With the U.S. election less than a month away, we have truly entered the crazy season of U.S. politics. COVID-19 in the White House, the President on cocktails of experimental drugs, stimulus package on again, off again, no on again, all against a backdrop of growing second waves of the virus across much of the world. Millions of jobs lost, millions working from home, schools opening and closing, lineups for COVID-19 tests and markets flirting with all-time highs. Welcome to the crazy train.
The election: crazy train
The potential outcomes, polls and probabilities of the upcoming election are well understood and will be the topic that dominates news cycle throughout October. The good news is it will all be over, and the uncertainty gone, on November 3, and we can get back to focusing on the economic and market outlooks into 2021. Or can we?
From a market perspective I’d make two comments regarding the election: First, whoever wins is less important than the risk of a contested election with no clear winner. That uncertainty remains the biggest risk to markets in the coming month. Much of the most recent market rally can be attributed to the fact that, through the month of September and particularly following the first debate, the Trump campaign lost substantial ground in polls in key battleground states. As the prospects of a clear Democrat win rose, the risk of a contested result declined. Second, unlike 2016, both candidates are known quantities. Markets can and will adjust to the expected platforms under either candidate, as that uncertainty disappears the moment the winner is clear. For markets, and to minimize any expected violence, let’s hope we wake up to a clear outcome on November 4.
The economy: The recession is still young
Economic fundamentals in many areas remain challenged, buffeted by two tectonic forces, one the ongoing economic reopening and recalling of temporarily laid off workers where a little over half have returned to work, and a smaller more precarious trend of temporary layoffs becoming permanent as many businesses are forced to shut down or restructure. How these play into the long-term economic outlook will depend on two key variables; the path of the virus and the economic policy responses.
The virus: the end of the world as we knew it, part one
The path remains uncertain with a clear second wave unfolding in many jurisdictions. Our belief remains that the virus will be around for a long time and the question is not when it goes away, but rather how we learn to live with and manage the risk. Critical to managing the virus is ongoing improvements in testing and tracing, progress in developing treatments to reduce the severity, followed ultimately by vaccines. While we are not there yet, we expect significant advances through 2021 that will enable further normalization of economies, including those sectors most impacted such as leisure and travel.
Policy response: monetary policy, the end of the world as we knew it, part two
With the economy still in deep recession, coronavirus cases on the rise and over 25 million Americans on some form of financial support, monetary and fiscal support remain essential to bridging economies through the crisis. It is way too soon for stimulus withdrawal. Within the policy space, monetary policy is effectively “all in.” Not to say they cannot do more. They can, and they will. The dramatic shift in the policy framework unveiled at Jackson Hole in August has closed the door on 40 years of inflation fighting and launched the Federal Reserve headlong into a deflation-fighting framework. This is financial repression; it’s complex but is a gamechanger. In short, interest rates stay at zero for years while quantitative easing (QE) and forward guidance become the tools of choice. The role of the Federal Reserve and QE becomes twofold; first, ensure market stability and function, and second, finance any government deficits that come your way. Buckle up, the real risk free rate of return will be negative for as far as the eye can see.
Policy response: fiscal policy, the end of the world as we knew it, part three
With monetary policy all in, the baton passes to fiscal policy as the primary framework for economic management. Currently, the U.S. is running off the embers of the nearly $3 trillion in stimulus launched earlier, but those programs continue to expire while political partisanship prevents the passing of further fiscal support ahead of the election. Signs of sluggishness are emerging, and we will test how far the past stimulus can continue to keep the economy moving forward. Ultimately, possibly before the election but more likely after and potentially not till next year, there will be another stimulus bill. It’s a question of when and what, not if. In the past decade, markets and economies became addicted to monetary support such that it could not be fully withdrawn. In the coming decade we expect economies to become reliant on enhanced levels of fiscal support and central banks to be captured into funding the fiscal impulse. Stimulus will not remain at current crisis levels, nor should it, but it will be structurally higher than what was considered ”normal” over recent decades.
With soaring deficits driving debt to gross domestic product (debt/GDP) levels toward 100% and beyond in most developed countries, the debate around debt sustainability and the need for fiscal prudence vs. the advocates of greater spending and proponents of modern monetary theory type policies are ramping. Get used to it, as I believe this will be the at the core of the economic policy debate for the next decade. From an investment perspective, the focus should not be on what you believe is the right approach, but rather should be on trying to understand what policies will be applied and what the market implications are for your portfolio.
Some observations related to the fiscal/modern monetary theory debate
First: it is fiendishly complex and, simply put, we do not know how the interaction of deficits, debt, economic growth, inflation and inequality will play out. What we do know is that most everything we thought we knew about monetary economics and inflation has been wrong for the past thirty years in Japan and for a decade plus in the U.S. and Europe.
Second: As mentioned above, with interest rates already at zero, the efficacy of monetary policy to drive economic outcomes is reduced and we will require greater fiscal stimulus to boost aggregate demand back toward potential.
Third: The biggest problem with fiscal policy is its dependence on politicians to make the spending and tax decisions. What and how you spend on fiscal stimulus will matter a lot. The only way fiscal stimulus can pay for itself is if it’s focused on increasing economic growth potential and not just on increasing consumption.
Fourth: Following the initial policy support in the wake of the 2008 crisis, we spent a decade pursuing loose monetary policy with tight fiscal policy and fiscal austerity. It didn’t work. The outcome was a decade of sluggish growth, rising government debt, exploding economic inequality and the most divisive social backdrop in our lifetimes. I do not believe our societies will survive another decade of the same policy approach. Knowing what does not work does not answer the question of what will work, but trying the same approach over, and expecting a different result, is one definition of insanity. We need to find a different path forward if we want any hope of seeing an easing of the explosive social economic trends currently unfolding across western society.
Fifth: Beyond default, there is only one way to manage the current debt burden. You have to grow your way out, as was done after World War II, the last time debt/GDP reached such extremes. To do so you need some inflation to boost nominal growth, and you need to keep interest rates below the rate of inflation, i.e. financial repression, as you attempt to shrink the debt/GDP ratio back to a sustainable level, as was also done post World War II.
Sixth: Government debt sustainability is really easy when you pay zero interest and the central bank buys (indirectly) the debt. The problem arises when rates do ultimately increase, or your currency depreciates, so there is a limited runway to pursuing such an approach. But given Japan is already approaching 250% debt/GDP, let’s acknowledge we do not know just how long, or short, that runway might be.
Seventh: Growth from fiscal stimulus along with rate suppression from central banks is a potentially benign path forward. But it is also an absolute tax on savers as it seeks to transfer wealth from savers (you) to debtors (government). Investors must be aware and adjust portfolios accordingly. Many investment strategies that worked over the past four decades when real and nominal interest rates were positive, and initially at historically high levels, simply cannot and will not work in the coming decade. There are no ”safe” investments that will yield a positive real rate of return in the absence of an unlikely deflationary bust. Investors, particularly those saving for, near to, or in retirement must work with their advisors to find an appropriate approach for them in what will remain one of the most volatile and challenging investment backdrops in decades.
Investment implication: three easy rules
Rule one: be active.
We expect the coming years to remain volatile. With rates at zero, there is no safe harbour in which to sit out the storm and collect a positive return. Investors need to shift their mind set to embracing and actively managing risk and volatility, not avoiding it. It will require partnering with teams, such as Signature Global Asset Management, who have the breadth, depth and culture of being active managers in terms of asset allocation, sector allocation, security selection and risk management. We bring the strength of a 50+ person team of global asset class specialists to managing clients’ money with a view to protecting capital and delivering reasonable returns through the cycle.
Rule two: If you need income, buy income-producing assets.
Sounds so simple, but when interest rates are zero, the traditional sources of income, government bonds, GICs and savings accounts no longer pay a rate of return above inflation. Instead of risk-free return, they offer investors return-free risk. New thinking is required. There are several asset classes that do pay income, from corporate bonds and various other credit instruments such as mortgages, to income-producing real assets such as real estate and infrastructure to stable dividend-paying equities. I believe most investors will have to turn to equities for more of their income needs going forward, and while they will come with more volatility, they also offer the potential of better inflation protection through growing cash flows and dividends over time, a factor that will be critical in protecting portfolios should central banks succeed in getting onto a more sustainable inflation trajectory.
Rule three: If you need growth, invest in structural growth industries and companies.
The coming year and decade will continue to be a time of accelerating change and disruption across economies, businesses, geopolitics, domestic policy making and society. Wherever you look there are clear signs that the world we will emerge into post-pandemic will be very different from the one we are leaving behind. One could argue this has been building since the last crisis in 2008. Whatever lens you choose to view the world around you, signs of significant change are evident and in many areas the pandemic has served as an accelerant to already unfolding trends.
While books could and are being written on many of these changes, I want to make two broad observations. First, accelerating change and disruption can be very unnerving, it is all too easy to focus on the very real negative aspects. But there are also positive dimensions. While there are clearly identified losers amongst disrupted industries, there are also tremendous opportunities to invest with the disruptors whom are often building entirely new industries and ways of doing things. There are winners and losers in disruption and from an investment perspective I want to find and invest in the winners, both emerging and existing, while sidestepping those in terminal decline, or those that cannot or choose not to adapt to new realities. Technology, digital disruption, health care and biotechnology, longevity, sustainability, and the China consumer are just a few broad areas of significant structural growth we are investing in.
In conclusion, we remain invested in our portfolios We retain a near maximum underweight in government bonds and have recently shifted to a slight overweight in equities. We expect the combination of easy monetary and easy fiscal policy will support economies and markets as they continue to emerge from the COVID-19 crisis through 2021. Spring is coming!