The equity markets bounced back handsomely this week. The S&P rallied +4.3% over the last five days while small-caps bounced +4.2%. EM was a standout with a +6.7% weekly gain. Interestingly, stocks were able to rally despite rising yields. The correction a week ago was blamed to some extent on rising yields. But that didn’t matter this week. Hotter than expected inflation numbers pushed the yield on the 10-year to 2.88%, up +5bps on the week. Both Intermediate and short-term government bonds lost -0.2%, while high-yield was up +1.8% and bank loans added +0.5%.
The inflation data boosted precious metals. Gold was up +2.6%, silver +2.3%, and gold stocks +5.4%.
Busting the Budget
Over the last few weeks we have seen an amazing change in the trajectory of government spending. Last week Congress voted to increased spending by nearly $300bn over the next two years, and this comes on top of $80bn that has been committed to disaster relief. And of course both come on the heels of the recent tax cuts that are likely to add at least $1.5tn to the deficit over the next ten years. Then of course there is the proposed infrastructure bill that might add another $200bn of Federal Government spending over ten years. An billion here and a billion there and pretty soon the numbers add up.
As you can see below, deficits are projected to be well over $1tn in both 2019 and 2020. If current tax policies are extended we are looking at a $2tn plus deficit in 2027 (even the baseline number balloons to close to $1.5tn!!).
As a percent of GDP the deficit in 2020 will be roughly 5%. This is a striking number because it would come about during a time of otherwise healthy economic growth. In the past a deficit of 5% was associated with recessions. The chart below details this well. It shows deficits as a percent of GDP (x-axis) against economic growth (y-axis). For example, deficits of 1% or lower are typically associated with periods of robust growth (>4%). Conversely, deficits of greater than 5% are associated with recessions. The current proposed deficit of over 5% stands out because it comes at a time when the economy is growing well above 2%. This isn’t normal, at least historically.
Another way to look at it is by administration. The graph below breaks out the average deficit under each president (red shows Republicans, Blue Democrats). The deficit under Trump will fall only modestly short of Obama’s, and Obama’s average is thrown off by the 2008-2009 financial crisis. Even Reagan, the father of deficit spending, ‘only’ saw deficits of close to 4%.
The Economist summed up today’s situation nicely:
“The mood of fiscal insouciance in Washington, DC, is troubling. Add the extra spending to rising pension and health-care costs, and America is set to run deficits above 5% of GDP for the foreseeable future. Excluding the deep recessions of the early 1980s and 2008, the United States is being more profligate than at any time since 1945.”
A Grand Experiment in Pro-Cyclical Fiscal Policy
If you are an old school Keynesian you subscribe to the idea of boosting deficits during lean times while balancing the budget during fat times. This might be a bit simplistic, but it captures the general intent. While Keynesian’s have been labeled a bit leftist the last couple decades, today they would rank as outright fiscal conservatives. It appears that the new mantra isn’t countercyclical, but procyclical. If the fire is burning, surely a bit more fuel is even better.
Keeping with The Economist theme, their cover a couple weeks ago captured the economic experiment taking place.
The immediate impact will almost certainly be higher growth, lower unemployment, and higher bond yields. Take the comments from J.P. Morgan recently:
“After Friday’s budget deal, (we) have upped…2018 US growth from 2.2% to 2.6% and 2019 from 1.6% to 1.9%; and lowered the 2019 unemployment rate target from 3.5% to 3.2%. The end-2018 US 10Y Treasury forecast has also been raised from 2.85% to 3.15%.”
But what are the risks?
Where is the Debt Tipping Point?
There are essentially two main risks: one more mythical than real, and the other more serious.
First there is the risk of fiscal bankruptcy. The simple refrain is that governments can’t deficit spend forever. After all, you and I couldn’t get away with such profligacy.
While the moral angle feels good, there is little historical evidence to support the gloom and doom crowd. Japan continues to be the counterpoint. As you can see below, Japanese debt-to-GDP has ballooned from 50% back in 1981 to roughly 250% today. And Japanese interest rates have basically declined this whole period. Many have bet against Japanese bankruptcy. This so-called widow maker trade got its moniker for a reason.
We have seen something similar in the U.S., just on a smaller scale. As you can see below the debt/GDP ratio has gone from roughly 30% in the early 19080’s to basically 100% recently, and bonds have been in a pronounced bull market (rates have fallen).
Another comforting sign comes from the bond market. If you look at Treasury Inflation Protected Security (TIPS) yields you see no noticeable changes. The real yields in the TIPS market essentially captures the risk investors put on a governments debt plus a premium for maturity. The chart below shows the real yields on a 20-year bond going back to 2005. They have barely budged despite the spike in the deficit. This means investors are no placing any greater risk of default on U.S. government bonds despite the budget trajectory.
Loose Fiscal Policy Puts Pressure on Monetary Policy
So if imminent default isn’t the risk, what is? It simply comes back to the idea that the surging debt levels are coming at the same time the economy is running at full employment and is more susceptible to rising inflation. Throw at lot of fiscal spending at the economy when there is a lot of slack (such as 2009) and you’ll never get inflation. Think trying to light a fire with wet wood. However, throw gasoline on a roaring fire and……well…you know.
The fear of this explains why longer-term bond yields (see chart below) have surged recently.
This week’s Consumer Price Inflation report didn’t help matters. Headline inflation hit 2.1% in January, 0.2% better than expectations, while the core gauge (excludes food and energy) was stable at 1.8% (expectations were for a dip in this measure). The red line in the chart bellows shows the core CPI rate. The green is the Fed’s preferred measure – the core PCE inflation gauge.
While not surging by any stretch, most think core inflation is headed to 2% this year. This has led investors to change their expectations for Fed policy. In the fall of last year few thought we’d see four interest rate hikes in 2018. Today the odds have growth to 25%, as you can see below. Four hikes would put the Fed Funds rate at between 2.25% and 2.50%.
But we shouldn’t get too carried away on the inflation theme, at least not yet. Core inflation of 1.8% is still well below the long-term average for inflation, as you can see below.
Inflation at this level hasn’t been a major problem for the equity markets, at least beyond some short-term volatility. You need a much bigger inflation shock to cause problems. Think back to the late 1960s and 1970s that are typically associated with inflation driven bear markets. Each downturn in equities was triggered by a move in inflation above 5%, as you can see below.
We are a long way from this.
But the budget trends certainly imply the following:
– Modestly better growth, at least short-term.
– A tighter jobs market.
– More wage pressures.
– A greater chance inflation surpasses the Fed’s 2% target.
The Dollar Wild Card
The other wild card is what happens with a U.S. dollar. The dollar has been weak of late, and analysts are blaming fears about the surging twin deficits for driving the dollar down. The twin deficits they refer to are budget and trade. The Bloomberg chart below is a little busy, but it shows the combined current account deficit (read trade deficit) and budget deficit (shaded blue area) against the U.S. dollar.
Dollar bear markets have typically been associated with rising twin deficits and visa versa. What will be interesting is how much of the new fiscal spending seeps into a much larger trade deficit. This would imply more dollar weakness. And more dollar weakness will goose inflation a bit more as it makes our imports more expensive. Another possible pro-cyclical trend.
How Will Powell React?
This is all well and good, but how will the monetary authorities react. Will the new Fed Chairman allow the economy to run a bit hot? Or will his hawkish side win out and push him to aggressively hike rates. And here lie the two million-dollar questions:
1) How will the Fed react to rising inflation and volatile markets? The Economist again:
“…in the short term most hangs on Mr Powell, who must steer between two opposite dangers. One is that he is too doveish, backing away from the gradual (and fairly modest) tightening in the Fed’s current plans as a salve to jittery financial markets. In effect, he would be creating a “Powell put” which would in time lead to financial bubbles. The other danger is that the Fed tightens too much too fast because it fears the economy is overheating.”
We think he will sound relatively hawkish at his first press conference on March 21st. The odds of four rate hikes this year are probably much higher than the markets think.
2) If Powell picks the tightening path, then how reliant is the developed world on ultra-low/negative interest rates? It’s not that long ago a ‘normal’ Fed Funds rate was 4% or 5%. Would such a rate today be crippling? We simply don’t know where the tipping point is.
Without a doubt the fiscal changes of the last few weeks are both a grand experiment and a test for monetary authorities. They are an experiment in sense of testing how much stimulus you can push into a mature economy at full employment without something breaking. And this will be the ultimate test for the Fed. Can they manage the economy utilizing just a very blunt interest rate tool.
Time will tell.
Have a good weekend.
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