Special Episode: Dr. Lacy Hunt, Chief Economist, Hoisington Investment Management Company

Join Vin, Zach, and DCG Managing Director Frank Farone in a timely discussion with internationally-renowned economist Dr. Lacy Hunt, Chief Economist of Hoisington Investment Management Company.  The four discuss: 

• How we have entered a Minsky Moment
• Bond investors “looking the wrong way down a one-way street”
• The longer-term implications of the debt overhang on the term structure of interest rates
• The current yield curve as a “cause and a symptom” 
• The outlook for bank lending, credit, and profitability

For more insights and ideas, visit DCG at DarlingConsulting.com or follow us on LinkedIn.

Transcript

[Vinny, 0:00]:

Welcome to "On the Balance Sheet" special episode this week. We have Doctor Lacy Hunt, who is the Executive Vice President, chief economist at Hoisington Investment Management, and Zach who better to join us than somebody who has 54 years of experience looking at studying the economy than Doctor Hunt.

[Zach, 0:24]: 

Then this is a big one. I know we're all really excited to have a guest of the caliber of Doctor Hunt on and for a lot of you folks who went to our conference last year, you know he was the keynote speaker there. We actually have a webinar with him and our President, Matt Pieniazek, is that coming up soon as well, so stay tuned for that. Today we're hoping to really get into the bond market rates, the Fed, inflation, and his thoughts on all of those things. And maybe even talk about Hyman Minsky, Minsky moments. Are we in one right now? And then we have some outlook on the banking industry, lending credit profitability, and kind of get his take, his assessment on where we stand there. So, I think this would be a great episode for our listeners and a wide range of topics.

[Vinny, 1:05]:

And absolutely, this is a time in the economy where there's just, you know, so much uncertainty and you know quasi panic if you will. And this is a gentleman who has been through this numerous times before. So, without further ado, I hope you folks enjoy Doctor Lacy Hunt.

[Frank Farone, 1:25]:

Welcome, everybody. I'm Frank Farone, managing director here at DCG. Co-hosting this very special and timely episode, along with my colleagues Vin and Zach. We're so pleased and delighted to have Doctor Lacy Hunt with us today. Doctor Hunt is executive vice president and chief economist of Hoisington Investment Management Company. Most of you know Hoisington as a large investment firm. They manage over $5 billion for pension funds, endowments, insurance companies, and many others. And Doctor Hunt is an internationally known and award-winning economist. We are very pleased to have him with us today. Now, we could easily spend the next 30 minutes plus going through his bio and all of his accomplishments over his five-decade career. And I would encourage you to look up Doctor Hunt and learn more about him. But we're just going to get right into the heart of the key questions. We know that many of you listeners are hoping Doctor Hunt can provide his wisdom on. So, up first Doctor hunt, I know at one point in your career, back in 1981, you were part of a monetary and fiscal affair panel during the Reaganomics and Stagflation Conference. And one of the other gentlemen on the stage was Hyman Minsky, who was a well-known economist himself. For our listeners who may not have heard of Hyman Minsky, he is attributed to the idea of the Minsky Moment, which, I'm paraphrasing here, it's effectively the point in time where a sudden decline in market sentiment inevitably leads to a market downturn and an inevitable crash. This usually occurs after a long period of stability and bullishness as the gains and the prosperity of the times diminish overall perceptions of risk. Risk leads to more risk, which leads to speculation and ultimately a crash. The most recent Minsky moment being the great financial crisis of 2008. So as someone who has closely studied Minsky, do you think the economy today is heading for, or perhaps even already in the midst of the Minsky moment?

[Doctor Lacy Hunt, 3:22]:

In a certain sense, we are, yes, we are, and we've been in this kind of situation many, many times in the past and really the origin of our predicament today really started with the pandemic response. It was hailed at the time. It was coordinated monetary and fiscal policy operation. The financial markets cheered it. However, it set off 2 very horrible chain reactions. First of all, it laid the foundation for the worst cost of living crisis that we've experienced in more than 4 decades. Because of the surging inflation, 180 million Americans have suffered a 3% decline in their standard of living in both 2021 and 2022. And in the first two months of this year, off of the depressed base, they're experiencing another 2% decline. The fact is that inflation robs almost everyone, but it robs the modest and moderate-income households the most. There was $10 trillion of monetary and fiscal stimulus, and it brought us two $2 trillion of GDP growth. It was a very good trade-off. But it did bring us a lot of inflation. And one of the important partners, it was really a monetary and fiscal policy partnership, something the flow reserve was not designed to be in part at the end because the Federal Reserve was supposed to be independent. And when the problem blew up, the fiscal policy partners were absent and the entire cleanup was left to the Federal Reserve. This is what happened in 1971. There was a partnership between monetary and fiscal policy. Richard Nixon's president, Arthur Burns, was running with it. I was in the Fed. Observe the situation. The program was hailed by the markets. But when it resulted in double-digit inflation, the fiscal quality partners are not there. The Fed had to do the entire job. Of course, as the inflation got out of control and so many of us were hurt by the inflation, the Federal Reserve had to act. Try to protect these modest and moderate-income households. But in providing the monetary largesse, which was extreme in both instances, the Fed caused another unintended consequence. And when you have extreme monetary ease, you encourage excessive risk-taking. The liquidity is there, rates are lower for a while. And people bore in. And they undertake projects that are dependent upon that stream of liquidity continuing. And so there ultimately had to be a monetary contraction after the failures of the 1970s. Took us a long time to get around to it. Took us into Paul Volcker, came in and the net result was that we had people make mistakes. They took on too much risk and the same thing happened in 2021, in 2020 and 2021 and 2022. And some of those mistakes are becoming evident. We've witnessed a record monetary acceleration in modern times. In 2020 and 2021. Now we've recognized a already record monetary deceleration and the bad actors are being exposed. We've already had some of them in the banking sector. But there was a lot of liquidity created and it suggests to me that this is not the end of the game. There’s a great study produced by Robert Barrow, it's called macroeconomic crisis since 1870, with one of his Harvard colleagues. Published by the National Bureau of Economic Research. And what they point out is that in these crises. Disaster situations. That there is not just one disaster. Multiple disasters. It's a process. And the monetary largesse went on for a long time before the Federal Reserve moved to contain it. And so what the Federal Reserve is facing is they're facing the consequences of the policy failure during the pandemic on 2 fronts. Inflation is out of control, coming down, but it's running 5%. More than double its target. And it appears that we've also trapped a variety of bad actors who took the liquidity too far and too unwisely. This is a process that has occurred before and they proved to be difficult and they appeared to be intractable and they are long-running. But it's sad that we have not learned from our prior experiences. We didn't learn from Minsky. We didn't learn from his contemporary Charles Kindleberger, who in my opinion was actually the greater thinker than Minsky. Kindleberger wrote a great book on manias, panics, and crashes. And so here we are. The Federal Reserve is trying to clean up its own mess, they don't have the tools to do so, especially when they have multiple problems. As we do today.

[Zach, 9:05]:

Doctor Hunt, this is Zach. And I think that's a good kind of segue here into - you were recently featured in an article on Morningstar. You mentioned that bond investors were kind of like pedestrians looking the wrong way down a one-way street. And I just wonder if you could opine a bit more on that, what you think are the biggest risks in the bond market. A lot of our listeners are bankers or fixed-income investors, things like that. And what you see the biggest risks are, where you see rates going, given all the things you just talked about with Minsky and Kindelberger et cetera.

[Doctor Lacy Hunt, 9:36]: 

Well, it's a great question. I'm a little bit humbled right now because I didn't quit myself very well in this time period. In retrospect, I overweighted the effect of the pandemic. I have one thing to do over. I would have ignored the pandemic impact, which was really for a very limited period of time. The key focus should be on the monetary and fiscal policy. I believe that the Fed will ultimately win the battle of inflation because they have to. We cannot leave 180 million of us with a 3% decline in the standard of living for three years. And it's just too painful. As to it, it exacerbates the income and wealth divide. And so I think the Fed will win the battle of inflation. But you know, they certainly made a big step in that direction, but the Fed has not always kept its focus. Last year, when they were raising rates through their so-called forward guidance or market guidance, they seemed to block back to overtightening. So, in the spring and again in the fall, monetary conditions eased. And the Federal Reserve wasted precious months to get the inflation under control. And so, it's not been a steady fight. Much has been accomplished. I did a calculation that if we took into account the money mountain that was created in 2020 and 2021, it would take us until the end of the second quarter of this year for the Fed to neutralize it. So here we are with a little bit more than three months to go, and I continue to do that calculation, and the Fed has more. So, if they don't stick with the task, there will be people that will be pleased that the Fed has given a reprieve, such as it did in June and October. But it will not relieve the pressure on those that are being hurt by high inflation. And it will probably allow those that have engaged in bad practices to become further mired in the problem. So, the Fed faces a very, very difficult problem. Having said all of that, the economy is weakening. I think we're going into a recession in the second half of the year. And I think that the Fed will ultimately win the battle against inflation because they have to. According to my calculation, if they do neutralize the money mountain by the end of June, given the lags involved and the fact that consumer inflation is very sticky, there are important factors in the way in which it's calculated. I don't see the Fed hitting its target this year, but I do see the sequential inflation rate going from the third to the fourth quarter being 3%. And then next year, I think we can get back to the Fed's target. But there's a lot of wood to chop to be able to achieve that, and it's by no means guaranteed.

[Vinny, 13:09]:

Hey, Doctor Hunt, this is Vinny Clevenger. Thank you so much for joining us. I'm a big fan of your quarterly review and outlook. It's sort of appointment reading for me to learn so much. One of the overarching themes throughout a lot of those outlooks is the largesse of public debt versus GDP. I guess I'm thinking more in the longer term for the bond market here. Clearly, if you go back to the Reinhardt-Rogoff studies, as soon as you get GDP over 90% for five consecutive years, it clearly inhibits growth. So often times, you turn on the TV these days and you hear this narrative that we're in a new paradigm and rates are going to be higher for longer and so forth. Explain how the debt overhang, which I think the GDP is lurking around 120, it's actually somewhat down a little bit, but we've been well over 100 for five years here. So explain how that influences the longer-term term structure of interest rates.

[Doctor Lacy Hunt, 14:06]:

I'll be glad to. It's a great question. The Reinhardt, Reinhardt, and Grove Golf Paper was published by one of the American Economic Association Publications, peer-reviewed. They looked at the large number of countries that pushed the gross government debt to more than 90% for five years. They excluded war years and periods of less than five years because they wanted to avoid transitory, cyclical, or military-type situations. And they found that when you go above 90% for five consecutive years that the economy begins to lose 1/3 of its growth rate against trend. So here are the facts, and in fact, the Reinhardt piece, Reinhart, Reinhart, and Rogoff piece is actually confirmed. We hit the 90% threshold five years in 2013. The historic rate of growth in the economy from 1870 to the present is 2.3%. And since 2013, when we've moved over the threshold of our R&R, we've only grown by 1.4%. So, 2.2, 2.3 versus 1.4, that means we've lost approximately 1/3 of our growth rate. And so, when the when the Fed ultimately contains the inflation, I fear that we will be facing many of the same problems that we had prior to the pandemic. We'll be in a debt overhang and a debt trap. The reason that debt is a problem it hearkens back to the production function and many people say that the people rile against debt, psychological reasons, and not sound economics. But that's not the case that I'm going to give you here. The production function is universal. It says that our economic growth rating per capita terms is determined by technology interacting with land, labor, and capital the three factors of production. It holds at the individual level, holds at the state level, holds at the macro level, holds at the global level. So, you could take sacks’ production function and take my production function, aggregate them together. We could take the state of Texas and New Jersey, aggregate them together. And one of the things that comes out of the production function is if you overuse a factor of production such as debt capital, initially you will increase economic capital. It's called increasing returns. If you continue to use debt capital, you get constant returns. In other words, the increase in debt capital doesn't boost growth or it doesn't attract a flat period. But if you insist on still increasing debt capital further, then you get declining GDP, you get decreasing returns to scale. Bedrock concept in economics it's a parabola. It's a beneficial period for debt for the period when it's neutral and then there's a period when it is negative and that's what we're going to hit now that that was moved aside because we jammed in $10 trillion of stimulus in two years. But we are going to return to that. And I think that it will be a difficult problem, not only for the United States, but for the rest of the world, because we're all extremely over indebted now they're circumstances that could make the law of diminishing returns a little bit better or a little bit worse. And that has to do when you get interest rate fluctuations. This year we have $10 trillion of debt that will mature and will have to be rolled over. A lot of that's in the federal government. And so, what's going to happen, the interest rates now are higher than when the debt was put on in 2020 and 2021. And there's going to be a dramatic surge in interest expense. Well, interest expense, as, as Hyman Minsky pointed out, echoed by Charles Kindleberger and Irving Fisher, interest expense is the least productive type of outlay, doesn't hire a person, doesn't build a plant, doesn't invest in technology. So, when you have an increase in interest expense. You actually get an accelerated decline in diminishing returns. Look at what's happening at the federal level. Last year we had a deficit of a trillion dollars. Official numbers. It will be a trillion 4, but I think the number reasonable number is really a trillion 5. The realist look at what happens the total debt because they have a lot of stuff off balance sheet. They hide it. Total federal debt this year will increase 1.6 to $1.8 trillion. And about half of that will be interest expense. It's not going to do 1 twit except keep the interest holders satisfied and the obligations met. And this is important because it is the marginal revenue product of debt that determines the velocity of money, which is an important calculation. Last year, velocity rose and confounded the Fed's ability, but I think as we get into 2024, the velocity of money is going to decline. And part of that will be a return to dimension returns, but also the consequences of having to pay a lot more for interest expense. And so, the economy has more than just the immediate problem of this horrendous cost of living crisis and the credit mistakes that were made during the monetary largesse. But we have the debt overhang that will return. And another element that I think is important to add. When the pandemic hit, for a long time, the United States had been the spender of last resort. The rest of the world was depending upon the United States to buy their goods. Because our economy, although it was doing considerably less than we've historically done, we were still on a relative basis doing better than Europe and Japan and China. And this over dependence of the rest of the world on the United States is also going to return, but it continued during the last two years, but it will return with a vengeance. And so, the rest of the world is going to be draining growth from the United States. So, it is not just the inflation and the excessive and poor use of credit that we have to deal with, but we also are going to be faced to deal with this massive debt overhang. That is now far worse, not only in the United States, but worldwide.

 [Frank Farone, 21:24]:

Doctor Hunt, this is Frank Farone again. Given your outlook for the second-half of 2023 in a recession, clearly we are in the middle of an inverted yield curve environment. Which typically is a precursor of that same recession that your outlook is for? What is your outlook for the banking industry as a whole, both from an earnings perspective and a credit-related perspective as the valuation of these leverage assets continues to decrease below market values?

[Doctor Lacy Hunt, 21:57]:

Well, you know, this is the 54th year of my career, started in 1969. I spent 26 years in banking, worked for three big banks. [Inaudible] Bank in Philadelphia, I worked for Chase Manhattan in the early part of my career, when it was run by the venerable David Rockefeller, and I spent nearly 15 years in the HSBC organization when HSBC was run by Sir William Purvis, knighted by Queen Elizabeth. And so, I studied banking, I wrote about that. I would have great difficulty trying to make money today because according to the numbers that I see, the delinquency rates on all four categories of bank loans are rising for 30 days or more and 90 days. Now this reflects 2 things. It reflects the fact that we've clobbered 180 million of us. It also reflects the fact that along with the increases in the federal funds rate, the credit card and mortgage rates have risen.

According to a series that I look at, may not be the most accurate, said that the average credit card loan in January was 20 1/2 percent. Think about that you bought $10,000. You pay 20 1/2%. After five years, you paid more in interest than you originally borrowed. It's a very steep rate. Another thing that's been so tough for a lot of families, households, is that inflation has been centered in food, fuel, and shelter. Now, economists, we call these pricing elastic goods. We're price takers. If you need shelter and you don't want to buy a home, then you rent an apartment. But when you drive up the price of homes, you then drive up the price of apartments. You drive up the cost of food. You can sort of shift to lower-priced items, buy more macaroni and less protein. Gasoline energy costs, they're no good substitutes. So, our modest and moderate-income households have a much higher percentage of their budget in these necessities? These price inelastic goods. So, these families have gone to very heavy credit card use. And those loans are now going sour. And one of the things that I follow, and I think it's very useful and anyone in banking should look should study it very carefully, is the senior bank Lending Officer survey. Which is conducted by the Federal Reserve, it's done every quarter. The new survey will be coming out here in early April. And the senior loan officers are saying that credit demand is falling across the board actually in the last several weeks, bank credit is actually contracted. And the reason it's contracted is because other deposit liabilities, which is the main source of bank funding, has dropped by over a trillion dollars. The Fed has put a vacuum cleaner on this vast money mountain of 2020 and 2021, and it's coming from the money mountain going into the vacuum cleaner and from the vacuum cleaner, it's going into the incinerator. And so, the banks are losing their funding capability at a time when loan loss reserves are rising, and they're being forced to cut back on credit. And that is a process that debilitates the economy and creates a lot of problems for a lot of others, and especially for those that they're borrowing practices were quite risky because they need the low rates for the projects to survive. And so, in this type of environment, there are multiple problems, and the banking industry is difficult. The yield curve is another problem. To me, the yield curve is a cause and a symptom. It's a symptom that the monetary deceleration, which is now unprecedented, is biting, and so you have a situation where your short-term rates are on top of the long-term rates. But a lot of financial institutions, small, medium-sized banks, all of them, to some degree, more or less, borrow  short and live long. So, when you're losing deposits, credit losses are rising and the yield curve is inverted, it impairs banking profitability. It's a very difficult environment at the present time. I don't think it will go away quickly. I wish I had better news, but. This is from a veteran of 26 years in banking and someone who studied banking long before he became a professional.

[Zach, 26:51]:

Well, it's not the most, you know, sanguine type of outlook. It's real, right? It's a realistic outlook and I think we're seeing that too in our travels and with our clients big, small and in the middle and honestly, we thank you so much, Doctor Hunt for your time today. We know you got a busy schedule and did you have anything else you wanted to add here today with us? Otherwise, we're just super appreciative that you were able to spend, you know, the last 20-25 minutes with us.

[Doctor Lacy Hunt, 27:14]:

No, I want to thank you for your excellent questions. Great questions. And it's nice to be with you all. We're doing some other things with you as well going forward. So, the best to each of you.

[Vinny, 27:29]:

You as well. Take care.

[Doctor Lacy Hunt, 27:30]:

My pleasure. I hope you all have a great day.

[Vinny, 27:38]:

Well, on behalf of Zach and I, we would really like to once again thank Doctor Lacy Hunt for his time this morning. We feel extraordinarily fortunate that he would share his insight and perspectives with our listeners here. So that's a wrap for this special episode. We will return to our regularly scheduled broadcasting, if you will, in the very near future. Thanks so much for listening to On the Balance Sheet.

[Outro, 28:06]: 

On the Balance Sheet is a podcast produced by Darling Consulting Group, DCG. All views and opinions expressed by hosts and guests are solely their own and may not represent those of DCG. All third parties are independent entities and are not affiliated with DCG. This podcast is intended for informational and educational purposes only and is not considered as advice. All views and opinions expressed are based on the information available at the time, it may have changed on current market and other conditions. For more information about DCG; please visit www.darlingconsulting.com or email us at info@darlingconsulting.com. Today’s background music is provided by John Sib at Coma-Media and can be found on pixabay.com.       

The text of this transcript was generated by an artificial intelligence (AI) model, and its organization, grammar, and presentation enhanced by AI, and as such may contain errors or inaccuracies. DCG is not liable for any damages, however caused, that may result from any use of this content.