(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.
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