1

2

Economic Armageddon“Over the last four years, Congress’ solution to our budget crisis has been a temporary patchwork of fiscal Band-Aids, passed at the stroke of midnight before critical deadlines,” said Delaware Congressman John Carney.

Congressman Daniel Webster of Florida added that “American taxpayers deserve to have a full and transparent accounting of the financial situation of our country.”

The thing is, taxpayers already have access to this information. It’s just not coming from the government. Academic researchers such as James D. Hamilton, professor of economics at University of California, San Diego, have spent years trying to figure out just how far into debt the U.S. government has fallen.

Now, the on-the-books figure most often cited when people discuss U.S. government debt is about $18 trillion. This is an astounding, nearly inconceivable amount of money. In terms that are easier to understand, the U.S. federal debt doubled as a percentage of GDP between 2007 and 2013.

But as Hamilton and others have shown, this is only a fraction of the true debt burden.

You see, the government’s accounting methods favor “off-balance-sheet liabilities” that keep the total debt number from ballooning to even more atmospheric heights. An accurate picture of the total debt would include these off-balance-sheet liabilities, which, according to Hamilton, amount to an incredible $70 trillion as of 2012. This means the total debt is at least $88 trillion, nearly five times higher than what appears on the balance sheet.

If you’re wondering how any government could possibly pay back such an enormous sum, you’re not alone.

A 2015 Government Accountability Office report states that, over the next several decades, we should expect huge growth in government liabilities that aren’t included in the officially reported numbers. The biggest category of off-balance-sheet liabilities comes from the additional funds needed to fulfill commitments to Social Security and Medicare participants.

The situation is so dire that if the U.S. federal government was an American company operating to Financial Accounting Board Standards, it would’ve already filed for bankruptcy protection.

Thus, it’s worth wondering how much longer the government can maintain its fiscal facade.

Let’s first take a closer look at James Hamilton’s report, which provides a clear-eyed picture of the government’s debt disaster. Then, Wall Street Daily’s Chief Income Analyst, Alan Gula, will provide an economic outlook for 2016 so we can see where the greatest short-term risks lie.

3

THE HAMILTON REPORT In 2014, James D. Hamilton, a professor of economics at University of California, San Diego, published a paper on off-balance-sheet liabilities.

Specifically, he wanted to see just how much the government could be on the hook for in terms of “implicit or explicit government guarantees and commitments.” His survey covered housing, other loan guarantees (such as student debt), deposit insurance, Federal Reserve actions, and government trust funds.

What he found was astonishing.

As the following chart shows, the government’s off-balance-sheet liabilities come to a whopping $70 trillion – even accounting for a positive return from Federal Reserve activities!

According to Truth in Accounting, the “accumulation of off-balance-sheet obligations and related accounting chicanery have played an important role in historically significant financial meltdowns in the private sector.”

And now, it’s happening in the public sector, as well.

Basically, there are five parts to the equation: housing, other federal loan guarantees such as post-high school education, federal deposit insurance, the Federal Reserve, and federal government trust funds (such as Social Security).

4

Interestingly, Hamilton calculates that the Federal Reserve was actually a net positive for the balance sheet, to the tune of about $1.13 trillion. He admits that the Fed’s assets are greatly expanded relative to historic levels, but he found in his calculation that most of these new assets were already liabilities of the broader government.

Unfortunately, the Fed’s net positives hardly made a dent in the total debt figure.

In housing, Fannie Mae and Freddie Mac were responsible for the majority of the government’s liabilities. Hamilton notes, “Because both Fannie Mae and Freddie Mac were originally created by an act of Congress, they are referred to as ‘government-sponsored enterprises’ (GSEs).” And after Fannie and Freddie were placed into conservatorship in 2008, their debts became the debts of the federal government (if they hadn’t already been).

In total, the off-balance-sheet debt burden from housing totaled more than $7.5 trillion in 2012.

Recently, I sat down with former U.S. Treasury advisor and global merchant banker, Martin Hutchinson, to discuss the impending crash – likely to occur within the next year – that’s the inevitable result of ultra-low interest rates, extreme confidence, and overbuilding.

According to Martin, one of the biggest signs of an impending crunch is when corporate and consumer debt levels are rising faster than the rate of GDP growth.

Martin also indicates that the junk bond market is beginning to fall apart, which is a potential catalyst for a series of events like we saw during the 2007 through 2009 Great Financial Crisis. Finally, Martin sees reckless monetary policy, with relatively cheap and easy money, leading to a misallocation of resources and overbuilding.

The end result likely won’t be pretty.

CLICK HERE TO VIEW THIS VIDEO >>

5

Next we have federal loan guarantees, specifically student debt. By now, most people are aware that the student debt bubble has reached historic proportions. According to the White House, roughly 70% of bachelor’s degree recipients are leaving college with student loan debt. In total, these students have accumulated about $1.2 trillion worth of debt, the second-highest level of consumer debt behind only mortgages.

Worst of all, it’s become apparent that students aren’t prepared to pay back their debt. According to the Consumer Financial Protection Bureau, one in four student borrowers is either in delinquency or default – and that number is trending upward quickly. With so much inertia in favor of simply forgiving large student debts, it seems to be only a matter of time before this bubble bursts.

Next up is federal deposit insurance. The Federal Deposit Insurance Corporation (FDIC) was created as part of the 1933 Banking Act to insure small depositors in the event that their banks became insolvent. During the financial crisis, the number of insured deposits rose swiftly, and the FDIC also increased the limit on deposit insurance from $100,000 to $250,000. At the time Hamilton’s report was published, FDIC-insured deposits totaled $5.9 trillion.

Finally, we have federal government trust funds. According to Hamilton, the budget impact associated with an aging population and other challenges could turn out to have much more significant fiscal consequences than even the mountain of on-balance-sheet debt already accumulated.

Basically, Medicare and Social Security are a massive anchor threatening to drag the U.S. government under.

Worst of all, it’s become apparent that students aren’t prepared to pay back their debt.

6

And the problem is only getting worse as the population ages and as interest rates begin to normalize.

Most projections call for interest rates to rise back to more usual historical levels over the next several years. For example, the consensus Blue Chip Financial Forecast anticipates a yield on 10-year Treasury bonds of 4.7% by 2017 (Bernanke 2013).

Returning to those levels of interest rates – or the even higher rates seen on average during the 1990s – would mean a doubling or tripling of the government’s current annual interest expense, even without further increases in federal debt from now on. Worse yet, the only way to stem the bleeding is for the government to start spending way less and start taxing way more – immediately. I’ll let you guess what the odds of that happening are.

Indeed, things are likely going to get worse before they get better. Regarding the short-term risks to the economy, our Chief Income Analyst, Alan Gula, has provided the following 2016 economic outlook. It’s an insightful look at a very precarious situation.

ECONOMIC OUTLOOK 2016 By Alan Gula, Chief Income Analyst

Economic growth is much slower than economists have predicted. In December 2014, the Fed governors expected the economy to expand at a pace of 2.6% to 3.0% (central tendency of real GDP growth).

Actual 2015 growth wound up around 2.1%. That’s below even the 2.5% expansion posted in 2014, as I warned it would be in last year’s economic outlook. Yet, in spite of flagging GDP growth and sub-2% inflation, the Fed decided to raise short-term interest rates.

Meanwhile, collapsing crude oil and natural gas prices have turned the energy sector into an anchor around the neck of the U.S. economy. According to Goldman Sachs, 30% of total S&P 500 capital expenditures (capex) came from the energy sector in the last 12 months. That’s still the highest percentage of any sector.

7

Add on the materials and industrials sectors, and we’re talking about 45% of total U.S. capex. Don’t let anyone tell you these sectors don’t matter anymore in our “technology- and services-driven economy.” In 2015, capex – which serves as a powerful economic stimulus – likely experienced its first annual decline since 2009. As I see it, lower corporate spending is still an underappreciated economic headwind.

Here are a few more issues that should concern economists and investors in 2016.

1) Excess Inventories

The following chart shows the total inventory-to-sales ratio for U.S. retailers, manufacturers, and wholesalers:

The ratio experienced a dramatic decline in the 1990s and early 2000s, likely due to improving supply chain efficiencies. Then, as sales plummeted during the Great Recession, there was a massive spike in the ratio. The excess inventory of unsold goods was worked off fairly quickly, but there was a lot of pain

8

associated with that process.

Now, relative inventory levels are slowly inching their way back up. By digging a bit further, we can see that declining sales is a big part of the problem:

Every single month in 2015 has seen lower total business sales on a year-over-year basis. In fact, the data appear downright recessionary when compared with the declines in the shaded areas. And the Fed is hiking rates!

Businesses are dreaming if they think a burst of sales is imminent. If you build it, they may not come. Inventory levels will need to be rightsized, likely through a combination of slower production rates and inventory liquidation. Headline GDP growth figures will suffer as a result.

2) Rising Healthcare and Rent Costs

According to the Centers for Medicare & Medicaid Services, U.S. healthcare expenditures amounted to $9,523 per person in 2014. That’s up 5.3% over the previous year. Astoundingly, the cost of prescription drugs surged 12.2% in 2014.

Insurance companies are passing these costs along to consumers in the form of higher health insurance premia and deductibles.

Ironically, the Affordable Care Act (Obamacare) is helping to make healthcare less affordable. And according to the White House, the cost of a benchmark Obamacare plan will increase by an

Ironically, the Affordable Care Act (Obamacare) is helping to make healthcare less affordable.

9

average of 7.5% in 2016.

Naturally, if you spend more on health insurance and out-of-pocket healthcare expenses each month, then you have less money for discretionary purchases – like eating out or buying a car. Also, if you save on gasoline but spend more on healthcare, then that’s a wash.

By this same logic, rising rents are crimping discretionary spending, as well.

The U.S. homeownership rate is at its lowest level since the 1960s. More and more people are renting, and rental costs are rising far faster than stagnating wages. Average rents have increased by 3.6% over the past year and have surged 12.7% since the beginning of 2012.

According to a study conducted by Zillow, renters can now expect to put around 30% of their monthly income towards rent. That’s the highest percentage ever. The rent (and health insurance) is too damn high.

3) Impending Credit Crunch

According to Standard & Poor’s, the trailing 12-month high-yield corporate bond default rate was 2.8% in November 2015. The high-yield default rate reached over 10% in 1991, 2001, and 2009. Thus, we have a long way to go before the default rate peaks.

Credit distress will spread over the next couple of years because a feedback loop has begun. An increasing default frequency will lead to falling asset prices, tightening lending standards, and even more defaults. Basically, the credit cycle has turned, and we’re now going to have a credit crunch (a crunch is somewhere between a pinch and a crisis).

An abundance of credit is necessary for our overly indebted economy to grow. Companies and individuals will increasingly find it harder to borrow money, and this impending credit contraction will deprive the economy of its lifeblood.

One final note: Many economists are missing this nascent economic downturn

10

because they’re on the lookout for the next Great Recession. But the next recession won’t look anything like the last one.

The U.S. banking system is in much better shape than it was during the last recession. However, even though there may be less contagion risk in the financial system, this doesn’t mean we shouldn’t be worried. The probability of a U.S. recession continues to rise against the backdrop of a weak global economy.

Consumer spending comprises around 70% of the U.S. economy, and consumer spending growth peaked in January 2015. At that time, the year-over-year increase in real personal consumption expenditures (PCE) was 3.8%. As of November, real PCE growth has moderated to 2.5%.

A vicious cycle has started. Lower consumer spending will result in lower production, which will translate into fewer jobs being created. Slowing employment growth will negatively impact consumer spending, and so on and so forth. Based on the risks and headwinds I’ve discussed, I believe we’ll see real PCE growth slow to below 2.0% in 2016. At that point, a bona fide recession will be at the doorstep.

Wall Street Daily provides its subscribers with unique opportunities to build and protect wealth globally, under all market conditions. We believe the advice presented to subscribers in our published resources and at our seminars is the best and most useful to global investors today. The recommendations and analysis presented is for the exclusive use of subscribers. Subscribers should be aware that investment markets have inherent risks and there can be no guarantee of future profits. Likewise, past performance does not secure future results. Recommendations are subject to change at any time, so subscribers are encouraged to make regular use of our website, www.wallstreetdaily.com.

© 2016 Wall Street Daily, LLC. Wall Street Daily, 105 W. Monument Street, Baltimore, MD 21201. All rights reserved.

Protected by copyright laws of the United States and international treaties. This publication may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Wall Street Daily. Information contained herein is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. You and your family are entitled to review and act on any recommendations made in this document.

Wall Street Daily expressly forbids its writers from having a financial interest in any security they recommend to their readers. All Wall Street Daily employees and agents must wait 24 hours after an internet publication and 72 hours after a publication is mailed before taking action on an initial recommendation. Wall Street Daily does not act as an investment advisor, or advocate the purchase or sale of any security or investment. Investments recommended in this publication should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

0322

2016