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Research Highlights - 02/07/2024

Research Highlights - 02/07/2024

February 07, 2024

In my next article for Forbes tentatively entitled, "Hoping For A Bad Recession To Fix Inflation Is Unfortunately Necessary", I write about one economic metric that's flashing yellow - the Output Gap. Figure 1 illustrates just how extreme the current output gap is for the US economy. I've compared this data to other sources (e.g., FRED) and found some differences to the current extreme reading relative to the past, but that may be due to the variance in data chaining to a different base year. Regardless, the current extreme measurement according to FRED was last witnessed just before the Dotcom Crash.

Highly positive output gap figures indicate that aggregate demand is so high in an economy that its resources are essentially "overworked" and producing beyond a sustainable capacity given its available resources. This usually occurs near full employment. Other factors that lead to highly positive output gaps are significant levels of consumer spending and government spending, both of which we've seen over the past couple of years.

In short, the likelihood of winning the inflation war is remote without a recession. There are simply not enough factors available to drastically reduce the rate of price increases from its recent surge. Disinflation may be somewhat likely, but remember that disinflation still means inflation, just at a lower increasing rate. Disinflation builds upon the already massive amount of embedded price growth experienced across every sector in the U.S. economy. What the economy would benefit from long-term is deflation. Deflation would reduce prices to a lower level. We do not require a reset back to pre-pandemic times, but a nice 10% decline in prices would not even give back half of the 23% cumulative inflation experienced in the past few years. Deflation is a phenomenon that occurs almost exclusively during recessions.

As mentioned, a major driver of the highly positive output gap has been government spending. As shown in Figure 2., the growth of US public debt over the past decade has been colossal - growing more than 88%. Meanwhile, the U.S. economy (net of inflation) has grown a measly 36%. Such a differential could indicate artificially sustained GDP growth at the expense of US taxpayers. Today, the interest expense on this mountain of US debt has increased massively since the implementation of the Fed's quantitative tightening (Mar/Apr'22), government spending. Federal money is now being diverted towards paying interest on debt instead of meaningful and impactful fiscal policy initiatives. By some estimates, the cost of paying interest on U.S. government debt will be a top 3 line-item in the federal budget, just behind social security expenses.

This backdrop does not bode well for the U.S.'s economic outlook. However, do not confuse economic malaise as a proxy for no capital markets opportunities. As I wrote in my last Forbes article, "It's Normal That The Stock Market And Economy Are On Different Pages", history shows that the markets and the economy have different reference points. For our investment portfolio strategies, we see many opportunities on the fixed income side of the capital markets - particularly in corporate debt markets - over this next phase of the monetary cycle.

Figure 1.

Figure 2.