Strategic Income Outlook April 2019

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.