The Next 40 years of investments. By Karl Denninger, in a mash up of here, here, and here.
This is a crucial economic post, because it warns of a fundamental economic change occurring over the next 40 years. It is a long term (“secular”) phenomenon, a forest that most everyone misses for the trees, at first.
TL;DR: The investing strategy that worked for the last 40 years — borrow as much as you can and buy assets — will now fail disastrously, because the great interest rate cycle has just flipped.
Economic cycles are real. The most-profound ones tend to be of long duration, equal to or beyond a human lifetime, just like geologic and climate cycles. …
You need to look at this for however long it takes until you realize what it means.
That’s the 10 year Treasury rate. Unfortunately it only goes back to 1962 on FRED but if you were to keep looking backward you would see that it has a roughly 80 year period through history.
This is a Kondratieff cycle which is roughly correlated with human lifespan. That is when the last person who went through the previous one is dead then the same cycle tends to repeat.
1981 – 2021 saw declining interest rates:
In this case we’re talking borrowing rates; the general shape of them has been, for 40 years, from the upper left to the lower right. [It is] not possible for it continue forever because rates below zero are in fact simply confiscating wealth from the lender … and thus will never be permitted on any sort of durable basis. …
In generally-decreasing rate environments (note that it wasn’t a straight line in either direction in the past) you can roll over borrowing at decreasing interest cost. This in turn encourages ever-higher leverage. Yes, small busts occur when you bottom-tick one of the declining points and then rates go higher for a little while (gee, you don’t see that just before 2000 and 2008 do you?) but the longer-term trend is down. …
Corporate and personal behavior have been molded by this for the last 40 years. Effectively no corporate borrowing has ever been paid off during the last 40 years because it has always been cheaper to roll it over than it was the last time. It therefore appears “stupid” to retain earnings and pay it down. But when the turn comes, and it clearly has, now every turn comes with higher interest expense instead of lower and now if you don’t retain earnings and pay it off you risk bankruptcy. …
2021 – 2061 will see increasing interest rates:
The trend reached its terminus in 2020; we now have roughly forty years of increasing rates on a long-term basis in front of us. About five of those years have already occurred and there are 35 more to go, like it or not. …
The previous 40-ish year cycle is over folks, and the upward swing is now occurring. It has roughly three to four decades to run before it turns the other way. …
It appears to be “free” to continue to accumulate national debt in a declining rate environment. But when that long-cycle turns, and it now has, you must not only reduce deficit spending it must be less than economic expansion or the ever-increasing cost of borrowing will inevitably go vertical on inflation and destroy the nation and its citizens.
US debt interest payments are starting to go vertical, as US Treasury bonds (typically 10 years duration) get repriced to the ever higher interest rates:
The market is too short-term focused, and always misses these big turnings at first:
The market is ignoring this. That’s idiotic and it is precisely that which leads to very serious market and economic dislocations.
The detonation hasn’t happened yet because corporations tend to take out roughly 10 year paper. Thus the serious rollover problems are just beginning to happen now and the same is true for much of the Federal Debt …
Economics have cycles just like this and we forget them for the same reason we do with the natural world; its inconvenient to read actual written history and comport your behavior with what appears to be an inexhaustible thing at a given point in time but which history has repeatedly proved is in fact not. …
Decades ago I recall being taught about the “business cycle” and that it was driven by human psychology that never has and never will change, and thus you should be aware of it and cautious in thinking that cyclicality won’t happen again at an inopportune time. Yet in the last 20 years I’ve not heard this once — not in the media, not in academia and certainly not among businesspeople! Indeed everyone believes that the Fed and “powers that be” have slayed said cycle and its dead, buried and gone. Wrong. …
Uh oh. Government welfare has to be cut way back, or else we get massive inflation — a bit like the 1970s, but starting from much higher expenditure levels:
There is no way to control the otherwise runaway federal interest expenses other than to dramatically cut deficit spending …
Asset prices will all trend down in real terms (except for the alternative moneys — which are in competition with the paper currencies):
The only rational expectation is that all of the premium generated by that compounding of debt into lower rates (that is in all asset classes, including real estate and stocks) from that prior 40 year trend is going to come back out.
That’s at least 50% in real estate on an average basis (and much more in some areas) and almost-certainly 75% or more in leveraged asset markets (like stocks) …
When does it become impossible for the market to ignore and thus those outcomes occur? When [the borrowed money] must be either paid off (which there is no money to do) or rolled over (at materially higher interest rates.)
If you’re thinking that any of the formulas that used debt as a successful tool for other than financing some element of consumption or production to be paid in full (e.g. a house to live in with no expectation of profit from its eventual sale or an industrial building and equipment to make a product with sufficient cash flow to pay it off on the original terms) you are going to be wrong for the next three decades unless, by pure happenstance, you hit the window of one of the short-term cycles that allows you to exit by paying off the principal on one further rollover without being ruined.
None of the schemes from the 1980s forward are going to work otherwise until another 30+ years pass. …
Debt:
To survive economically in a secular rising rate environment you must not be dependent on leverage — that is, debt — whether that dependency is direct or indirect. That is, your financial operating condition whether as a person or business must be on the basis of retained earnings. …
The term “cash on cash” means just that — the cash return on cash cost.
If you never violate that then you may come up against tough times or even be forced out of whatever business or line of employment you’re in but you will not wind up with a negative balance because you can’t. You can wind up with zero but never less than zero. …
If you put up $100,000 to buy a house in cash the most you can lose is $100,000. But if you only put up $20,000 as a down payment (20%) you can lose five times what you put in….
During a secular declining rate environment it looks attractive to do the latter and most of the time it is … But in a generally-rising rate environment only cash is reasonably safe …
The fire sale cycle:
When the fire sales come — and they will — you must only buy for productive use that which you can earn a profit from cash on cash for real. If you have only a little cash then you can only do little things. That’s ok; as this cycle progresses through the next several decades there will be more opportunities and both patience and fiscal rectitude is rewarded in a generally-rising rate environment.
Why?
Because not everyone who has previously committed to a Ponzi-style financial scheme will blow up at the same time. This in turn means that the mark-down of asset prices of all sorts will come in a step-wise fashion and there will be plenty of people who, believing that “the previous paradigm” will shortly reassert itself, think they got a bargain and thus take out leverage to acquire said asset.
They will all prove to be wrong and many of them will have to puke up said asset at a lower price when they subsequently blow up due to being unable to maintain said asset’s earning capacity against ever-increasing costs of holding it in the form of higher rates and lower prices for comparable assets. …
Contemplate the dude who has levered into rental cabins here in the Smokies. [Consider] the guy down the street with another one; he gets foreclosed on and I buy his for half the price of what you paid. You’re dead because I can undercut your nightly rate by 20% or more and still make money; your cabin sits empty. The problem comes if I took out debt to do it and then a year later you blow up and your cabin goes up on the market at a 75% discount to the original price of both. If I paid cash I’m still ok (I must drop my price and thus will be making less) but if I borrowed the money now I’m bankrupt as well because when that happens the new owner of the other one undercuts me and I cannot match him!
This is the leverage cycle in reverse and it is coming in all asset classes. Stocks (and worse, crypto!) are the ultimate leverage game in this regard and will get hammered since virtually every corporation has debt on their balance sheet and they never generate enough retained earnings to pay it off.
Everyone looks at “debt coverage” as interest only on said loans but in a rising rate environment that is going to continue for three decades that doesn’t help you since you’ll have to roll it at a higher rate and thus a materially higher interest expense — which immediately and durably subtracts from operating income. Worse, corporations cannot raise prices into this to cover it because the very same cycle hits the customer (whether industrial or consumer) at the same time.
Political magic won’t help:
The key thing to remember is that this is a multi-decade secular trend, not something The Fed or the next Congress (or President) will be able to alter through fiscal or other economic policy. Yes, there will be counter-trend moves just as there were in the previous 40+ years but the actual top and change in the secular trend is decades into the future — not six months, a year or two years down the road.
You must evaluate all economic opportunities through this lens; if you do then you will find plenty of opportunities provided you do not have leverage on now that prohibits you from taking advantage of them when they present themselves — and they will. …
Housing:
Prior to the 1980s we were in a generally-rising rate cycle. You bought a house, you had a mortgage, and if you were wise you stayed in the house to raise your kids and then you had a mortgage-burning party when it matured and you made the last payment. Virtually everyone of my parent’s age when I was growing up did precisely that; mortgage burning parties were common. Over the last 40 years they’ve been non-existent.
Oh by the way home prices went up slower than wage increased during that time! Why? Because rates were generally rising and thus the payment one could make, was limited by wage increases and due to generally rising rates the amount you could borrow was capped. In addition no bank in its right mind would allow less than 20% down because in a rising rate environment if there was a recession and you lost your job without that equity cushion the bank would take an actual loss trying to resell your foreclosure; that 20% down payment was the only way to mitigate that risk.
In that time more than a four year loan on a car was unheard of and even that was considered rather dangerous. …
This world is coming back and neither you or anyone else can stop it from happening.
The “powers that be” may not want that to happen but it is happening. The markets, whether real estate, stocks or mundane and routine businesses like medical care and car dealers don’t believe it — yet — but they will recognize it eventually simply because facts just are and if they don’t adjust they’ll go bankrupt and cease to exist.
I think he’s saying to get out of debt fast, and stay out of debt as much as possible for the next 35 years. Expect asset prices to trend down and interest rates to trend up until 2060.
