YCG Investments
“If you buy above average businesses at below average prices, on average, we believe you should come out ahead.” — Brian Yacktman

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“Debt is like any other trap, easy enough to get into, but hard enough to get out of.” Those words, once penned by Mark Twain’s contemporary, Henry Shaw, could not resound any louder than it does today. With the national debt exceeding $14 trillion, we are trapped in uncharted waters in the largest monetary experiment in history.

Keynesian economics rules in Washington, where the prescribed drug for our economy’s problems is another dose of stimulus. Like Pavlonian dogs, the markets seem to react almost instinctively bullish at even the slightest hint of another injection, and the stimulus is considered to be working. However, it fails to address the underlying problems (See Keynesian Economics blog).

Healthy economic growth stems from savings that are invested, not from debt or by printing money. However, stimulus money is generally being used to finance consumption instead of growth or investment in goods and services the rest of the world wants. In this manner, we are not really growing the economy by creating new jobs and growth. Even with the stimulus, we aren’t really thriving. We’re simply surviving; holding on to our fiscal life raft and hoping the storm will eventually calm.

Sadly, when the stimulus spending putters out, the mirage-like growth we’ve seen will disappear with it, and so will the promise of a calm economic climate. So what’s next when that occurs? Can we really continue to inject euphoria into the economic system, encouraging the use of debt to solve a problem caused by excessive debt? As Einstein famously said, “Insanity [is] doing the same thing over and over again and expecting different results.” We know full well that someday we will have to pay the consequences of living beyond our means as a nation.

If we viewed the government as a business, it would certainly not be an attractive stock. Expenses exceed revenues, and the remaining cash flow shortfall is being supported solely by financing activities – not a sustainable path. It seems reasonable to think that the only reason Moody’s Investors Service even gives the U.S. an AAA credit rating is because of the currency’s reserve status. However, even Moody’s has warned the country’s top AAA credit rating is at risk.

Clearly, the national debt situation isn’t getting any better. Eventually, to solve a debt problem you have to start spending less than you earn. This can be accomplished by either spending less or creating something of value to cover your spending habits. Currently, the government’s budget plans to spend about $1.70 for each $1 in revenue, and last year it was spending $1.60 per $1 in revenue. So the government seems to be going on a spending spree in the wrong direction. In the long run, this almost certainly leads to extreme debt and inflation. Of course, Keynes never was worried about the long-run…

With the gross debt-to-GDP ratio* currently at 93%, we are on pace to exceed 100% debt-to-GDP by the end of this year. Sure, during WWII in 1946 our gross debt-to-GDP rose up to 120%, but our current situation does not resemble 1946 in any way. In 1946, spending was non-mandatory, with almost all of the borrowing coming from the government’s needs for war machines and supplies. Once the war ended, government was able to produce a budget with surpluses and quickly pay down the debt. In fact, during Truman’s presidency (1945-1953), debt-to-GDP went from 120% to about 70%.

Fast forward to 2011, and our budget is quite different. In the current budget plan, so-called “mandatory spending,” things such as Social Security, Medicare, Medicaid, etc. that are not legislated from year to year already soak up all of the annual revenues! Short of a major overhaul of these social programs, we are driving up a mountain of debt. Of course, the other side of the equation is increase tax receipts, but not only can we not raise taxes enough to keep up with the increased spending, but attempting to do so has far greater unintended consequences for the economy (See The National Debt Road Trip and Happy Tax Day blogs). We wish we could exercise some fiscal restraint and live within our means. But we don’t plan on any self-control coming anytime soon. We see the Federal Reserve using the wealth effect tactic in providing a false sense of security. It is this feeling of security that has lead people to believe in this recent market recovery, but we cannot keep ignoring the 800-pound gorilla in the room – the national debt. Of course we always wish the day of reckoning could be forgotten or pushed back awhile. However, no amount of pushing it back or kicking the can further down the road will prevent the inevitable: that day must and will come. When it does, the bond markets will indeed rebel. Yet, another reason to be invested in strong multi-national corporations with pricing power and diverse currency revenue streams.

*Note: We are discussing gross debt (public debt plus intra-governmental debt), not public debt. Publicly held debt represents the impact of government borrowing on the current economy, and intra-governmental debt represents the future promises we have made.

Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.

Posted by: Mike Yacktman | February 23, 2011 | Permalink

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