The Stock Market Cash Flow
Page 8
Sovereign Fundamental Analysis and Fiscal Policy
There are two types of policy that affect sovereign fundamentals: fiscal and monetary. In the case of United States, you’re going to find that many of the problems we see with the numbers on the financial statements are due to foolish fiscal policy.
Fiscal policy refers to how a government chooses to spend its money. The ugly numbers we will uncover have little to do with bad luck or unforeseeable events. We’re also going to view this policy in light of some demographics to determine what the future will bring.
Fiscal Policy
In the United States, fiscal policy is set by Congress. The words politics and policy refer to the decisions made by those who are in positions of power. The United States Congress has many powers. But when it comes to fiscal policy, it has two fundamental and obvious powers that have and will have an impact on the nation’s financial statement:
1.Congress can raise or lower taxes.
2.Congress can increase or decrease spending.
This means that much of how the financial statement of the United States looks is determined by Congress and its fiscal policy. Congress will determine income by tax policy. It will determine expenses by the budget. Taxes and spending can create a surplus or a deficit. If there is a deficit, Congress may be required to borrow to cover the shortfall, forcing it to increase debt.
Let’s break all that down piece by piece. Republicans and Democrats, influenced by their respective special interest groups, create legislation and submit a budget for the country. The Tax Code is a list of the laws that require people and corporations to pay taxes. The United States Internal Revenue Code contains thousands of pages of tax policy. As we begin to assemble a financial statement for the U.S. government, we can begin by putting taxes in the income column so that it looks like this:
The U.S. government’s spending activities are very complex. Income generated through taxes is spent on a variety of things including military, public roads and infrastructure, education, entitlement programs, debt payments, and more. All of this spending gets added up and put in the expense column like this:
Next, we’re ready to talk about gross domestic product (GDP)—perhaps the largest asset of the United States. The explanation I want to give you is a little different from standard accounting practices and approaches it from the Rich Dad perspective we mentioned earlier: assets put money in our pockets. The opposite of this, of course, reminds us that liabilities take money out of our pockets. Remember, this is not an accounting lesson. Instead, this discussion is designed to help you understand what’s happening from a fundamental viewpoint.
Let’s start by understanding what gross domestic product actually means. It’s an important financial term for your investing vocabulary. GDP is used to describe the amount of goods and services a country produces during a given year. All of these goods and services are totaled together and given a dollar value, which we call GDP.
Since the U.S. GDP is the value of all the productivity of the United States, let’s put it into our financial statement in the asset column. This is accurate in the sense that the nation is only as strong as its people and corporations, and the value they produce.
As the people and the corporations of the country earn money, shown as GDP, the government takes a portion of that money as taxes. This makes GDP a vital part of our sovereign fundamental analysis. It’s the engine that produces money that the government can tax.
All of taxes and spending are dependent on the size of the GDP. Let’s visualize the GDP as a big pizza. Congress gets to take a slice out of that pizza in the form of taxes. As long as that pizza stays large, then the government is satisfied with that slice. But what happens if one day the pizza shrinks? Suddenly, the government’s slice isn’t as large as it was before. And if the government has to continue taking a smaller slice of a smaller pizza for several years in a row, then it gets really hungry. That period of time—the years when the pizza is smaller—is known as a recession.
When GDP shrinks, and the size of the government’s slice shrinks, Congress faces a real problem: It doesn’t collect as much as it expected in taxes. When the citizens and the corporations are producing less, they usually earn less. With less money being earned, the total amount of taxes collected drops. As a result, the income of the nation gets smaller. This is what we see in a recession.
You may be wondering why this is a problem for Congress. It can just hurry and cut spending to match the lower tax income, right? Well, it’s not that easy. Governments are known for making future promises to their citizens. Once they make these promises, it’s not easy to get out of them.
Let’s look at some of the promises made by the United States and how difficult it is to modify them quickly when tax income is drastically reduced.
When the government commits to a war, it’s a very expensive action. Moreover, there is seldom a clear end date for a war. You can’t just stop fighting one day when the money runs out. And when the government promises citizens that it will pay for their Social Security and Medicare benefits, they need to fulfill those promises. And at any given moment, the country has road construction underway and other infrastructure improvements that need to be finished. There are countless government offices that need to stay open to serve its citizens. And the U.S. government has taken on a lot of debt, and it needs to pay that back as well—or at least keep making payments on that debt.
Just because the breadwinner of a household loses his or her income-producing job, the expenses of life don’t stop piling up. The family still needs to eat, have clothing, and have a roof over their heads. It’s the same for a country.
However, in a situation where income is suddenly lower than expected, individuals usually behave very differently compared to a government. When the government’s tax income is reduced, it has the power to change policy and take a bigger percentage of our money than it did before. Congress might feel pressure to raise taxes in order to make up for the decline in tax income. Of course, it can also make decisions to cut its spending. But with so many people contributing to those decisions, and so many points of view, the fight over what cuts to make can get ugly in a hurry.
This is a good time for us to look at the government’s cash flow for some additional insights. Remember, cash flow is calculated by subtracting expenses from income. For the government, it looks like this:
Cash Flow = (Taxes Collected) – (Government Program Expenses)
If the tax income is greater than the amount of government spending, we call it a positive cash flow or a surplus. However, if the government spending is greater than the tax income, we call it a negative cash flow or a deficit.
You probably already know the difference between a surplus and deficit. The reason I have decided to address this simple and basic topic is that I’m continually shocked by the number of people I teach around the world who do not know the difference between debt and deficit. A debt is simply a promise to pay. A deficit is a shortfall. It’s a massive difference, and one you need to understand sooner rather than later.
Suppose your dog becomes sick and you take it to the veterinarian. That is an unexpected expense, and it might cause you to have a shortfall that month. If you have enough money in your bank account to cover the bill, you can simply cover the shortfall (deficit) that month by writing a check. However, if you don’t have extra money in your bank account, you might have to put that expense on your credit card. This means you promise to pay back the bank later (debt) for that visit to the vet now.
If the government has a lot of money in the Treasury, it doesn’t really worry about a little deficit spending. It will just use money in the Treasury to pay for those unexpected expenses or unexpected shortfalls in tax income. And if there isn’t a deficit, there will be a surplus of tax income to help grow the government’s treasury account.
But the United States doesn’t have a surplus. They have a very substantial deficit. What’s worse, there isn�
�t any money in the Treasury for the government to borrow from. This serious deficit situation has forced the government to take on massive amounts of debt to pay the bills.
How big of a number are we talking about? In 2012, the United States deficit was over $1 trillion.
One of the reasons cash flow is so important when conducting a fundamental analysis is that it can tell us, as investors, if an entity is cashflow positive. Or what I see as being financially solvent. As we look at the situation of the United States, we can see that it is cash-flow negative, or what I see as financially insolvent. Rich dad would see this as a sign of financial cancer. It is the one number that instantly tells you there might be trouble. This type of simple fundamental analysis helps us gain insight into the financial strength or weakness of an entity. It is possible that a deficit might just be a short-term bump in the road. Most of the time, however, a deficit spells trouble.
The income statement of the United States shows a policy of deficit spending. Congress has actively chosen to continue spending more and more money that it does not have, which means it is forced to take on an ever-growing mountain of debt to pay for this spending. Even a beginning investor can easily see the relationship between the U.S income statement and its fiscal policies.
Seeing into the Future Through Policy and Demographics
Ugly numbers are littered across the financial statement of the United States government. As of this writing, the deficit is now pushing again to more than $1 trillion and there is an on-balance-sheet debt of close to $17 trillion. However, that is only the beginning of the problem. The ugliest number that the United States is facing is not on the balance sheet at all. But it will have a massive impact on it in the next few years. It is the impact that demographics will have on current U.S. fiscal policy.
In March of 2011, Investment Outlook published an article by William H. Gross of PIMCO titled “Skunked.” In his report, he cites that Medicare, Medicaid, and Social Security account for 44 percent of federal spending, and this percentage is rising steadily.
After World War II, the United States experienced a population explosion known as the baby boom. Most of these baby boomers are not yet eligible to collect Social Security, Medicare, and Medicaid. But in the coming years they will be, and the policy of the U.S. government is to give these baby boomers what they have been promised. Because these promises are financial commitments that don’t yet show up as debt, they are off-balance-sheet promises.
Here is an example to help you see how off-balance-sheet promises work. When you borrow money from the bank to purchase a car, this debt is a promise to pay and shows up on your balance sheet. You might also have a policy in your household of paying for your children’s college education. This policy, however, requires no transaction to be recorded on your balance sheet today. It is an off-balance-sheet promise. It is a promise to pay that is every bit as powerful as the promise you made to the bank to pay off the car loan. A promise is a promise. The bank is entitled to the money that you’ve promised to pay. Your children are also entitled to the money you promised them. Whether or not it’s a good idea to promise your children to pay for things in the future is not relevant. If you begin to look at your future and factor in the rising cost of education, you could be paying a lot of money. But a promise is a promise, and when they reach college age they will expect to collect on that promise—no matter the cost to you. So while your car loan would show up on your balance sheet as a $50,000 liability, the promise to your kids (which the credit agencies would never see) could total over a million dollars. If you have no money available when your kids come to collect on your promise, you will have to borrow it. In some ways you are now running a Ponzi scheme because you are now making new promises you can’t keep in an effort to meet old promises. The off-balance-sheet debt will eventually migrate onto the balance sheet. This is what’s happening to sovereign balance sheets all over the world today.
Some people think they could get rich as an investor if they only had a crystal ball to tell them the future. The truth is you don’t need a crystal ball. Policy plus demographics equals the future. Fundamental analysis today can help you forecast for tomorrow.
The baby boomers in the United States are entitled to having the promises of Social Security, Medicare, and Medicaid fulfilled. If the U.S. government tried to change this policy, the boomers would not be happy.
So let’s do a little analysis: If 44 percent of the current federal spending already goes directly to Medicare, Medicaid, and Social Security, what do we imagine will happen when the huge numbers of baby boomers hit retirement age? There are over $100 trillion of entitlement liabilities that will be need to be paid to the baby boomers.
Without thinking (or caring) how their policies might impact the nation’s financial statement in the future, politicians promised a lot of people retirement money and coverage for much of their healthcare costs—no matter how expensive it becomes.
Reminder: Fundamental analysis tells you the strength of an entity.
So far we have learned that a basic financial statement gives us the following six numbers.
1.Income
2.Expenses
3.Cash Flow
4.Assets
5.Liabilities
6.Equity (net worth)
For many people it is sometimes easier to draw these numbers as a picture, a common practice at Rich Dad workshops.
As you get better and better at fundamental analysis you will be able to see relationships between the numbers and get better at judging the strength of entities.
For example, let’s look at the relationship of two numbers in our U.S. financial statement: DEBT and GDP as of January 2013:
GDP is vital to any country because it is the economic engine that creates cash. The more goods and services a country produces, the more cash the country creates and the more taxes the country can collect. So a country’s ability to pay off debt is dependent on its GDP. This can be a very powerful gauge of a country’s strength or weakness.
Let’s imagine that you are an economist at the prestigious Standard & Poor’s financial markets intelligence company. The S&P uses fundamental analysis to determine the financial strength of companies and countries to help investors determine how risky it would be to loan them money. After all, if a country can’t pay me back, I might think twice about loaning it my money by purchasing its bonds.
If your job at Standard & Poor’s were to give the United States a credit rating, how would you go about it?
You could start by looking at the relationship between its debt and its GDP because it helps you answer the question of whether or not the country has a strong enough GDP to enable it to collect the taxes it needs to pay its debts.
To help tell the story of these two numbers we can view this as a ratio.
In other words, as of this writing, the debt that is on that balance sheet of the United States is over 100 percent as large as its GDP. Remember that policy is the reason a financial statement looks the way it does. These numbers don’t happen by accident.
Putting the Debt/GDP Ratio into Perspective
When the European Union (EU) introduced the Euro, it set a standard of financial strength for each member country. Because debt/GDP reveals so much about a country’s financial strength, it set the criteria of a debt/GDP of no more than 60 percent.
Today, many of the countries in the European Union have pushed well above that bar and investors that are proficient in fundamental analysis see the European debt situation as a serious crisis.
Here are some of the numbers...keeping in mind that these number will change over time:
Italy DEBT/GDP = 120 percent
Greece DEBT/GDP = 165 percent
Portugal DEBT/GDP = 107 percent
Ireland DEBT/GDP = 108 percent
EU AVERAGE DEBT/GDP = 82 percent
In fact, you will find that many of the numbers you’ll see when doing a sovereign fundamental analysis will be in relation
to the GDP. Any discussion of sovereign fundamental analysis would be incomplete without introducing relationships to GDP.
So you don’t get the whole story if you look at a country’s expenses alone. You need to look at them relative to GDP. It’s also incomplete to just examine a country’s deficit; we must look at it relative to the GDP. It’s incomplete to just examine a country’s taxes; must we look at them compared to the GDP.
Keep the Big Picture in Mind
The overriding point of this chapter is not to cover every detail of sovereign fundamental analysis. It’s easy to get caught up in the details. Many teachers, myself included, have a tendency to focus in tighter—getting smaller and smaller—as they teach. Whenever I do this with Robert he scolds me and says, “Andy, you’re getting small on me.” It’s a welcome rebuke because I have learned that as a student we cannot learn the small picture (content) until we learn the big picture (context). Water has little value without the pitcher, and the pitcher is of no use to us without the water. You need to start out with an empty pitcher and make sure it’s large enough to hold the water we plan to fill it with. If you have no pitcher at all—or your pitcher isn’t large enough—the waters spills to the floor and is lost. So be aware that at this point in your education, I’m only introducing you to things like debt/GDP ratio to help you appreciate the power of the larger lesson:
Fundamental analysis really does help us discover the strength of an entity.
Monetary Policy Is Part of Sovereign Fundamental Analysis