US Banana Republic

The exorbitant privilege of having the world's reserve currency has kept the dollar stronger than its fair value.  Of course, it helps to have the next 2 biggest currencies yielding negative rates out to 30 years on the curve.

Recently, Argentina's stock market plunged by 40%, and the US dollar denominated Argentina 100 year bonds dropped 30%.  Here is a look at Argentina's government budget deficit as percent of GDP:

Nothing crazy, but it has gotten above 5% of GDP.  Here is the US budget deficit over the past few years and estimates out to 2021:

As the economy has remained steady since 2014, the US budget deficit has gotten bigger and bigger.  It is now around 5% of GDP.  That is while there is record unemployment and what has been a raging bull market in stocks.  In the past, even as recently as 2000, there was a budget surplus during the business up cycles, but in this current upcycle, the budget deficit hasn't shrunk, but has ballooned higher.

The US economy has basically achieved above trend growth through massive tax cuts and big increases in government spending ($300B for 2018/2019).  That is only sustainable if inflation stays low.  Argentina, Brazil, Venezuela, and other banana republics has shown throughout their history that if you have rampant government spending financed by money printing (QE), the end result is high inflation.

Having the world's reserve currency can buy you a lot of time before the currency starts losing relative value and foreigners start losing confidence in it.  We are not there yet, but the more the US government pushes the limits on how many dollars the free market can handle, the closer you get to the US becoming a banana republic.

The US has one of the lowest effective tax rates among the developed nations while also maintaining a gigantic military.

Taxation is a control on inflation, as it reduces the amount of currency in circulation.  Big budget deficits financed by the central bank (yes, that's the eventual path when the economy weakens, ZIRP and QE) is what will happen, and that is straight out of the banana republic playbook.  The big difference between Europe and the US is that the European Union's charter limits government budget deficits to less than 2% of GDP, and for the most part, its execution is successful.   That is a strong counterbalance on ECB money printing, keeping inflation under control.  The US has no such limits on budget deficits, and the trend is for bigger and bigger deficits, and most of the voting population doesn't care or understand the consequences.  The ones that do worry about the deficit worry that the US government can't pay back its debt, but that's ridiculous.  The government can just print money to pay back the debt.  The consequence of a growing national debt and big budget deficits in both up and down cycles is inflation, or currency debasement.

There has been a lot of talk in the media about a pending recession, many pointing to the inverted yield curve and surging bond prices.  I don't agree on the US recession calls for 2020.  There is just too much government spending, not enough excess capacity, and not enough inflation to cause a recession.  If oil was at $100/barrel, corn at $8/bushel, and natural gas at $7/mcf, then I would be more open to the recession idea.  But that's the opposite situation, with commodity prices low, wage growth the highest it has been since 2008, and with the stock market still close to all time highs.

The strength in the bond market is a relative game of negative yielding European debt causing a chase for "safe haven" yield in the US Treasury market.  The weak European and Asian economies are what's causing the huge plunge in US yields, not any imminent recession signs.  Yes, the leading indicators are slowing down but they mostly point to slow growth, not negative growth.  And with such a huge rally in bonds and yields this low, slow growth is enough to keep the SPX elevated for now.

Eventually, the SPX will fold under the pressure of no earnings growth even with low yields, but that's probably a 2020 story.  The biggest bomb that could go off on the stock market would be a liberal Democrat (non Biden) beating Trump in November 2020 and raising corporate tax rates and pursuing anti trust legislation against the corporate giants.  Anyway, the stock market is so short sighted, November 2020 may as well be November 2024.  But if Joe Biden fades from the top as I expect and a liberal Democrat (probably Elizabeth Warren) wins the Democratic primary, then all bets are off, and a real ticking time bomb will be placed right at the footsteps of Wall Street.

Its a resilient market, we got the classic V bottom off the mini fear low on last Thursday.  Everyone knows the drill, after 10 years of this action, and with FOMO, the things fly on a feather once it hits bottom.   Just watching and waiting, no good trades here.