never agreed to 3 points on top of the vig!  Am I something special?  Some sort of schmuck on wheels?

Henry Hill: Morrie, please!  You borrowed Jimmy’s money, pay him.

Morrie: I never agreed to three-points on top of the vig!  What am I nuts?  Come on!

Henry Hill: Are you going to argue with Jimmy Conway?  Just give him his money so we can get the heck out of here!

Now, I know what you’re saying…what in the world does this have to do with the markets or the economy.  Well, I am glad you asked.

Happy Deficit Day

As some of you may have seen in the news earlier this month, October 3rd was National Deficit Day.  If you didn’t post a selfie to your favorite social media site holding up an empty wallet to celebrate that day, well, you missed out.  

National Deficit Day is the day that the government crosses over and spends more than the revenue it takes in during a given year.  The last few years it has fallen in November, but this year it was a month earlier in October.  Decades of deficit spending have contributed to the government’s $22.6 Trillion (with a “T”) dollar debt.  We got to this place because politicians in both parties saw an opportunity to use economic theory to argue for ever-greater government spending.  In the 1930s, the economist John Maynard Keynes argued that governments could lessen the pain of recessions by spending more money.  But now, it’s being used for all sorts of other things.

You see, Keynes’ theory was a siren’s call to politicians.  Keynes identified government spending as a policy tool, but politicians used it as a political tool.  A politician’s goal is to get elected, and voters like politicians who spend money in their districts.  Voters also like good economic conditions, so politicians will do what they can to alter general economic cycles to keep the economy humming along while they’re in office.  All of this has caused federal spending in the U.S. to rise from less than 15 percent of the economy (as measured by GDP) after the close of World War II (in which the government was funding two wars) to over 20 percent today.

But like Morrie, someone must pay for all the spending, and voters generally do not like politicians who raise their taxes.  The solution politicians discovered was deficit spending.  When the government borrows to pay for deficit spending, it requires future taxpayers (like my three daughters) to pay for today’s spending via future interest payments.  To put this into context, this method of paying for government spending has become so popular among both voters and politicians that the official federal debt is now more than six times the government’s annual collections from all sources combined, and this amount excludes unfunded future liabilities (such as social security and medicare).












Source: CBO

Do Deficits Matter?

Back in 2002, then-Vice President Dick Cheney famously told Paul O’Neill (President George W. Bush’s first Treasury secretary) that “Reagan proved deficits don’t matter.”

Seventeen years later, again under Republican rein, President Donald Trump, the self-described “king of debt” (yes, he said that), is running a budget deficit at an annual rate of over $1 Trillion (again with a “T”), in part because of the Tax Act of 2017 which he signed into law.  What makes this deficit somewhat different is that the economy is not in a recession or depression.  No, it’s occurring as the economy hits its 10th year of economic expansion, nor does it resemble what Keynes would describe as a policy tool.

Meanwhile, progressives and socialists in the Democratic party are now discussing the idea of Modern Monetary Theory (MMT).  Proponents of MMT say that government borrowing in a fiat currency should be unconstrained by deficits.  In essence, the bonds issued could always be paid off by, printing additional currency (better known as diluting or devaluing the dollar).  If an excess of spending were to strain resources and cause (hyper) inflation, fiscal policy would then be adjusted to rein it in (good luck with that).

Opponents of MMT include the current Chairman of the Federal Reserve Jerome Powell.  When questioned about this issue by the House Banking Committee Chairman Powell said, “The idea that deficits don’t matter for countries that can borrow in their currency, I think, is just wrong.”  Moreover, he added, the Fed’s “role is not to provide support for particular policies,” an apparent reference to utilizing the central bank’s balance sheet to finance something like the Green New Deal or additional defense spending.

Jimmy Conway wants to get paid!

Powell’s remarks were cheered by most economists and financial market pros (this one included).  Budget deficits are bad because they either crowd out private investment or could potentially send interest rates and inflation soaring.  Deficits may be tolerated in times of national emergency, but those debts ultimately must be repaid, with interest (on top of the vig Morrie!), thus imposing both a greater burden on succeeding generations and a potential drag on future growth.

But these puritanical notions are even getting pushback from those within the Democratic party and their partisan economists.  Jason Furman, Chairman of the Council of Economic Advisers during the Obama administration and Larry Summers, Treasury Secretary during both under the Clinton administration, both wrote that concerns about deficit should take a back seat to more pressing needs, such as rebuilding infrastructure.  Although I may not completely agree with that statement, I could at least understand it in a vacuum.  But Mr. Furman and Mr. Summers forget that politicians do not spend money wisely, and that’s where their theory falls apart.

So, with little press or fanfare, the U.S. national debt hit crossed $22 Trillion on its way to “infinity and beyond!”.  Currently, the U.S. debt (held by the public)-to-GDP ratio sits at 80%, and the CBO projects that debt will skyrocket to 152% by 2048 (see chart on the next page).  Yet yields on the U.S. government debt are near historic lows (between 1.67% - 2.08%).

 












Additional Source: CBP

Time for muscle

Just as Henry Hill acted a muscle for the mob, so has the Fed when it comes to Washington and deficits.

The Fed currently can lower interest rates under the partial guise of a wobbly economy and global trade wars, but make no mistake that the Fed has another task at hand which is trying to finance all of that red ink flowing out of Washington.

Since the beginning of the year, I have believed that the Fed was back on a path to zero-rate policy (read my paper Saved by Zero, April 16, 2019) largely because they could not allow dollar domination while all other central banks lowered rates and also because the capital cost of deficit spending could create a serious economic headwind.

To be more specific, the supply of debt coming to markets to fund the debt and deficit can lead to funding stresses.  So, by keeping rates low, even if a treasury auction is not well subscribed, low rates allow for that auction to clear at a level that doesn’t cost too much to the government.  The Fed has been helped this year to a large extent by negative interest rate policies (NIRP) around the world.  Earlier this year, the market had over $17 Trillion (yes, again with a “T”) of negative-yielding bonds, so global investors looking for positive yields came to the U.S. markets.

The Treasury Department is also getting into the act of helping clear its very own auctions.  Credit Suisse has estimated that the department will issue $800 billion (sorry, no “T” just a “B”) in new debt before the end of this year and increase its cash balance by $200 billion.  So that’s like paying off your Visa card with your American Express.

So, realizing the various issues facing them, the muscle of the Fed has stopped quantitative tightening and added over $100 billion (this paper is brought to you by the letter “B”) daily to the Repo markets.  Chairman Powell said that it’s not to be called quantitative easing, but it is.  This process helps keep the yield curve low on the front end.

Jim Grant of Grant’s Interest Rate Observer said it best in an interview last week when asked about liquidity;  “People talk about the absence of liquidity, and liquidity means basically money, it means the capacity to transact in securities at more or less continuous prices.  So they say “There is not enough liquidity.  Can’t the Fed do something?”  Maybe the Treasury is doing too much.  Maybe the problem is too many bonds to be financed.  The demand for overnight financing strikes me as not necessarily a function of the paucity of liquidity but rather as an excess of…collateral, meaning bills, notes, and bonds of the United States government.  We are running trillion-dollar deficits at a time of supposedly high macro-economic cotton.  What we have had in the past ten-years is more and more intervention to perpetuate more and more excess,…especially in the world’s credit markets.”

Omerta

In the mob, Omerta is a Southern Italian code of silence and a code of honor that places the importance of silence in the face of questioning by authorities or outsiders.  This code was life long, and for those who wanted to change their ways and leave the mob, it normally meant they ended up in a box or in the back of a car.  Once in the mob, always in the mob.

The same thing can be said for central bank intervention.  The great experiment that was started 30-years ago by the Bank of Japan (BOJ) and has perpetuated with central banks around the globe after 2008 becomes very difficult to change.  The central-banking mob has given individuals, corporations, and governments cheap money for the last 10-years.  Everyone is in, and no one can get out.

For example, consider the servicing cost of the United States deficit in the current fiscal year, which is just shy of half a trillion dollars - $497.2 billion through July 2019 and will exceed 2018’s record $523 billion by the end of the year according to the CBO.  Over the past decade’s debt explosion, taxpayers have shelled out $4.4 trillion (now you’re saying it to yourself, and I don’t even have to write it) in financing cost.  These costs are with interest rates at just over zero percent.  Could you imagine what that cost would be if the 30-year Treasury were at 5.00% versus 2.10% currently?  Of course not, and neither can the Fed.

The bottom line is that the Fed is now venturing to print money to monetize federal deficits, which have become too big for the economy to finance on its own.  Consciously or not, runaway federal spending is now driving monetary policy.

Mob Rules

So in a land of political mobsters, budget deficits and central bankers, here are some of my “rules” that I think advisors and investors should be aware of if deficits continue to rise.

  • First, rates likely remain low for quite some time. I am now anticipating another Fed Funds rate cut potentially this week and/or in December.  Investors are going to have to take more risks to get any yield.  That can be in the form of longer duration, lower credit quality (junk bonds), or moving from bonds to equities.  Diversification becomes critical because investors are left with little options.  But understand there is no “free lunch.
  • Beyond adding $100 billion dollars of liquidity (currently) to the repo market, the Fed announced a plan to start purchasing short treasury bonds in the open market (but Chairman Powell says don’t call it quantitative easing). Thus, even though rates are likely to stay in a trading range, the yield curve could steepen.  Those that have bond portfolios should review the average maturity and duration to understand the mark to the market risk they may experience.
  • As discussed in my paper called “Pot Luck” in June, Gold seems to be a popular asset class right now. In June, when I discussed the opportunity in gold, it was trading at $1287.00 per ounce.  As of the middle of October, the price has been around $1500.00.  Those worried about devaluations of currencies generally run to this asset class as a haven.  That seems to be modus operandi right now.
  • Diversification, diversification, and more diversification will be the playbook for the survival of portfolios over the next few years. Investors should take a hard look at what they own and not just review the number of holdings (I have five mutual funds), but get granular as to the historical correlations of those investments (yes, but they’re all large-cap US).  There are websites and software programs designed to help advisors and investors explore the true diversity of a portfolio, and that technology should be used.
  • Low to zero rates create a strain on the social fabric of the population. For the “haves”- low rates force investors to buy equities (which they may own),  ultimately creating asset inflation and high net worth.  For the “have-not’s” - those who live off on a fixed budget and depend on a limited income in retirement or those who need pensions to retire but are facing pension cuts, they feel left behind.  So, as we watch the politics of both parties, understand that the “giveaways” by politicians are nothing more than pandering to the “have-not’s.”  These policies create a vicious loop of deficit spending that helps to create the very imbalance it's trying to fix.
  • Along the same line, be leery of any politician in any party with the intent of instilling Modern Monetary Theories. There are various examples where countries have tried to instill that type of policy only to see hyper-inflation and devaluing of currency.  MMT supporters respond that the same fate wouldn’t happen to the U.S. because we are the world’s currency, but my retort would be why test the world’s appetite for dollars.

Witness Protection

The end title card of the movie “Goodfellas” states that, as of the film’s release in 1990, the real Henry Hill was still a protective witness for the arrest of narcotics conspiracy, and that he has been clean since then.  He was one of the few who escaped the mob life.

There is a great book called “This Time is Different” (2009) by Carmen Reinhart and Kenneth Rogoff, which digs into this subject far deeper than I did today and is a great read.  They counted 250 “modern” government defaults from 1800 – 2006.  Another study by the Bank of Canada finds that since 1960, 145 governments have defaulted on their obligations.  A staggering number.

The cycle of borrowing, default, and new borrowing has a long and continued history over the last 2,300 years.  Debts are generally scaled-down, and nations start anew.  Like the loans that caused the great recession in 2008, news sovereign loans will be offered and bought just as was Greek debt several years ago.  Fortunately, investors have short memories when it comes to opportunities.

The next 10-years of the investing cycle are likely to be very different than what we have experienced over the last 10-years.  Continued central bank intervention is likely going to keep interest rates abnormally low (maybe even lower) forcing investors to make a very hard choice on the risk they take.  Investors need to work with an advisor team that can help them navigate these difficult choices.

What is not likely to change is the way the political mob operates.  They will continue to waste our money for votes in order to hold on to policial power.  But unlike Henry Hill, the voter can always “escape the mob” by voting the mobsters out.


Past performance is not indicative of future results. This paper is provided for informational purposes and should not be construed as a solicitation or offer to buy or sell securities or any other financial instrument.  Lakeview is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. Securities offered through SA Stone Wealth Management, Inc, member FINRA and SIPC. Advisory services provided through Lakeview Capital Partners, LLC (“LCP”). LCP is not affiliated with SA Stone Wealth Management. More information about the firm can be found in its Form ADV Part 2, which is available upon request by calling 404-841-2224 or by emailing info@lcpwealth.com