Article by Edward Harrison of Bloomberg

The article below is by Edward Harrison, senior Editor at Bloomberg. The article puts into context deficit spending and high interest rates. I have added a few explanatory words in parentheses. His main points are:
  • Government spending around the world will remain high because of security issues (wars), infrastructure, and imperative needs (climate change).
  • Governments are spending more money than they receive in taxes, therefore increasing deficits.
  • Higher interest rates are needed to attract investors to buy the government bonds needed to support the spending.  
  • Globally, 88 countries will hold elections this year and it is unlikely that candidates will announce they will raise taxes to reduce deficits. They would lose the election if they did.
  • Increasing and high interest rates will be bad for bond investors.
  • The economic stimulus created by deficit spending on the part of governments accelerates economic growth and can be good for risky investments, such as stocks. Stocks benefit from economic growth because the growing economy boosts profits. Recall from my recent note that companies can pass along the higher costs of doing business to their customers (https://marketresilience.blogspot.com/2024/04/weekly-note-april-10-2024.html).

Global Deficits Will Keep Interest Rates High

By Edward Harrison

(Bloomberg) -- For the first time in nearly 60 years, the US government is attempting to effect fiscal stimulus to both increase social well-being and stave off geopolitical threats. That (1970s) episode ended in high inflation. This time the guns-and-butter policy is global. And so, it makes sense to think inflation, and therefore interest rates, will remain somewhat elevated. How that will affect asset prices is not yet clear.  

Deficit spending is here to stay

I was scrolling through Bloomberg’s website this morning to catch up on the news when I saw a piece that put everything into perspective for me. The headline? Climate change to cause $38 Trillion a year in damages by 2049. Don’t get me wrong; this newsletter article is not going to be about climate change per se. Instead, I am thinking about the pressing and sundry reasons that will fuel persistent fiscal deficits globally for years to come.

In a world in which those deficits act as stimulus for the private sector, the only logical conclusion is that monetary policy is likely to be tighter to offset those deficits. The combination means higher near-term economic growth, persistently higher inflation and higher interest rates. For investors in government bonds, that’s going to be bad news, at least until long-term interest rates stabilize at a higher plateau and then decline. But then bond investors can join savers in reaping the benefits of higher rates while equity investors will have to judge whether discount rates or (profit) growth end up mattering more.

Secular trends pushing up inflation will also push up deficits

Let’s start this piece, not with climate-directed deficits but, with the secular forces I mentioned last week as keeping inflation higher. The three big ones are increased defense spending, de-globalization and a relative dearth of seasoned workers as Baby Boomers are replaced by the Baby Bust generation. Of those tectonic shifts, only the demographic trends won’t be driven by government directive. Add climate- and infrastructure-led spending to the mix and you have a triumvirate of secular trends — security spending, re-shoring, and infrastructure investment — that governments around the world will take an active role in fostering. To use a phrase from the Cold War days, we’re talking about guns-and-butter (the government spending money to fight battles AND keep people fed) fiscal spending.

The pandemic started this. We hadn’t had a global pandemic of such horrifying magnitude for 100 years. And so, all the rulebooks on government spending, debt and deficits were torn up as countries struggled to keep people from dying while also keeping the economy afloat. Having just left that period with climate-related disasters and geopolitical tensions front and center, governments are alert to taking the same tack to the aforementioned almost existential problems. And that has relaxed deficit taboos everywhere.

Take Italy, for example. The country expects a deficit of 4.3% this year and 3.7% for 2025. That’s certainly down from the still pandemic-influenced level 7.2% in 2023 but it’s well above the now defunct Maastricht criteria on debt and deficits in the EU. And the 2025 level is higher than previous government projections…

The world’s two biggest economies, the US and China, are very much leading the charge on this level. In recently published remarks, the IMF says, “in both economies, public debt is projected under current policies to nearly double by 2053.”

Deficits are money in your pocket

Here’s the thing. Unlike monetary policy, which acts with long and variable lags because its transmission to the economy is uncertain, fiscal policy works straight away. Deficit spending is basically money in your pocket. The government spends money into the economy and then claws back some percentage of that through taxes. If it taxes us less than it initially spent, it has basically created a windfall for the private sector.

For every dollar of deficit, advanced economies issue government securities with interest that cover those deficits to the penny. And so deficits translate penny for penny into a net increase in non-government financial assets as this government debt is the usually considered the safest benchmark financial asset in any currency area (though the eurozone complicates that concept). This is exactly why people talk about deficit spending needing to increase during recessions as fiscal stabilizers like unemployment insurance kick in to prevent economic freefall.

Think of how this worked in the pandemic during lockdowns. Governments around the world told you to stop working in order to prevent the spread of Covid-19 killing millions more. Many people were thrown out of work due to that shutdown of the economy. But knowing that the loss of income from large swathes of the population would cause a Great Depression, governments simply created money by fiat and credited people’s bank accounts so they could live as if they were receiving a constant paycheck from work.

Having spent that money into existence by keystroke, they then issued government debt to cover most of the spending. Governments didn’t increase taxes to cover the additional spending because doing so would collapse the economy. They simply let deficits balloon. And the result was a massive net transfer of assets into the private sector. We ended with an economy that saw a temporary collapse in output from being idle but that had the financial assets to make up that loss over time, preventing the short, sharp recession from having a measurably negative impact on financial assets and home prices.

How much money are we talking about

If we want to get a sense of how much governments are adding to demand today, the IMF’s recently-published figures are a good place to start. They estimate that the primary deficit, that is the percentage of government spending not covered by tax receipts not including interest expense, was 5.5% in 2023. In 2024, a year not affected significantly by Covid-19, they think that percentage only goes down to 4.9%.

What’s more, the IMF notes that “88 economies representing more than half of the world’s population “ will hold elections this year. The reality is you are not going to see incumbent politicians raising taxes in an election year to bring a deficit in check — unless they want to lose the election…

So 5% seems like a pretty good baseline to think of in terms of net transfer from the public sector. And since governments spend 30% or more of total output in advanced economies, we’re talking about 1-2% of GDP added by those deficits. That’s a big change in the baseline rate of growth.

I have nothing to say here about the need for increased defense, infrastructure or government-aided investment spending — nor about how whether that additional spending should be matched by increased taxes. That’s a political question. The reality, however, is that governments across the globe have decided to spend more without taxing more. That policy mix increases overall demand for goods, services and employment in the economy, likely raising the baseline level of inflation.

The Fed gets it now

So after months of inflation coming down as our post-pandemic economy normalized, we’ve stalled. With those added deficits, who says the baseline level of inflation isn’t 3% instead of the Fed’s 2% target. If it is — and I believe it is certainly higher than 2% — the Fed and other central banks have a decision to make. Do they try and get back to 2% by making monetary so restrictive it sends us into a recession or do they accept a higher level of inflation?

It’s a tricky question, in the 1970s in the US, for example, inflation declined after the first Oil Shock for months after the recession ended. Eventually it stalled at 5% though. And then it rose. That’s the outcome central banks are looking to avoid…

But how restrictive do they make policy? And what will be the impact on inflation? We don’t know and neither do they.

At a minimum, the Fed gets it. Just this week Fed Chair Jerome Powell said we will see the Fed’s target fed funds rate at these levels for longer than he had anticipated. He’s not making a judgment on whether inflation is permanently higher or whether the Fed will tolerate 3% inflation, mind you. He’s just stating the obvious that, with core consumer price inflation (CPI) close to 4%, more work needs to be done before the Fed cuts rates.

What that means — with the Fed’s target fed funds rate stuck at 5.33% and 10-year yields more than three-quarters percentage-points lower — is that long-term interest rates have to rise over time. After all, why would I buy your debt and pay you less money for taking on interest rate risk for longer unless I thought rates were going to come down? I wouldn’t. So the longer rates stay elevated, the less I and other investors are likely to think rates come down. That means the government must pay higher long-term rates. And all interest rates across the economy rise as a result.

The lesson for (bond) investors is mostly about downside risk

The lesson for holders of Treasury securities is clear then. Hold your assets and prepare for them to be worth less. Now you could hold to maturity and not lose any money. But the opportunity cost means you lose anyway. So holders of Treasury bonds are worse off. And I assume the same is true globally because the secular increase in deficit spending is a secular phenomenon. And what the Fed does has global implications because of the importance of the US dollar.

Beyond that, things get a bit murkier. For fixed income, whether we mean investment-grade bonds, high yield bonds, leveraged loans, private credit or mortgage-backed securities, higher yields on longer-term safe government assets mean higher yields on these other fixed income products too. But higher rates generally mean more financial distress too. So we should expect the spread in yield between government bonds and other fixed income products to go up.

Spreads are pretty low now because the economy has been so good. And for lower-grade bonds, there is always the potential for a credit rating upgrade as the economy holds. So it’s not a hard and fast rule that higher yields mean wider spreads. Nevertheless, on the whole, between higher government yields and spreads, I would expect fixed income products to suffer somewhat in an indefinitely higher for longer period.

Of course, eventually long-term yields peak, either because all of the eventual higher-for-longer impetus gets priced in or because the economy deteriorates and it becomes clear rates will go lower. So the period of pain for Treasury holders is limited. And since, the prospect of higher fed funds rates isn’t on the table yet, many will simply ride it out. When the economy turns down, that’s when lower-rated fixed income products will feel it most.

What about equities? If government deficits are boosting inflation because they’re also boosting growth, I would think the growth side outweighs the inflation side. A better economy makes it easier to discount (higher growth rates) well into the future…

Deficit spending helps risk assets (e.g. stocks)

On the whole, I tend to think the prospect of higher deficit spending is good for the economy in the medium-term and therefore buoys risk assets (such as stocks). Two years ago I wrote about how equities fared during the 1970s. My conclusion was that, equities did really well during the mid-1970s upturn. From the October 1974 bottom to the November 1980 for the S&P 500 you saw a 15% annualized (stock market) return during the worst inflation we’ve seen in a century.

But equities got savaged during the two oil shocks and the two other recessions after guns and butter was adopted before nosebleed interest rates crashed inflation with the economy. So overall, the 1970s was a lost decade as a result.

In the near-term then, geopolitical risks and climate change are likely to add to deficit spending in a way that buoys risk assets. The real question is what happens with monetary policy. Right now, central banks are telegraphing their desire to stick a soft landing. But if inflation remains sticky for longer, that calculus could change, and the probability of a soft landing with it.



Market Comment - April 15, 2024

Global markets have been shaken since my note last Wednesday. Renewed inflation concerns have caused commodities to gain in price, and stock and bond prices to decline. The wars in the Mideast and Ukraine also have investors on edge. For reasons discussed below, the best strategy right now is to maintain our current positions in DJIA- and NASDAQ-linked ETFs, although I will review conditions daily. 

Last Friday (April 12), the Micro MRI, which tracks the short cycles of return and indicates market resilience, was at the 10th percentile of levels since 1918. This is a very low level (note 1) and suggests that the stock market will soon experience a short-term move higher as it reverts toward its long-term mean, indicating greater resilience for the market.

It appears that our physics-based driver of short-term investor emotion has a meaningful relationship to the DJIA for the last several weeks. The figure below shows price of the DJIA (brown line) ending last Friday. It also shows the Physics-Based Driver (purple) and the Micro MRI (green).

The Driver is at a low point this week and can be expected to move higher next week. Because of the way we calculate the driver, we can forecast the Driver several weeks into the future. The next upleg of the Driver is reasonably steep. The figure also shows that at the beginning April, the DJIA (brown) and Micro MRI (green) began to move in tandem with the Driver (purple), which I discuss below. 

A consistent image emerges for the current week: a) the Micro MRI (recently at the 10th percentile), and b) the upswing of the Micro Driver (purple) both indicate that the market is likely to be more resilient soon. Getting out of the market now is not prudent; doing so would miss the anticipated rebound. 

The longer-term MRI (not shown) indicate that staying in the market is appropriate as well. As of last Friday, the Macro MRI is still in the upleg of its cycle and unambiguously so. The Exceptional Macro has been present for several months as well. These are reliable indicators of a positive longer-term trend in the stock market. The algorithms that evaluate the MRI also indicate that staying in the stock market is prudent. 

The path of the Physics-Based Driver has been apparent for some time. In the April 10 blog post:  https://marketresilience.blogspot.com/2024/04/weekly-note-april-10-2024.html, I mention an upcoming test of the stock market’s strength. We are in the middle of that test and, at least so far, it does not appear that the market will get an A+.  Unfortunately, the conditions described above did not allow time to pull our money out of the stock market and then get in before the anticipated rebound. 

Moving in Tandem

Historically, when the DJIA, Micro MRI, and the Physics-Based Driver move in tandem, as apparent in the figure above, it is a warning sign for future market weakness. Generally speaking, when the market follows the Driver, the market will decline when the Driver inevitably moves to the downleg of its cycle, shifting from investor optimism to pessimism.

If tandem movement continues in the current situation, we may see the market move higher in response to the conditions described above and then experience long-term weakness in the May/June timeframe. I will provide additional thoughts later this week.


Note 1 - You may recall from a recent note that the Micro MRI made a trough in mid-March, moved higher for a week or two, and then resumed its downleg April 4. Forming a trough and resuming the downleg of its cycle is not uncommon and is often related to current events. That appears to be the case in this instance. In most historical cases, the best strategy is to ride through the decline, which is what our algorithms are programmed to do.    



Weekly Note - April 10, 2024

Sections in this note:

  • Comment on Performance
  • High Stock Valuations
  • Upcoming Test of Stock Market Strength
  • Historical Precedents Support a Positive Outlook for Stocks
  • Stocks Tend to Hold Value During Extended Inflationary Periods
  • Corporate Earnings are Resuming a Positive Trend

Comment on Performance

The performance of our portfolios has been lower than our target returns. While our losses have not been as great as the alternatives that many investors use, we have not participated in the periodic gains of the stock market. Please be patient through this period. Our strategy is to be aggressive when the market is resilient and to be conservative when the market is vulnerable to declines. Over the last few years, we have been better at avoiding declines than capturing resilience.

In 2023, uncharacteristically ambiguous signals from our key metrics and high stock valuations resulted in portfolios that were more conservative than needed. For investors sensitive to losses, this may have been appropriate. But we will need to be more aggressive to generate our target returns. Our portfolios can be much more aggressive than they are now, and they will be when we have stronger positive signals.

High Stock Valuations

Stock valuations for the DJIA continue to be high, hovering at about the 90th percentile of levels since the late 1990s - a level they have been at for several quarters. As you may recall from prior notes, our recent research indicates that during historical market phases like the current phase, valuations have been significantly higher than in other phases. This observation suggests that we need not be concerned about valuations. However, disregarding higher valuations will be more prudent in a few weeks, as discussed below.  

Upcoming Test of Stock Market Strength

The stock market is coming to a test of its strength and the extent to which it can support currently high valuations. Since late December of last year, the stock market has been supported by two important drivers of resilience: a) the Exceptional Macro Market Resilience Index, which over most of the last 100 years has indicated a strong bull market, and b) a period of naturally-occurring optimism. An important feature of naturally-occurring optimism is that we can forecast how it will change over the coming several weeks, which we cannot do with the MRI. 

While still present, the Exceptional Macro is showing signs of weakening. It is not appropriate to act on this alone because it may strengthen, but it is worth noting, considering the upcoming end of the naturally-occurring optimism. 

The naturally-occurring optimism will start to fade over the next week or two. In that short period of time, we will see the strength of the current bull market and its ability to support high stock valuations without the tailwind of naturally-occurring optimism.

The next period of (long term) naturally-occurring optimism is likely to start in June (roughly). As we move through the weeks from now through May, it will become clearer if it is prudent to shift to a more aggressive model portfolio on page 2 of the weekly pdf. 

We will make the portfolios more conservative if it looks like the market is failing the test. We will make the change outside of the regular trading schedule if needed.

Historical Precedents Support a Positive Long-Term Outlook for Stocks

Historical precedents support a positive outlook for the stock market. Of the last 80+ years, 1989 is the year that has similar market dynamics in terms of both MRI and naturally-occurring shifts in optimism. That year saw strong returns.  If the market follows these precedents, we might expect a gain of over 5% over the next three months.  

That said, the performance of the DJIA over the last three months has been lower than the average of similar periods. This suggests that the market is being weighed down by other factors, one of which may be high valuations. 

Stocks Tend to Hold Value During Extended Inflationary Periods

Stocks tend to hold their value during inflationary periods.  Figure 1 below shows the Consumer Price Index over the last 100+ years in the lower panel.  The steeper the line, the higher the inflation rate.  Periods of high inflation are indicated.  The DJIA (log scale) is in the upper panel. 

Figure 1

Figure 1 shows that during the high-inflation periods the DJIA had flat returns or gains. None of the periods has extended stock market losses.  Major losses occurred after the 1929 stock market crash. During this period, the CPI declined – a period of deflation. 

The point for us today is that stocks tend to be reasonable investments during inflationary periods.  Companies can pass along to consumers the higher prices they incur while doing business.

Corporate Earnings are Resuming a Positive Trend

Corporate earnings are moving higher, which supports the view that companies can maintain earnings growth during inflationary periods.  Figure 2 below shows the price of the DJIA (log scale) and the earnings of companies in the index (log scale) since 1997. “A” indicates when earnings resumed their upward path, despite higher inflation. 

Figure 2

Figure 2 suggests that the recovery in corporate earnings is underway. While consumers dislike inflation, corporate earnings tend to be insulated from its effects. 

The negative impacts of inflation tend to come from the battles to fight inflation.  The Fed increases interest rates to slow economic growth. Slower growth reduces corporate earnings and may lead to economic recession.  As of now, however, the Fed’s focus appears to be on when interest rates should be reduced to encourage growth as opposed to when to increase rates to slow economic growth.  The threat of higher interest rates seems, at least for now, not to be a major threat.