January 2021 Macro Commentary
A New Paradigm in U.S. Fiscal and Monetary Policy
Less economic cyclicality supports risky asset valuations…but a new set of risk factors for investors to evaluate
by Sanjay Khindri, CFA on January 5, 2021
During the pandemic-ravaged year of 2020, U.S. GDP is expected to decline by almost 4%, the largest annual downturn of the post-war era. Despite the dramatic hit to growth, the S&P 500 finished 2020 by delivering a 16% annual return, bringing its two-year annualized return to ~ 22% and its 10-year annualized return to almost 12%.
The salient drivers of 2020’s stock market performance are the transient nature of the Covid-19 pandemic and the unprecedented policy response by fiscal and monetary authorities. For comparison, while the GDP decline in 2009 was a more benign 2.5%, the economy was structurally impaired following the Great Financial Crisis, leading to constrained growth for several years. On the contrary, in 2020, governments and central banks stepped-in with substantial support programs while large banks and lending institutions were in strong capital positions to support the flow of credit. Notably, the 2020 recession was not caused by an asset bubble or some economic externality, but by an exogenous shock, making it much more palatable for policymakers to respond quickly and forcefully.
To be sure, there will be lasting impacts from Covid-19 as it relates to consumer behavior and the operation of certain industries. The more subtle and important changes for investors to consider however are how the pandemic has changed the policy model going forward. This new paradigm broadly supports higher levels of risky asset valuations, at least in the short-term, but introduces some inconspicuous risks medium-term.
Monetary Policy
Monetary authorities operate according to two overarching goals: stable prices and “maximum employment”. Historically, the Federal Reserve would respond to changes in inflation dynamics, which were inherently linked to employment dynamics, by changing interest rates, i.e., “the interest rate cycle”. The interest rate cycle itself would drive economic expansions and contractions which presumably would lead to greater overall economic stability than if there were no monetary authority at all.
But over the past 10 years, the Fed has failed to achieve its stable price objective. The Covid-19 pandemic has driven cumulative inflation over the last economic cycle further below target, leading the Fed to now target above-average inflation to compensate. Combined with the decoupling of inflation and employment dynamics, the implication is that the interest-rate cycle, for the time being, is dead. The first shift in the monetary policy paradigm is that economic growth dynamics in the near-term will not be driven by changes in short-term interest rates.
The second shift relates to the moral hazard hole the Fed as dug for itself. I have previously written here about the substantial liquidity and market support programs the Fed and Treasury put in place at the height of the pandemic. The justification for these programs was obvious, but market participants will now expect this same level of support during the next economic downturn, no matter the cause.
If the Fed doesn’t oblige, markets will ensure it eventually does…this is how high asset valuations will play a role. There is now significant asset price downside without considerable liquidity support in times of stress. The asset price downside itself can have severe economic consequences that the Fed will be forced to manage.
This new monetary policy regime is supportive of sustainably higher asset valuations: less economic cyclicality via the interest rate cycle combined with unlimited market and liquidity support during a downturn. While most investors focus on the level of real Treasury yields as the driver of higher equity multiples, the more recent expansion in equity valuations should also be explained by a further contraction in the equity risk premium, i.e. the incremental return required over that of risk-free assets (see here).
Fiscal Policy
From 2010 up until 2017, fiscal policy did not play an overly supportive role in economic growth. While the Federal Reserve was undergoing a consistent program of quantitative easing, increases in the monetary base never meaningfully circulated throughout the real economy. The quantitative easing during Covid-19, however, has been much different: Monetary policy eased while governments rapidly increased spending, leading to extraordinary increases in broader measures of the money supply. In short, increased budget deficits provided a new conduit through which quantitative easing could operate.
The lesson of this simple model is that in a short-term time frame, expansionary fiscal policy is highly supportive to economic growth when monetary and fiscal policy are in congruence. The longer-term impacts however are less clear. Despite policy uncertainty due to a divided Congress, there are reasons to expect more active fiscal policy going forward, at the same time that the monetary policy framework has shifted.
While fleeting in nature, the pandemic will result in some lasting structural changes. Demand for transportation and office space could be permanently lower, while some degree of goods and services consumption may not shift back from virtual and delivery-based platforms. Management teams of companies across industries are highlighting the role software and technology have played in managing through the pandemic. It is no wonder then why economic growth continues to rebound while unemployment claims remain well above the levels seen after prior recessions: technology and software are highly productive investments.
The crucial point is that the step-change in the use of technology is not a cyclical cost-cutting exercise. The implication being that the U.S. economy has experienced a permanent upward productivity shock which will keep unemployment sustainability elevated and the wealth gap wide (see here). Stubbornly high unemployment and the growing wealth gap will keep pressure on policy makers to increase spending to drive their economic agendas…a new fiscal policy paradigm.
A New Set of Risks
How long the new policy regime lasts will be determined by how quickly and robustly policy makers can achieve their goals. Until that happens, there are a new set of risks to consider. Rationales exist for why central banks do not continually suppress interest rates and why governments are reluctant to perpetually increase deficits. Unintended consequences can emerge, causing market and economic disruption.
Disturbance to the supportive near-term policy backdrop could manifest in two interrelated outcomes: 1) more volatile swings in long-term interest rates via both inflation premiums and real rates, and 2) a change in the willingness of foreign investors to hold U.S. dollar assets.
Two attractive attributes of U.S. risk-free assets to foreign investors are price stability and liquidity. In turn, these attributes are driven by stable inflation and the predictable recycling of the U.S.’s twin deficits (trade and budget) back into U.S. securities. By suppressing short-term interests throughout an economic cycle, the Fed may be risking a trade-off where it loses control of long-term interest rates. In the same vein, whether government budget deficits are financed by the Federal Reserve or not, the stability of bond yields will depend on the perception of the government’s ability to continue to attract a steady flow of foreign capital into U.S. dollar assets. The risk is not that of a debt crisis, but that the risk-rebalancing of long-term interest rates happens with such magnitude and rapidity to disrupt the valuations of other asset classes.
In short, the investment risk framework has been altered from one of evaluating the cyclicality of an equity security to questions of the attractiveness of holding U.S. dollar assets in general. How this risk impacts equity valuations is more nuanced; but simplistically, the suppression of interest-rate-cycle-induced economic cyclicality is beneficial for higher beta sectors. The potential introduction of longer-term real interest rate volatility, however, is a negative harbinger of growth sector returns that have been supported by low and stable bond yields.
Gallatin Capital Management, LLC
Important Disclaimer: Gallatin Capital Management is not registered as an investment advisor with any state or federal agency. This material is for your information only and is not intended to be redistributed or used by anyone other than you. The information contained herein should not be regarded as an offer to sell or a solicitation of an offer to buy any financial products. This material, including any investment recommendations herein, is intended only to facilitate discussions with Gallatin Capital Management as to its investment offerings and strategies. The given material is subject to change and is not guaranteed as to accuracy or completeness and it should not be relied upon as such. The material is not intended to be used as a general guide to investing, or as a source of any specific recommendations.