The Road Ahead

For those who asked for a year-end macro update, this is what I see happening in the months ahead:

As higher interest rates trickle through the economy, there will be more layoffs and significant downward pressure on real estate prices and financial markets.

At some point, the U.S. Federal Reserve will have no choice but to begin lowering interest rates. Here's why:

In 2022, government expenses will total ~$3.7 trillion. Military spending will total ~$800 billion. Which adds up to a total of ~$4.5 trillion in expenses for 2022.

Total U.S. tax revenues for 2022 are expected to be ~$4.8 trillion - this figure mostly comes from individual, corporate, payroll, excise, estate, and gift taxes, and in my view, is highly optimistic, as capital gains taxes will be far lower this year than in 2021.

Assuming the $4.8 trillion figure to be accurate, the U.S. government will have ~$300 billion left to cover interest payments on their debt.

The problem is that in 2022, total U.S. debt stands at ~$31.23 trillion, and interest payments on all U.S. government debt will total ~$400 billion, meaning that the U.S. will be ~$100 billion short in covering interest payments.

Now what happens as tranches of U.S. debt reach maturity and need to be "refinanced" at today's interest rates? As retired hedge fund manager Greg Foss points out, if we conservatively assume that $30 trillion of debt needs to be replaced at a 3.2% interest rate, total annual interest expense on U.S. debt becomes $1 trillion, which is $600 billion more than they're paying in interest this year.

Put another way, if the U.S. government was a corporation, it would be completely bankrupt.

Hedge fund manager James Lavish explains the situation with a credit card analogy:

Assume that you build up a balance on a credit card, and the monthly interest payment you have to make on that balance is more than you have after making payments on life essentials like housing, transportation, and food. Feeling stuck, you turn to a second credit card to help pay for the things you need, only now, your credit score is lower and the amount of interest you have to pay on the growing balance on your second card is higher than that of your first card. As the balance and monthly interest payment on your second card grows, you reach a point where you have no choice but to start using a third credit card to meet your monthly needs - this scenario is known as a debt spiral.

How do you get out of a debt spiral? Assuming you still have monthly income, the only way to not go bankrupt is to have the interest rate on all of your credit cards lowered to a level that will allow you to afford the interest payments on the balances on each of them. You're never going to be able to pay down the actual balances on those cards - you're only looking to stay alive and avoid bankruptcy by being able to afford your monthly interest payments.

This is the situation that the U.S. is in right now - it will never be able to pay back its debts. The only way it can continue to exist is by lowering interest rates, which will allow it to afford interest payments on all of its debts (treasuries and bonds), and as each tranche of debt matures, it will roll it over into new debt at an interest rate that the government can afford.

The U.S. is not alone in being trapped by unsustainable debt. Many countries will fail to make interest payments on their debts before the U.S. does, including Canada and most countries in Western Europe. Argentina, Lebanon, Turkey, Greece, Spain, Portugal, Italy, Sri Lanka, Zambia, and Egypt are just a few of many countries that are finding it increasingly difficult to borrow money at affordable rates given their risk of defaulting on sovereign debt, measured by credit default swaps.

There are 2 rational and responsible actions that can help people, businesses, and governments get out of a debt spiral and onto a sustainable path:

1. Lower spending.

2. Increase income.

Politicians generally won't lower spending because doing so increases the likelihood that they will lose their jobs - put simply, less spending translates to less votes.

Governments can generate more income by raising taxes, but higher taxes will hurt the economy through lower profits and lower growth, which will ultimately lead to lower tax revenues.

Governments can also generate more income by printing money to hand out stimulus checks or fund war, but money printing promotes inflation, and doesn't typically lead to a sustainable increase in a country's real economic output.

So simple math tells us that in the months ahead, the U.S. government will have little choice but to begin lowering interest rates, and since the USD remains the global reserve currency for now, most countries will follow suit in lowering interest rates so that their respective fiat currencies can maintain enough of a correlation to the USD to allow for the usual volumes of importing and exporting of goods and services.

Looking decades ahead, the mathematics of debt and interest payments also tells us that all fiat currencies will continue to be debased via money printing in a low or even negative interest rate environment - this is the only way that countries will be able to afford interest payments on their debts. The end game is a debt jubilee, an accord between the biggest countries that allows for forgiveness of debts and a reset of currencies to allow for a new beginning.

What can we do to protect ourselves?

First, to any extent possible, decrease unnecessary spending and increase income.

Every individual must take into account their unique circumstances, including age, income, savings, expenses, goals, responsibility for dependents, and risk tolerance. My view is that we should aim to have enough savings to cover our daily expenses for a minimum of 3 years. Beyond this, I think it's rational to have some hard assets that offer some degree of protection against fiat currency debasement - silver, gold, and Bitcoin are examples of such hard assets - even a 5% allocation to silver and gold and a 1-5% allocation to Bitcoin offers meaningful insurance against currency debasement.

Beyond having a responsible level of savings and some allocation to hard assets, I favour investing in deep value assets i.e. financially healthy companies that for a variety of reasons, are trading on public markets at significantly less than their intrinsic value. I can't give individual investment advice, but for those interested in learning about deep value investing, I can suggest beginning by listening to free podcasts with Mohnish Pabrai, William Green, and Preston Pysh.

Last week, I had the pleasure of spending some time with a highly accomplished professional risk manager named Greg Foss, who encouraged me to be more vocal about what we can do to protect our financial health. Our conversation inspired me to write a short 10-part thread on Twitter which can be found here:

https://twitter.com/Ben_Kim/status/1601695581600362499

I hope these thoughts are helpful to some.

Sending love to all,

Ben