October 2020 Macro Commentary
Can’t see the Forest for the Trees…
Is now the time for Keynesian Economic Policy?
by Sanjay Khindri, CFA on October 3, 2020
This year has been a roller coaster of a ride for both the global economy and global markets. Volatility in both asset prices and public sentiment has been very high recently, owing to numerous factors: the U.S. election, the persistence of Covid-19, renewed Brexit uncertainty, to name a few. The U.S. in particular is dealing with a number of short-term unknowns that seem to be heavily occupying both investor’s and consumer’s minds, and for good reason.
But if we “rise above the trees”, the global economic picture is a little brighter. In the Eurozone, for example, we are seeing a strong fiscal and monetary union that was unthinkable following the experience of the debt crisis of over 10 years ago. The U.S. is having a more difficult time on the political front, but the slowing of the economic rebound and record high unemployment will eventually force political sides to come to an agreement on a second major stimulus bill, despite near-term wrangling. Post election, fiscal policies will be there to support the economy, regardless of who wins.
The bigger picture for the U.S. consumer and investor is driven by two important questions: 1) what are the structural and lasting impacts of the Covid-19 pandemic, and 2) are demand-side or supply-side economics the best way to manage these impacts? The answers to these questions will help gauge the magnitude and sustainability of economic growth going forward, and how that growth will be distributed across sectors of the economy.
The answer to the first question is a little clearer. We know that the pandemic has led to digital business transformations that were eventually going to happen anyway and will not reverse after a widely distributed vaccine. The ability of the software industry in the U.S. to quickly provide new digital solutions to businesses has been incredible. Some technology companies will tell you that they have pulled forward over three years of revenue growth just due to Covid-19. The other side of this however is that business productivity has also seen a positive step change, implying that many businesses are learning to do more with less labor capital.
Then there is the small business impact. Investors tend to focus on the headline economic numbers and the performance of the stock market; but the headline economic numbers are masking a big divergence in the economic reality among different sectors of the population. And the stock market, while correctly foreshadowing the economic rebound, is also being heavily supported by monetary policy. One representation of this divergence of fortunes is an alternative measure of unemployment which focuses on hourly workers (i.e. small business employment). The Homebase data[1] below clearly supports the reality of this bifurcation.
Homebase data on “Employees Working”
Percentage represents the change relative to the average for January ‘20
Another example of some of the underlying economic issues can be seen in the utilization of the Federal Reserve’s Main Street Lending Program. This facility was set up to support liquidity to businesses that are not large enough to access capital markets. But take-up (utilization) on this facility has only been a third of a percent, and not because of a lack of demand, but because of the unwillingness of banks to lend based on the creditworthiness of borrowers (under this program, banks must retain a portion of the loan).
The summary of the answer to the first question is that we’ve undergone a structural shift in aggregate consumption where larger, well-capitalized companies capture higher share, leaving smaller consumer-facing businesses without the customer base and profit profile to access sources of capital. Further, productivity growth has been pulled forward reducing the demand for labor.
So, what is the appropriate fiscal response to this new economy? Are incentive (supply-side) economics still relevant? The answer to the second question is less clear, but what is clear is that in all the times of history where Keynesian (demand-side) economic policies had the potential to consistently drive economic growth, now would be one of those times. In 2016, tax-cuts and trickle-down economics made sense. The U.S. economy was at trend-growth while the global economy was entering a cyclical up-phase. Financial conditions were stable and consumer confidence was strong.
But today is very different. The global economic outlook is uncertain, and confidence has been damaged. The long-term demand outlook for certain goods and services has been structurally impaired (think for example of the energy intensity of future global GDP growth just based on less business travel alone). Would tax cuts as an example not just lead to a higher overall savings rate, or be recycled back into the same businesses that have actually benefited from Covid-19?
The one thing that demand-side economics has going for it is the Federal Reserve. Normally, large deficit-financed government spending would lead to higher real interest rates and the textbook crowding-out of private sector spending. We actually witnessed a brief period of this in late 2018 following the deficit-financed Trump tax cuts which led to a boost to GDP growth. But today, the Federal Reserve’s inflation and employment targeting constructs have changed. When combined with the output gap created by Covid-19, the Fed will monetize increased government spending which will cap any growth-degrading rise in real interest rates.
Tax Increases and Social Division
As investors, we should be cognizant of potential increases to corporate tax rates as well as the spending impact from higher marginal income tax rates to fund heavier government spending.
On the corporate tax rate side, going from 21% to 28% implies a less than 9% hit to earnings for a company paying the full effective rate, and ignores any positive aggregate demand impact from a step-change in government spending. Further, a 28% rate is 7% points lower than the 35% rate we’ve had since the early 90’s, and the new territorial tax system is maintained.
On the personal income tax side, it has been researched and documented[2] that the marginal propensity to consume is much lower at higher wealth and income tiers. The research on this topic must be taken into account when evaluating any multi-trillion dollar government spending proposal.
I am not arguing whether demand-side or supply-side policies are in general better than the other; I think investors should simply ask themselves: what is the likely net economic impact of each policy within the context of a given economic backdrop? I am arguing however that the economic outlook is favorable regardless of election and policy outcomes.
The bigger risk from an investor perspective is related to social division and the evolution of socioeconomic factors over the next few years. These factors have the potential to be more economically disruptive and therefore potentially driving fiscal stances further to the edges of the political spectrum.
[1] https://joinhomebase.com/data/
[2] As an example of this research: https://www.bostonfed.org/publications/research-department-working-paper/2019/estimating-the-marginal-propensity-to-consume-using-the-distributions-income-consumption-wealth.aspx