From Steven Vannelli, CFA: The interplay between debt and income can be a difficult thing to understand. Here is a useful analogy. Imagine a hot air balloon lying on the ground preparing for take-off.
The fuel tank, used to heat the air, is the balance sheet in this analogy while the loft of the balloon is the income statement. The pilot begins by firing the burner, causing the balloon to inflate with hot air and slowly stand up. With a little more fuel, the balloon lurches from the ground into the air. It took a good bit of fuel (debt) to get the balloon rising (income).
Once aloft, the balloon keeps rising with less fuel required than take-off. In this phase, loft is achieved with minimal fuel, or said differently, income (loft) is growing faster than debt (fuel). But, once the hot air balloon reaches a certain altitude where the air is thinner, further heights become more difficult to realize. The pilot needs to start burning more fuel (debt) if he intends to keep climbing (growth). At this point a marginal diminishing return sets in where the amount of incremental fuel (debt) required to keeping rising (income) becomes greater and greater. There is a point reached where no amount of incremental fuel can lift the hot air balloon any higher.
Since the Great Financial Crisis of 2008, the federal government has been burning massive amounts of fuel for the US economy to take flight. In the chart below, I show the annual increase in federal debt (red bars) and the annual increase in US nominal GDP (blue bars). In the latest quarter, the federal government increased its debt load by $1.05 trillion while US GDP expanded by $632 billion at an annualized rate. This has been a pretty typical feature of the US economy since 2008.
In the first three quarters of 2015, debt growth was held in check by the debt ceiling and fiscal conservatives in Congress. Notice the negative effect on GDP growth in this period as growth slowed each quarter. Then in fourth quarter of 2015, the debt ceiling was suspended and the flood of federal debt began again. Predictably, growth picked up too.
But, this has not always been the case. The next chart shows annual growth in federal debt and GDP. Absent a recession (1990-91), the historical norm is for GDP to grow more than federal debt.
Unless or until the US can start experiencing GDP growth greater than debt growth, the US appears to be stuck in a hot air balloon economy. With the debt ceiling around the corner, we may shortly test the hypothesis of whether or not the US is on a self-sustaining recovery path.
The SPDR S&P 500 ETF Trust (NYSE:SPY) fell $0.25 (-0.11%) in premarket trading Wednesday. Year-to-date, SPY has gained 6.03%, versus a % rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of Gavekal Capital.