by Franklin J. Parker, CFA
The Summary
- The FOMC meeting last week reaffirmed the commitment of the Federal Reserve to keep short-term interest rates low and asset purchases going, which is exactly what was expected. In addition, Powell advised markets that any inflation spikes are expected to be short-lived (largely due to the “bullwhip effect“).
- Yields continue their march higher, and investors betting on the Fed to intervene and curtail the increase in 10-year US Treasury yields were sorely disappointed last week. Higher borrowing costs are generally seen to hurt businesses reliant on cheap capital (like tech), and the rotation out of growth toward value is in full swing.
- Powell testifies before congress on Tuesday and Wednesday of this week, and critics of current Fed policy on both sides of the aisle are becoming more vocal. He is likely to face tough questions about inflation, asset bubbles, and prudence. On Friday we get a read on the health of US consumers with personal spending, income, and consumer sentiment posting.
The Details
A new consensus is emerging in economics.
In short, the consensus centers around the real constraints facing government borrowing. Traditionally it was inferred that governments must be responsible with their borrowing lest they go bankrupt. Under this new paradigm, however, bankruptcy is not considered a danger because governments can simply print more of their own currency to repay debts. In contrast to the traditional view, spending constraints come from economic dislocations like excessive inflation, asset bubbles, unemployment, and productive capacity, rather than from the difference between tax revenue and spending.
This shift in paradigm can be fairly readily seen in a breakdown of US debt ownership. As of July 2020, the largest holder of US Treasury bonds were US government related entities. The Federal Reserve owned about 36% of US debt, whereas social security, Medicare, and various government-related pensions owned around 28%. That puts the US government as the largest single holder of US government debt: 64% of debt outstanding is owed to entities tied to the US government. To place this in perspective, China—the largest foreign holder of US Treasuries—owns only about 4% of US debt.
This new economic consensus tends to give governments a much longer spending leash. Deficits are not viewed as a net negative always; rather, deficit spending is context-dependent. That is to say there are times when deficit spending is bad and times when it is good. More traditional guidelines are also abandoned: the Phillips curve (the link between inflation and unemployment) has been largely discarded, and the Taylor Rule (which has traditionally guided interest rate policy) have both left the policy conversation, to name just two.
Without the more traditional hard-and-fast rules, we must rely on the insight and wisdom of policymakers to manage the various economic variables properly. This creates risk, of course. An economy that is heavily reliant on policymakers is fragile with respect to bad policy. There is a legitimate risk that policymakers get it wrong eventually, and the subsequent economic dislocations do real harm to people.
As citizens, we all have opinions on whether such a shift in the economic paradigm is, long-term, good or bad. However, as investors, we cannot play the game we want, we must play the game that is actually on the field. Whether good or bad, this is the current economic consensus, and it has several outcomes, such as:
- central banks are a key variable in market returns;
- plentiful liquidity can override economic fundamentals (i.e. poorly-run companies can continue to succeed for quite some time);
- inflation is likely divergent—consumer goods (where automation can lower prices) tend toward deflation while commodities (where production is constrained by location) tend toward inflation;
- asset prices will tend to increase while wages will tend to stagnate.
To be fair, our current economic regime has no precedent, so it can be difficult to make confident predictions. In this environment, mental flexibility is likely to be an investor’s most valuable trait. As is usually the case, wisdom, prudence, and tradecraft stand to add considerable value to investors with goals to achieve.
Chart of the Week
Markets get a read on the most important component of US economic growth: consumer spending. The past year has seen a considerable contraction in spending from individuals. However, with the recent round of stimulus, a high savings rate, and the ongoing economic recovery, the US consumer is expected to come roaring back in the first half of 2021. This Friday, we get a sense of how much traction consumers really have.
Reuters polls expect consumer confidence to increase slightly to 96 (it was around 130 in February 2020), and personal consumption to have increased by 0.1% month-over-month.
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