Last year’s fourth quarter selloff was largely triggered by fears that the Federal Reserve (the “Fed”) had overshot the mark with its December rate hike, and that elevated borrowing rates would cause a recession. The Fed’s subsequent pivot back to accommodation and calming suasion was very well-received by investors in the first quarter, as risk assets such as equities and high yield bonds snapped back nicely. Treasuries rallied as investors are now more confident that the rise in rates is over (or that the Fed “put” is back). The high yield market had its best start (+7.4%) since 1992, when it was up 7.5% and it was the third best start to the year since 1985. Since both risk-on and risk-off assets have done well, it raises the question of where do we go from here? To better understand this, we look at a number of the major themes that could affect the markets going forward.
The race for the White House has begun, and as campaign rhetoric heats up, markets often react. It seems that early contenders have big spending plans, so perhaps we should frame these proposals within the realm of what is realistic and what is not. Borrowing to support spending beyond one’s means for extended periods of time is not without peril. Eventually, the credit risk becomes too great for lenders and they cut off available lines of credit. While this is the case for individuals and companies, it does not appear to be part of the discussion regarding government debt. Typically, unbridled spending funded by borrowing results in rising inflation, which usually acts as a brake against continued fiscal recklessness. Despite the ballooning of deficits around the world, inflation is barely noticeable in developed economies, and interest rates have eased, so deficit spending continues apace.
Some of our elected representatives are now proposing gargantuan spending plans, which will require much larger deficits; The Green New Deal is one such grand proposal, estimated to cost between $51 - $93 trillion according to Douglas Holtz-Eakin (former Director of the Congressional Budget Office). The trick for politicians behind it is how to pay for it without causing irreparable harm to our nation and our economy. Rational economic theory, and simple math, would argue that borrowing such enormous sums through normal channels is not only impractical, but foolhardy. To finance this bold new scheme, some have suggested a radical theory which purportedly can make such eye-popping expenditures a reality; Modern Monetary Theory (MMT).
While not new, MMT theorizes that deficits don’t matter, and governments can spend as much as they want because they can simply print money. Sound too good to be true? Despite the rounds it’s making in the press and in some corners of government, we believe it is. The backbone of MMT is that unlike quantitative easing (QE), where a central bank buys government bonds issued by the Treasury with printed money, the printing presses would create money that could be spent on far flung projects almost ad infinitum. The economic returns on these expenditures are uncertain at best.
In QE there are some checks and balances, because the excess cash created by the Treasury in selling government bonds to the Fed typically finds its way back to the central bank in the form of excess bank reserves, which in theory can be lent out by banks for capital investment. If the economy overheats, the central bank simply stops creating artificial liquidity and reduces these reserves, which dampens the propensity to lend and slows the economy and with it, inflation.
There are no such controls with MMT. Governments must always be able to sell enormous amounts of government debt when operating with a fiscal deficit and/or print enough money to close the gap. Otherwise the house of cards collapses on itself as investors shun that country’s debt and interest rates shoot upwards, at a time when the country has a peak debt load and all of that printed currency massively devalues. Some notable examples of too much borrowing, followed by liberal use of the printing press resulting in hyper-inflation are Germany (during the Weimar Republic) in the 1920s, due to their misguided attempt to print money to pay back external debt; Hungary in the 1920s and 1940s, Zimbabwe in the early 2000s and of course Venezuela today. Rational economists have spoken out against this madness, a few are quoted here:
- Larry Summers (former Treasury Secretary and former President of Harvard University) – “…fallacious at multiple levels”, “…stretched by fringe economists into ludicrous claims…”
- Paul Krugman (Nobel Prize winning economist) – “…the MMT people are just wrong in believing that the only question you need to ask about the budget deficit is whether it supplies the right amount of aggregate demand; financeability matters too, even with fiat money.”
- Janet Yellen (former Chairman of the Federal Reserve Board of Governors) – “That’s a very wrong-minded theory because that’s how you get hyper-inflation.”
- Maya MacGuineas (Committee for a Responsible Federal Budget) – sarcastically, “It’s a very seductive idea,” … “I can spend money on everything.”
It is important to remember that the purpose of debt is to buy today what one cannot afford. Another way of looking at it, is that what you would have bought in the future is pulled forward, thereby meaning that there will be less demand tomorrow. In aggregate, when nations stimulate their economies through massive deficit spending, they are almost certainly dooming the future economy to slower growth. This counter-intuitively means that the more you stimulate, the less likely future inflation will be a problem. That is, until you hit the tipping point and can borrow no more and hyper-inflation sets in.
While we believe calmer heads will eventually prevail regarding MMT, we should be vigilant about some of these outlier spending proposals as they can roil markets. Should these proposals remain on the table as the election nears, perhaps we should begin to worry. Stay tuned!
Putting aside potential inflationary pressures that could be created by excessive government spending, there are a few additional dynamics related to low interest rates and inflation that are worth monitoring. Since the great financial crisis of 2008 there have been some short periods of rising inflation, but persistently low Gross Domestic Product growth seems to have kept it in check. Interest rates have also hovered at near record levels for most of the past 10 years. While the Fed has finally started the long-awaited normalization process, the extended period of low interest rates has also caused a change in consumer behavior: savings rates have risen while consumption growth has remained muted. Contrary to ivory tower economists who believe that penalizing the return on saving (via lower interest rates) will cause savers to spend, the U.S. Personal Saving as a percentage of Disposable Personal Income increased from around 4% in early 2008, to 7.5% at the end of January 2019. Japan has also experienced a similar rise in savings following a long period of near zero interest rates.
If consumers favor saving over spending, it is tough for economic growth to accelerate and for prices to rise meaningfully. Demand for savings investment vehicles also keeps interest rates low. Japan is a prime example of this change in consumer behavior creating a seemingly endless negative feedback loop and Europe is on the verge of falling into the “monetary stimulus at any price” trap as well. Their demographics are also amplifying the effect as older population cohorts are no longer working and have reined in their spending. We are starting to see similar behavior here among the Baby Boomers. As much as the central banks try to stimulate growth with schemes to buy bonds at elevated prices, even to the point of slipping into negative interest rate territory, working and retired populations continue to respond to non-existent returns on their savings by saving even more and frustrating policymakers. Currently, 17% of the global bond market has negative yields.
National economies are not stand-alone entities; they are intertwined in ways that policy makers do not fully understand yet. This dialectic has inherent spillover effects. According to the Wall Street Journal, outgoing European Central Bank President Mario Draghi is finally beginning to worry about the adverse effects of negative rates. By comparison, given our strong rule of law, economic size, market depth and early intervention to stabilize our banks, the U.S. market is still one of the best places to trade and invest capital. This may explain why we see so much foreign demand for U.S. Treasuries, not to mention the competitive interest rates we offer compared to Europe and Japan, the other two desirable bond markets. To date, the Treasury continues to be able to sell bonds to willing buyers both domestically and globally. The anchoring of near zero rates globally has no doubt caused our interest rates to stay lower than they probably should be this far into an economic cycle.
Another issue hampering upward price elasticity is the rise of the zombie corporation. A zombie company is one who cannot or can barely meet its interest expense from operating cash flows and needs to borrow to pay interest and/or principal due. Japan has many such companies because for a long time the cost of borrowing has been virtually zero, so companies that would ordinarily have gone bust continue to linger. We are now seeing a rise in zombie companies in other large economies, such as here, in Europe and in China. This is not healthy as these companies are creating unnecessary price competition, are not investing in productive capacity and are possibly crowding out more productive borrowers. They may also be keeping a cap on inflation. This is a dilemma: how does the Fed raise interest rates high enough to finally kill the zombie business model, without tipping us into recession? To be clear, we are not in favor of high inflation. That is a decided negative for consumer spending, but a balance is needed to allow corporations the profits to invest in both capital and labor.
We have examined some reasons for slower economic growth and stable inflation, but there may be a tail wind coming in a very important contributor: housing. It has been one of the weak spots causing investor concern late last year. Historically, economic growth is not durable without growth in housing. Usually the largest ticket item consumers buy, its multiplier effect amplifies economic growth as people buy new furniture, appliances, etc. Buyers are sensitive to mortgage rates and as the Fed was normalizing the fed funds rate in 2018, mortgage rates also rose commensurately, thereby dampening demand for housing and increasing the inventory of unsold homes. This slowdown, along with the flattening and slight inversion of the yield curve (which we wrote about in our year-end Outlook) seems to have spurred more speculation about when the next recession will begin but we think that as rates stabilize at lower levels we may see a rebound in housing demand, which may bolster economic growth later this year. Despite the growing sentiment that the Fed may cut rates soon (Bloomberg currently puts the odds of a Fed rate cut by January 2020 around 80%), we feel that there are enough cross currents, despite falling global bond yields, to not write off this recovery just yet.
While it is difficult to accurately forecast the timing of the next recession, we believe that growth will remain slow but positive. We will surely have a recession eventually, but the green shoots we are seeing very recently, such as a rise in home sales for February, may prolong the recovery. We don’t know yet which force will be more influential in driving the housing market: price elasticity from lower mortgage rates or the fear of a recession? The Fed appears to be very sensitive to market gyrations now and any sign of further weakness may likely be met with more dovish cooing and possibly a stimulative policy shift downwards in rates, as was the case in 1998, when the Fed cut the fed funds rate by 75 basis points (0.75%) in response to global events such as the Asian currency crisis. Keep in mind that 1999 was a very good year for risk assets! This is not our base case, however.
The economy continues to slowly bump along, and we are seeing some signs of firming. Hopefully these continue and extend the runway of this recovery. Uncertainty regarding the ultimate resolution of our trade skirmishes, Brexit, etc. still hangs over the markets, but the longer they go on, the more markets seem to become inured to the headlines. Although it’s the same refrain we’ve sung for a number of years, it bears repeating: during low growth environments small deviations from expectations tend to cause much hyperventilation among investors and the low volatility we have seen recently may give way to more pronounced market swings that may yield some interesting opportunities at more reasonable prices.
We are continuing to upgrade our positioning with an eye towards managing risk, while garnering reasonable returns. We do not feel that now is the time to stretch for yield following the strong rebound we’ve seen this year. In the meantime, given the very flat yield curve, shorter duration higher quality bonds are a good value, as are selective convertible bonds.
As always, we thank you for your support and welcome your comments and questions.
Sincerely,
Carl Kaufman, Bradley Kane, Craig Manchuck
Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
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Modern Monetary Theory (MMT) is a heterodox macroeconomic theory that describes currency as a public monopoly for a government and unemployment as the evidence that a currency monopolist is restricting the supply of the financial assets needed to pay taxes and satisfy savings desires.
Quantitative easing (QE) is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
Gross Domestic Product is the monetary value of all the finished goods and services produced within a country's borders in a specific time period.
A basis point is a unit that is equal to 1/100th of 1%.
Duration measures the sensitivity of a fixed income security's price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.
Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g. depreciation) and interest expense to pretax income.
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© Osterweis Capital Management
© Osterweis Capital Management
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