Policy Dynamics and Their Impact on the Economy
Clients of the Firm,
Fall has arrived and with it a shift in the winds of politics has grabbed most headlines. Markets have been swayed by every breaking news event, ranging from whistleblowers and impeachment inquiries, to China trade talks and candidate health issues. Certainly, there is no lack of news cycle to move markets.
Rather than focus on these short-term headline risks, this letter will focus on the coming shift in money management dynamics driven by three important macro policy issues. These issues are: the future capacity of central banks to influence markets and asset prices, the need for fiscal stimulus to offset it (the funding of which may attempt to re-balance the wealth gap) and the negative drag of global protectionism and consequent currency war. The resultant policy implications are uncertain and long-tailed, but merit examination as we plan for future investments, asset allocations and risk management.
Central Bank Limitations on Stimulus
Since 2008, central banks have played an essential role in supporting global economic growth. This action was accomplished through lowering interest rates (in some cases below zero) and buying assets to ensure borrowing costs for companies, sovereigns and individuals remained at extremely low levels. In turn, this re-leveraging of the global economy after the financial crisis of 2008-2009 resulted in inflation of prices across most investable asset classes. The most obvious examples are in stocks and bonds, but this price inflation is also evident in commercial and residential real estate in some markets.
The Federal Reserve attempted to exit this stimulative paradigm by raising interest rates and reversing asset purchases, instead pursuing a policy of balance sheet reduction or quantitative tightening. Approximately one year ago, the market balked at this exit strategy sending junk bond yields higher and stock prices 20% lower in the 4th quarter of 2018. Subsequently, the Fed reversed course and began cutting interest rates against the backdrop of heightened trade war concerns and a weakening global economy in both Europe and Asia. Stopping short of publicly admitting a mistake in policy, the Fed’s action seems to indicate they feel they went too far too fast on tightening monetary policy.
This Fed policy change is bad for yield seekers in fixed-income, while good for prices of bonds. Initially, it has been supportive of equity prices albeit with increased volatility. That said, with rates at negative yields on trillions of dollars worth of global assets, central banks are reaching the limits of their ability to intervene in asset markets and economies with monetary policy. Perhaps the biggest resultant risk emerging is the potential for central banks to lose control of the price stability and to have risk reprice the bond market and with it all other relative risk in every asset class. Investors are forced to question whether or not Europe has already reached a point of diminishing impact where future cuts mat not result in intended stimulus. Indeed, the negative yield experiment in Europe and Japan may be failing with the unintended consequences of moral hazard and weakened banks.
Fiscal Stimulus Implications
This daunting picture can be partially mitigated with fiscal stimulus from the global superpowers. The U.S., Japan Germany and China have the ability to introduce fiscal stimulus programs on infrastructure, clean energy and network spending among other programs. These programs would have to be funded by either a reduction in the wealth gap (through tax increases), through deficit spending (increasing debt) or printing money (creating inflation through the money supply). Each one of these solutions on the fiscal side has implications for different constituencies and negative and positive consequences depending upon which side of the political general ledger one sits. There are puts and takes with each policy approach and none of these are mutually exclusive.
Current U.S. policy is supply-side in nature, funded by increasing debt. The idea is that current spending through deficit spending and tax cuts will increase overall GDP and consequently increase tax receipts in out years as a result. Through “trickle down” economics, the velocity of money increases and essentially a rising tide floats all boats. While U.S. GDP has grown between 2-3% over the past two years, recent data is showing modest slowing domestically, calling into question whether or not this policy will have the long-term impact intended.
Competing policy from Democratic candidates calls for an increase in taxes to fund fiscal stimulus. Their plans include reversing recent tax cuts and adding additional wealth, investment and income taxes on high earners. These tax increases would ostensibly fund either an enhanced ACA health care plan or Medicare for all, subsidies for college education and debt, infrastructure and other social priorities. Again, puts and takes. Wealthy and high income individuals and corporations would subsidize entitlement programs for everyone. These competing economic ideologies form the basis of a major part of the political dialogue, not just in the U.S., but globally as well.
Deficit spending cannot continue indefinitely without either creating default risk or inflation. In the first case, countries issue so much debt that they can’t repay it and investors are forced to fund (through losses) the difference between what they can afford and what the initial debt amount was. Alternatively, countries print more currency in order to pay off borrowers and in the process create significant inflation as the money is worth less and less as supply increases. The former scenario lays the burden on financial investors with the subsequent economic fallout to all. The latter outcome lays the burden on all simultaneously. Neither outcome is good for markets.
Income and wealth tax increases lay the burden on those people and entities that make or have made money. This can have a negative “trickle down “ impact as people spend less money due to the higher taxes. This reduces the amount of goods and services they consume from lower income lower wealth households. Severe tax increases clearly have a larger impact on this effect. Consumption taxes such as a VAT (value-added tax) could hold some promise, but are often criticized for having a disproportionate impact on the poor, essentially inflating prices through taxation rather than money printing.
Protectionism and Global Currency Wars
America embarked upon a protectionist trade policy from the day of President Trump’s inauguration, waging a trade war with both China and Europe and using punitive tariffs as a mechanism to try to bring trade balance to our bi-lateral trade relationships. The impacts have been profound so far. In the U.S. , farmers have been hurt the most because of retaliatory measures (less spending) by the Chinese on soy and other products. In China, supply chains are being disrupted as either tariff costs are partially absorbed by Chinese suppliers or U.S. sellers are moving supply chains to other countries such as Vietnam. Countries have been trying to deal with this issue by attempting to negotiate with the U.S. in bi-lateral trade discussions. Major trading partners, Mexico and Canada, have reached a trade agreement with the U.S. (the still to be ratified USMCA). In addition, Japan and South Korea have reached limited agreements.
A second response to tariffs has been de-valuing currencies in order to effectively compete. The way this works is a country reduces the value of its currency by printing more money or intervening in funding markets. The goal is to reduce the currency enough so that it offsets the impact of tariffs. This brings domestic good prices more in-line with no tariff competition. Of course, this has a domestic inflationary impact as previously discussed and lays the pain at the feet of consumers. This then slows the domestic economies of de-valuing countries and is generally only useful as a temporary measure while trade negotiations proceed.
This risk of a no-deal trade war is that global growth slows precipitously and ends up impacting the country that started the trade war it hoped to win. In the U.S., we are starting to see the signs of a slowing global economy in the form of negative US manufacturing and services numbers, which are being further impacted by the trade war.. A prompt resolution to the trade war with China (less likely) or at least a truce in escalation may be enough to improve sentiment. To be clear, some damage has already been done and there will likely be a persistent economic drag as a result. In other words, growth would be better without the tariff and trade dispute overhang, particularly with China.
Consequences of Policy
The consequences of the policies covered in this letter are disparate, creating uncertainty in outcomes. Markets generally dislike uncertainty and thus volatility can be expected as these very important policy decisions play out over the coming months and years. As a money manager, it is our job to both understand the risks of policy and to develop the coping strategies to deal with them as they emerge. These strategies go to the heart of asset allocation decision making, risk management and thoughtful investment selection. Valuation decisions are made in this context both from a sentiment risk perspective as well as a quantitative risk assessment relative to risk-free assets. We believe combining policy expertise with fundamental and risk analysis tends to lead to the best outcomes in uncertain times. As always, we welcome your comments and questions as we navigate the road forward together.
Peter C. Wernau
CEO, Wernau Asset Management
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