The financial and economic world has changed. The US economy and the financial markets are now in a new paradigm where fiscal policies (money creation and government spending), rather than monetary policies (managing the level of interest rates) affect and drive outcomes.
The Federal Reserve
Since 1977, the Federal Reserve has operated under a mandate from Congress to “effectively promote” the goals of maximum employment, stable prices, and moderate long term interest rates” — what is now commonly referred to as the Fed’s “dual mandate.” The Fed tried to achieve both of those mandates through monetary policy, effectively controlling the level and direction of interest rates.
All that changed coming out of the economic collapse of 2008.
In an attempt to arrest that economic collapse, the Fed lowered interest rates from 5.25% to 0%.
Unfortunately, this did not revive the economy. Furthermore, once interest rates approached the 0% baseline, that Fed policy tool was exhausted. Uh oh…
Enter “fiscal policy”, otherwise known then as “Quantitative Easing” (1,2,3…, etc.).
These QE programs were the Fed’s unorthodox attempt to stabilize the economy by effectively injecting (massive amounts of) cash into the financial system. QE policies dramatically increase the available money supply (M2). They also help keep long-term interest rates low, making it easier for banks to lend, with the hope of spurring economic growth. In this current 0% interest rate environment, the economy is now fiscally driven, rather than monetarily driven. That is the new economic order in which we now find ourselves.
But these fiscal policies carry their own potential risks.
Introducing the Debt Trap
Lacy Hunt (Hoisington Investment Management) has explained that due to the massive levels of debt-financed stimulus, our economy is actually now in a classic debt trap.
Academic research shows that once government debt exceeds 60% of GDP, it begins to have a depressive effect on growth (due to debt service pressures). Today, government debt is 127% of GDP, and climbing (off the chart)!
A Virtuous Circle. Hunt explains that a debt trap is where “too much debt actually weakens growth, which elicits a policy response that creates more debt that results in even more disappointing business conditions.” A virtuous circle of downward pressures on growth (and for the moment, inflation).
That is exactly why the economic recovery coming out of 2008 was subpar. It also suggests that future baseline economic growth, outside of the temporary sugar high following recent and expected fiscal injections, is likely be sluggish as well.
But wait! If you simply looked at the stock market, you might think that conditions on main street were great. Why the disconnect?
It’s gotta go somewhere…
Ned Davis Research keeps a data series titled “Money Supply (M2) Growth versus Industrial Production Growth”. The thought behind that series was that money supply growth in the economy would ultimately have to end up in one of two places. The real economy – aka Main Street (industrial production) or the financial economy – aka Wall Street (the stock and bond market).
Coming out of 2008, since;
1) the economic recovery coming out of 2008 was sluggish,
2) the growth in money supply was massive (QE programs) and
3) inflation was subdued (due to the building debt trap),
…The financial economy (Wall Street) emerged as the winner.
Oops!… I did it again
If you thought the QE programs of 2009 – 2010 were impressive, they pale in size when compared to what is going on now. Since last March, we’ve again had massive fiscal stimulus as the FED has made available $2.5 trillion dollars in lending to support households, employers, financial markets, state, and local governments. And yes, because main street remains sluggish, most of that money has once again ended up in the financial markets.
What’s the end game??
This seemingly never-ending fiscal stimulus could conceivably go on for quite a while. That is, unless inflation becomes a problem.
The dynamics of the debt trap are helping to subdue those potential pressures for now. More debt-financed fiscal stimulus is paradoxically creating slower growth and keeping unemployment relatively high.
However, this the paradigm might potentially change if the original Federal Reserve Act of 1913 is ever amended in such a way that allows the FED to create money and pay bills directly, bypassing the U.S. Treasury (which currently acts as a choke point against Central Bankers running wild).
You would hope that such a legislative change would be a long shot, but in this politically charged day and age, do not assume that anything is out of the question.
What does that mean for us here at BCM?
Asset Allocation and risk control is more important than ever.
Why do I say that? Because no matter what measure you choose, you can’t escape the fact that stocks are expensive. Why does that matter? Because historical data shows that at the expensive valuation levels that stocks are at today, forward five-year returns are muted, at best.
Now expensive valuations may matter in the short run, but they likely will however matter a lot should the FED be given a free hand, outside of U.S. Treasury controls.
We play the hand we’re dealt.
We do not underestimate the embedded financial and political risks that define the world that we live in today. We will continue to manage our portfolios through the coming years as we always have – with our allocation structure as well as our market risk model.
Importantly, we must also never forget that we are in this for the duration. As the financial writer Morgan Housel states; An investor’s goals shouldn’t be the best annual returns. It should be to maximize wealth. And you get that through endurance – not to be the best in any given year, but to be the last man standing.