Balanced Asset Allocation. Lee Bill

like a machine. Money flows through the machine from buyers to sellers. Buyers exchange their money for goods, services, and financial assets. This is what money is used for, and it is only worth something because you can exchange it for goods, services, and financial assets. Sellers sell these items because they want money. Buyers buy these things to fill a need. Goods and services help support their lifestyles while financial assets are used to preserve and increase wealth over time. An economy is simply the sum of billions of transactions between buyers and sellers. An economy grows when there are a lot of such transactions and it stagnates when the flow of money slows. At a fundamental level it really is that simple.

      The Short-Term Business Cycle

      The ability to borrow money slightly complicates the mechanics of the machine. If borrowing were not allowed in the system, then buyers would only buy what they could afford to pay using existing money. There would be no deleveraging because leverage would not exist. The economy could be more stable, although it may operate below its potential because capital would not flow as efficiently. With borrowing, a buyer is able to spend tomorrow's income today. If I want to buy a good, service, or financial asset and do not wish to (or cannot) pay with cash, then I can simply promise to pay for it in the future. I have created credit. This is what typically happens when you buy a house, swipe your credit card at the grocery store, or promise to pay your friend back if he buys you lunch. In each case you have created credit. Your balance sheet has been leveraged, and the amount of debt you owe and your debt service have just increased. A simple way to summarize these concepts is to say spending must be financed either from money or credit (so spending = money + credit).

With leverage an economy can grow more than it would otherwise because buyers can use both money and credit to make purchases. If they don't have enough money, they can use credit to buy what they couldn't afford to pay for with current funds. Because your spending is someone else's income, when you buy more using credit, then others earn more than they would otherwise. Then their increased earnings lead to increased spending and so on. The economy grows because it is simply the sum of all the transactions. Figure 1.1 displays this general cycle.

Figure 1.1 Basic Cycle of Economic Growth

      The central bank plays a key role in managing this process. The Federal Reserve (known as the Fed) is the central bank of the United States; other major economies around the globe have their own central banks. The objective of the central bank is to try to smooth out fluctuations in the economy. Fluctuations can be measured in terms of both economic growth and price stability or inflation. The Fed does not want the economy to weaken too much because reduced spending feeds into falling incomes, which begets more spending cuts. The Fed also does not want prices to rise too quickly. If there is too much money chasing too few goods, services, and financial assets, then upward pressure is exerted on prices, which can be harmful to an economy if it goes too far. In short, the Fed seeks the goldilocks economy (moderate growth and low inflation – not too hot, not too cold, just right).

      How does the Fed try to maintain economic and price stability? The main policy tool the Fed uses is to control short-term interest rates. Whenever the economy is weakening or inflation is too low, the Fed can stimulate more borrowing by lowering short-term interest rates. When inflation is too high or the economy is growing faster than desired, then the Fed can raise interest rates to curtail borrowing. Recall that total spending must be financed by money or credit. The supply of money is relatively fixed most of the time. However, the supply of credit constantly changes and is largely influenced by interest rates. All else being equal, the lower the interest rate you are being charged the more money you would borrow and the higher the rate the less you would borrow. When credit is cheaper, the growth of credit typically increases and vice versa. When the Fed wants to stimulate more borrowing to support the economy or to increase inflation, it lowers rates to a level that encourages sufficient borrowing to achieve the desired outcome.

This interrelationship is why we have the familiar business cycle: The economy weakens, the Fed lowers rates, credit expands, spending picks up, and the economy improves. Eventually inflation pressures may build and the cycle reverses: The Fed raises rates, credit contracts, spending declines, the economy weakens, and inflation subsides. These cycles typically last three to seven years and are easily recognizable because of both their frequency and the relatively short time frame between inflection points. Investors have seen these cycles so many times that they have a good understanding of the pattern and how they work. Few are surprised when the cycle turns because they have firsthand experience with this dynamic. Figure 1.2 displays the normal business cycle.

Figure 1.2 The Normal Business Cycle

      Most investors, economists, and even lay people are probably familiar with the above-described parts of the economic machine. What follows next is much less understood, and in fact the concepts that will be presented have been completely missed by many economists and certainly by most investors.

      The Long-Term Debt Cycle

      There is another cycle that is working in the background of the economic machine just described. Most people are completely unaware of its existence because the cycle only hits its inflection point once or twice in a lifetime. By comparison, the business cycle covered earlier turns every three to seven years, on average. This longer-term cycle, often referred to as the long-term debt cycle, may last many decades before it changes direction. The only time it really matters and is worth paying attention to is near those critical inflection points. It is at those rare moments that no one can continue to ignore the powerful forces that ensue.

      As covered above, the short-term business cycle exists because the Fed moves short-term interest rates in response to economic conditions. Over time, whenever the Fed lowers rates, increased borrowing adds to debt levels on balance sheets. Debt levels can continue to rise for a long period of time due to the self-reinforcing dynamic that is involved. The dynamic is self-reinforcing because the creditworthiness of a borrower is based largely on the value of his assets and income. Lenders want to make sure that they can be paid back. The higher the borrower's income and collateral, the higher are the odds of repayment. Going back to economic machine basics, when I borrow and spend, then the economy grows because that spending is someone else's income. In sum, when we borrow to spend, our collective incomes rise. Rising incomes further support debt accumulation. Additionally, the value of our assets increases through this leveraging phase of the cycle because we have a greater ability to spend on assets such as stocks and real estate. The boosted spending on assets pushes their prices higher. The cycle is virtuous in nature: More borrowing leads to increased spending, which improves incomes and asset values, which are the key factors used by lenders to assess creditworthiness of borrowers.

Therefore, the short-term business cycle (three- to seven-year boom-bust economic cycles) operates within this longer-term debt cycle (50- to 75-year leveraging-deleveraging cycles). Each time the Fed lowers rates, the amount of debt in the economy increases; when it raises rates, debt growth slows. The level of debt generally does not materially decline during this phase; the growth of the debt merely pauses temporarily. Then the economy requires additional stimulus and debt levels go up once again. This continues until the total amount of debt in the system is too high and can no longer rise. In other words, balance sheets go through a long period of leveraging as they are constantly supported by higher asset values and incomes. This cannot continue forever as the cycle ends when debt limits are reached. We collectively hit our debt ceiling when we can no longer make interest payments on our debt and our assets have become impaired. At that point, we are no longer creditworthy and have difficulty refinancing our debt and increasing our borrowing. Our aggregate balance sheet is too highly levered relative to our assets and income and must be repaired over time. The typical dynamic is illustrated in Figure 1.3.

Figure 1.3 The Virtuous