“The nuclear arms race is like two sworn enemies standing waist deep in gasoline, one with three matches, the other with five.”
-Carl Sagan
If you have some unscheduled time this weekend and are interested in what is perhaps the ultimate book on risk management, I recommend reading Command and Control by Eric Schlosser. It is really three books in one. It chronicles the history of nuclear weapons development and management in the United States from both a policy and scientific/technical perspective, which is fascinating. But what is perhaps most interesting about the book is its vivid account of the events leading up to the Damascus Accident – one of the closest calls we have ever had as a country to accidentally detonating a nuclear warhead on US soil – and how it lays bare much of the illusion of safety.
Regarding the Damascus Accident, the year was 1980 and the location was just a few miles north of Damascus, Arkansas. There sat the 374th strategic missile squadron, home of 9 Titan II intercontinental ballistic missiles – the largest ICBMs ever built by the United States. The missiles there were armed with W-53 thermonuclear warheads – 9-megaton nuclear bombs, each with the explosive power equivalent to three times all the bombs dropped during World War II combined, including both atomic bombs.
On the evening of September 18th, 1980, two missile repairmen were sent to check on a low-oxidizer condition in the upper stage of one of the missiles – a not unusual condition. During the routine maintenance procedure, which required a large socket wrench to unscrew a pressure cap roughly two-thirds of the way up the 103-foot-tall missile, a seemingly trivial accident occurred. The socket fell from the wrench. The socket weighed nine pounds and fell seventy feet before hitting the thrust mount, ricocheting off it, and then colliding with the side of the missile and tearing a small hole in the missile’s aluminum skin. Moments later, fuel began to spray from the side of the missile.
Approximately 9 hours later, at around 3:00am, a cascading sequence of risk management failures ultimately culminated in the total explosion of the missile. The concrete launch duct closure door (the missile silo door), designed to protect the ICBM from first strike nuclear attack, weighed 740 tons. So powerful was the explosion, it sent that missile silo door 200 feet in the air and 600 feet away from the missile silo. Meanwhile, the W-53 warhead landed about 100 feet from the launch complex’s entry gate. The debris was scattered across 400 acres surrounding the launch complex. The only good news was that the W-53’s safety features operated correctly and prevented both the detonation of the bomb and any leak of radioactive materials – a remarkable accomplishment given the magnitude of the explosion.
Amazingly, there have been numerous episodes over the last 60 years in which we have come exceedingly close to disaster.
In 1961, a Boeing B-52 Stratofortress carrying two 3-4 megaton Mark 39 nuclear bombs broke apart in mid-air while refueling over Goldsboro, North Carolina, dropping its nuclear payload in the process. Declassified information in 2013 revealed that one of those two bombs came extremely close to detonating. Of the six required arming devices on the bomb preventing detonation, five had armed. Close really does count in horseshoes, hand grenades and thermonuclear warheads.
What I took away from Command and Control was threefold. First, we have been incredibly lucky these last 60 years. Not just because of our own mishaps, but because if we, the United States – with all our careful precautions – have come this close on multiple occasions to self-annihilation, surely other nuclear powers have come equally close or closer still. To that end, the HBO series Chernobyl helped cement my suspicions. Second, that despite incredibly careful planning, complex systems like the broader Command and Control apparatus can have mechanical or human error failure points that were simply not imagined until too late. Third, that the last 60 years have been marked by unprecedented human progress on fronts too numerous to list. In other words, despite these many close calls, progress has marched on. Nevertheless, the existential risk of destruction continues to loom in the background just as Carl Sagan described.
Dr. Strangelove or: How I learned to Stop Worrying and Love the Bomb comes to mind.
So it can be with markets and central planning. The last thirteen years have been remarkable by historical standards. Consider the following.
How much debt did the US Federal Government carry at the end of 2007? $9.2 Trillion dollars. How much debt did the US Federal Government carry at the end of the first quarter of 2021? $28.1 Trillion dollars. That’s an increase of 205% in just over 13 years (+$19 Trillion).
Meanwhile, what was the size of the Federal Reserve’s balance sheet at the end of 2007? $922 Billion dollars. And what was the size of the Fed’s balance sheet as of 6/23/21? $8.1 Trillion dollars. That’s an increase of 778% in ~13 years (+$7.2 Trillion). To be fair, not all of that increase has been in Treasuries. The holdings include around $2.2 Trillion in Agency MBS.
Final question. What was US GDP at the end of 2007? $14.7 Trillion dollars. And how much was it in Q1 2021? $22.1 Trillion (annualized). That’s an increase of 50% in just over 13 years (+$7.4 Trillion).
So, US Debt has grown by $19 Trillion, $7 Trillion of which (~40%) sits on the Fed’s balance sheet, while Annual US GDP has risen by $7.4 Trillion.
US Debt to GDP stood at 62% at the end of 2007. At the end of Q1 2021, it stood at 127%. That is a remarkable increase in 13 years. To put those numbers in context, US Debt to GDP was perched between 30-40% from 1965 through 1985, then rose from 40% to 60% in the seven years from 1985 to 1992 but remained +/- 60% of GDP from 1992 through 2007. We truly have been on a different fiscal and monetary path these last 13 years than at any point in the preceding 45 years.
When viewed in the context of the longer term, the recent rise is still remarkable. Debt to GDP rose from effectively zero to 30% in 1865 on the back of the Civil War, but then steadily fell back to less than 5% by 1900. Debt to GDP reached 110% in the 1940s on the back of World War II, but then steadily fell back to less than 30% by 1970. This time around, the increase has been unrelated to major conflict. The non-partisan CBO projects that US Debt to GDP will reach 202% over the next 30 years by 2051. This assumes deficits of 8% per annum from 2032-2041 and 11.5% per annum from 2042-2051, based solely on currently enacted laws.
For further perspective, at 127% Debt to GDP the U.S. is tied for the 7th most heavily indebted country on Earth (on a Debt to GDP basis) – tied with Eritrea. Ahead of the US stand these 6 countries: Japan (237%), Venezuela (214%), Sudan (177%), Greece (174%), Lebanon (157%) and Italy (133%).
Now consider that in mid-2007, US 10-year Treasury yields were 5% and were 4.2% by year-end 2007. Today, they yield around 1.5%. It does seem remarkable that our Debt to GDP has more than doubled in the last 13 years, yet our cost to borrow (on 10-year paper) has fallen by around two-thirds. That likely has more to do with the rest of the developed world offering zero to negative yields, i.e. JGB 10-year yields stand at 5 basis points, and less to do with the risk profile of the US improving.
Final Final Question. Where was the S&P 500 at the end of 2007? 1,468. And today? 4,319. That is a gain of 194% over 13 years, or a CAGR of 9%. That is equally remarkable. The market simply does not care about the future state risk profile sufficiently far ahead. As we say often around here, risk happens slowly, then all at once. In fact, not only does it not care about sufficiently down the line, i.e. long-term risks, it barely seems to recognize short-term, in-your-face risks.
The S&P 500 didn’t waver last January when a novel, highly transmissible, lethal respiratory virus was shutting down the world’s third largest economy; then, all at once it cared beginning in mid-February. Similarly, the S&P 500 reached a then all-time high in October 2007 even though the US Housing market was clearly careening downward with transaction volumes having peaked more than 2 years earlier and home price appreciation rates having peaked more than 15 months earlier in mid-2006. But by the Summer/Fall of 2008 markets were paying attention.
That is why it is important to be aware of the risks, to be proactively prepared for the risks, including the existential long-term risks, but not to get overly hung up on them in the short to intermediate term. Case in point, many were betting on a housing collapse as early as 2005.
Sometimes the right move is to stick with the trade for the final portion of the move, even when it seems like the inflection will soon be upon you. That is the call we have been making to stick with Quad 2 until the signal(s) say otherwise. The S&P 500 has been rewarding that call with new all-time highs throughout most of June. Remember that markets can be like trains, with considerable inertia.
The roadmap is helpful. It tells a tale of what’s probable across a certain duration. The long-term path of US Debt to GDP, for instance, appears to be on a one-way track to Thunderdome, but there are so many twists and turns along that path that it would be foolish to not clip the myriad opportunities along the way. Sometimes the best thing to do is the hardest thing to do as it seems to make the least sense when viewed from sufficiently far away.
Immediate-term Risk Range™ Signal with @Hedgeye TREND signal in brackets:
UST 10yr Yield 1.43-1.58% (bullish)
UST 2yr Yield 0.22-0.29% (bullish)
SPX 4 (bullish)
RUT 2 (bullish)
NASDAQ 14,129-14,667 (bullish)
Tech (XLK) 142.60-149.37 (bullish)
Energy (XLE) 52.12-56.20 (bullish)
Financials (XLF) 35.60-37.61 (bullish)
Utilities (XLU) 62.68-64.71 (bearish)
Shanghai Comp 3 (bearish)
Nikkei 28,106-29,395 (bullish)
DAX 15,450-15,811 (bullish)
VIX 14.08-18.56 (bearish)
USD 90.12-92.73 (bearish)
Oil (WTI) 71.91-75.14 (bullish)
Nat Gas 3.31-3.79 (bullish)
Gold 1 (bearish)
Copper 4.13-4.45 (bullish)
Silver 25.43-26.78 (neutral)
Enjoy your Independence Day,
Josh Steiner
Managing Director
