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The Gray Rhinoceros of Debt: a visible and ignored threat

The Gray Rhinoceros of Debt: a visible and ignored threat

September 24, 2024

Topic of the week:

We all know what a black swan is: those unforeseen and rare events that have a major impact, such as the Covid-19 pandemic, but few of us know what a “gray rhino” is, a different but equally important concept. This term is used to describe a problem that is obvious and known, but often ignored or underestimated, and which, if not properly managed, can have catastrophic consequences.

Just as the gray rhinoceroses represent visible threats that are ignored, the American hegemony, consolidated at Bretton Woods, was a response to the need to prevent obvious economic disasters after the devastations of war, establishing the dollar as the global financial anchor to avoid future crises. At the conference held in Bretton Woods, New Hampshire, in July 1944, it was agreed that the U.S. dollar would be the world’s primary reserve currency. At that time, 44 nations pegged the value of their national currencies to the dollar, which in turn was convertible into gold. In other words, from then on, when someone handed you a dollar, they were actually saying, “I pay in gold, but for convenience and safety, this gold is hidden under New York City or at Fort Knox.” The purpose of this system was to prevent a recurrence of competitive devaluations.

This decades-long arrangement came to an end on August 15, 1971, when then-President Richard Nixon interrupted the television programs to make a surprise announcement to both the nation and the world: the unilateral end of the Bretton Woods system and the severing of the dollar’s last link to gold. The main consequence of this breakup was that money printing no longer needed to be backed by any kind of physical reserve, but was based on trust. Thus, the amount of money in circulation could be increased without limit, simply by the will of the leaders. This ability to print money without a backing allowed countries to print more money to finance their debt. Since then, the United States, and most countries, have continuously accumulated deficits, raising their debt to unprecedented levels. As we see, debt and money are two sides of the same coin.

The consequences of the end of the gold standard began to become evident in the 1970s. One of the main ones was the fall in real wages, i.e., the purchasing power of individuals net of inflation. As a result, what could previously be achieved on the salary of a single family member was no longer sufficient, and it became necessary for both parents to work to maintain their standard of living and meet their needs. This has led to people having to work much more and, in many cases, to resort to indebtedness. On the other hand, the capacity to get into debt has skyrocketed. In the past, debt was compensated by a rapidly growing labor force and rapid growth in production. Today, the labor force is shrinking and efficiency, if it grows, grows much more slowly than in the past.

So, if the labor force is smaller and smaller, and productivity is not what it was in the second half of the 20th century, what is left for governments to do to keep the system from collapsing and to maintain confidence that debts will be honored? In principle, the only way to manage this growing debt is, on the one hand, by increasing taxes and, on the other hand, by using inflation.  On the tax side, the tax burden (tax revenue/GDP) in Western countries has been increasing to maintain a fair and generous welfare state. To put this in context, according to the National Statistics Institute (INE), the tax burden in Spain rose from 14.7% in 1965 to 42% in 2023. There does not seem to be much room for further increases. On the other hand, inflation is gradually reducing the real value of debts. However, we should not fool ourselves: inflation is a way of stealing the value of our labor. People may be working the same, earning the same, but buying less. In the old days, this process was called “bastardization,” which consisted of removing precious metal from circulating currencies, thus decreasing their intrinsic value, which is equivalent to printing unbacked banknotes. In short, inflation may make debts more manageable, but it acts as a disguised tax on workers.

This analogy of the “gray rhinoceros”, represented by mounting debt, reminds us that not all crises are surprising or unexpected. Unlike black swans, gray rhinos are in plain sight, threatening devastating consequences if ignored. Debt, which has grown steadily after the end of the gold standard, has become an obvious but often neglected problem. As governments face pressure to manage these debt levels through taxation and inflation, we are seeing these measures quietly erode the purchasing power of workers, a form of modern “bastardization.” Ultimately, without more structural measures, this gray rhino will continue to advance, threatening economic stability and the well-being of future generations.

The beacon of the markets:

The Fed’s decision to cut interest rates by 50 basis points, the first cut in more than four years, resulted in a generalized rise in risk assets. In the equity markets, rises averaged around 1.5% in the main markets. The S&P 500 closed Friday with a gain of +1.36%, very similar to the +1.42% of the Nasdaq 100, both US indices above the European benchmark: the Euro Stoxx 50 only rose by +0.59% while the Ibex 35 did better, with a rise of +1.85%. It should be noted that the S&P again set a new all-time high at 5,733.57 points and the Ibex 35 a new annual high at 11,826.70 points, falling less than 60 points short of the high set in 2015.

In the fixed income markets, sovereign bond yields rebounded between 6 and 8 bps as a result of the analysis of the Fed’s comments, which suggest that the move to lower interest rates initiated last Wednesday will not be as significant or as fast as the market expected. The 10-year Treasury ended the week at +3.74%, with the German Bund at +2.22% and the Spanish Bono at 3%. All of them had set new annual yield lows during the week, but as we have mentioned, they rebounded slightly after the Fed’s decision was announced.

In the alternative markets, the tone was the same: gold reached a new all-time high, spurred on by the dynamics of lower interest rates and the worsening of the situation in the Middle East. For its part, Brent closed its most bullish week since April on the anticipation of an improvement in the global economy, the possible arrival of new stimuli in China to reactivate its domestic demand and the growing crisis situation in the Middle East.

At the macroeconomic level, the week did not have too many references, but they were decisive. In China, the central bank left the prime lending rate unchanged at 3.35%. In Europe, the ZEW investor confidence index continues to show signs that the euro zone economy remains weak while European CPI data was fully in line with expectations.

In the US, retail sales releases were better than the market anticipated, construction and new home permits data beat analysts’ expectations and weekly employment data beat forecasts, pushing back existing fears about the labor market. Against this backdrop, the Atlanta Fed’s Q3 2024 GDP estimates rose to 3% from 2.5% previously. And on top of it all was the Fed’s decision to cut interest rates by 50 bps, which surprised a part of the market that was still expecting a move of only 25 bps.

For the current week we highlight the PMI data in Europe and the US, where we will also learn how consumer confidence evolves, the final GDP data for the second quarter of the year will be published, which will be close to 3% growth, and above all the PCE data, a reference for the FED in terms of the pressure that consumption may generate on the CPI.

The quote:

And we bid farewell with the following quote from William Clay Ford Jr, American entrepreneur, executive chairman of Ford Motor Company and great-grandson of the company’s founder: “building a strong business and building a better world are not contradictory goals, both are indispensable ingredients for long-term success.”

Summary of the performance of major financial assets (9/23/2024)

This report does not provide personalized financial advice. It has been prepared irrespective of the particular circumstances and financial objectives of the persons receiving it.

This document has been prepared by Portocolom Agencia de Valores S.A. for the purpose of providing general information at the date of issue of the report and is subject to change without notice.  Portocolom Agencia de Valores S.A. assumes no obligation to communicate such changes or to update the contents of this document. Neither this document nor its contents constitute an offer, invitation or solicitation to purchase or subscribe for securities or other instruments or to make or cancel investments, nor may they form the basis of any contract, commitment or decision of any kind.

The information contained herein has been obtained from public sources believed to be reliable, and while reasonable care has been taken to ensure that the information contained herein is neither uncertain nor unequivocal at the time of publication, we do not represent that it is accurate and complete and it should not be relied upon as if it were.  Portocolom Agencia de Valores S.A. assumes no responsibility for any loss, direct or indirect, that may result from the use of the information provided in this report. Past performance of variables may not be a good indicator of future performance.