thinking back to 1968

My first duty station in the Army was Fort Carson, in Colorado Springs, CO. On my first day, an old sergeant took me under his wing (he must have been 28 or 30). Of the many things he told me back then I remember the most vividly how proud he was to be an infantryman–because, he said, the Army was the only place in America where a man of color like himself would be judged by his skills rather than by the color of his skin.

He’d be long since retired by now, assuming he survived fighting America’s wars. I can only imagine how appalled and betrayed he would feel to see that our commander-in-chief is centering his reelection campaign on white racism.

I think Doc Rivers sums it up:

the Fed’s new inflation stance

Fed Chair Powell, speaking virtually at what would otherwise be the annual monetary policy conference in Jackson Hole, Wyoming, set out a new protocol yesterday for what the Fed would do if the US ever had inflation (a sustained period in which prices in general rise) again.

The old policy was to begin to choke back economic growth by raising interest rates once price increases started to roll, with the objective of holding inflation at or below a 2% annual rate. The new policy is basically to not be so eager, but rather to sit back for a while and see what happens.

Why the change? What does it mean?

some context first

The late 1970s was a baaad time for the US economy. Politicians had successfully arm-twisted the Fed into running an extra-loose money policy for most of that decade. This ended up creating runaway inflation, an economy-killing disease thought to only be found in the worst third-world countries (and Weimar Germany, of course). Prices were rising at close to an 8% clip in 1978, with 11% in prospect for 1979 and progressively bigger figures after than.

Families began to turn their paper money into physical things as fast as they could so that inflation wouldn’t eat into value. They accumulated large inventories of everyday items, on the idea that they’d only be more expensive later on. This hoarding itself drove prices up more. Companies began to borrow heavily, thinking they’d make money just by repaying fixed-rate loans in inflation-diluted dollars. They used the funds to acquire hard assets–real estate developments or gold mines or cement plants or ships–that had absolutely nothing to do with their core businesses but which they told themselves would be inflation-proof and maybe even rise in value.

To shatter the belief in ever-rising prices, and the loony-tunes behavior it sparked, Paul Volcker raised the fed funds rate to 20% in early 1980 and kept it ultra-high until mid-1981, causing a deep recession. This also made prices fall, breaking the inflationary spiral that had developed in the late 1970s. This left families trying to figure out what to do with eight years’ worth of canned goods and corporate boards stewing about their brand-new gold mines–just as the gold price began a fourteen-year swoon.

a 2% target

As inflation and nominal interest rates both continued to decline for decades (the 10-year Treasury yieldid about 5.7% in 1999), theoretical economists began to discuss what the ideal inflation rate might be. They arrived at 2% as their ultimate goal. The Fed decided to see if it could accomplish this with the real economy.

And it succeeded. Some years ago, however, it and other national central banks began to realize that while they’d done a bang-up job getting interest rates down, they had somehow lost the ability to get them, even temporarily, to move in the other direction. What was once an aspirational downside goal had suddenly become an unattainable ceiling.

How so? Who knows. The result is that the world has been constantly been flirting with deflation–the bane of the Great Depression of the 1930s. Whoops.

back to Powell’s statement

I think he’s saying two things:

–given the gigantic amount of government debt run up by Trump administration bungling and its questionable decision to fund the lion’s share in very short-term instruments (which disguises the extent of the damage but puts the country at risk should rates begin to rise), he is not about to create a new crisis by prematurely raising short rates

–given that monetary theory has trapped us in a place where traditional policy tools don’t work so well, Powell would like to see us well above the 2% line before he begins to tighten

Yields went up by a mere 0.05% on the announcement, meaning Wall Street had been assuming the Fed would remain an island of calm in a sea of administration economic madness.

end game (iii): if Biden wins…

As I mentioned earlier in the week, the investment implications of a Trump reelection are straightforward. As an American, I’d be deeply shocked and disappointed by the implied repudiation of traditional American values. As an investor, I’d expect a continuation of the “flight capital” market we have been in for some time, with a return of the domestic economy-centric Russell 2000 names to the bear market they had been in for most of Trump’s time in office, until late March of this year.

I find the stock market consequences of a Biden victory much harder to handicap. My thoughts so far:

–the transition of power might not be smooth. Trump has already declined to say he will accept the election result if he loses. He has begun to disrupt mail service on the, perhaps mistaken, idea that this will suppress more votes for Biden than for him. More “dirty tricks” may be in the offing. He may also end up testing the limits of the law by pardoning himself for any crimes he may have committed before or while in office.

Worries about abuse of power may have some negative effect on stocks around election time. It’s equally possible, though, that, sensing defeat, traditional Republicans will distance themselves from Trump in advance (as some seem to me to be already doing this), signalling that party loyalists should no longer follow Trump, thereby minimizing the damage he might otherwise do. It’s hard to know, but it says volumes about Trump that musing about what amounts to a post-election coup attempt doesn’t sound totally crazy. Can we be even remotely similar to Moscow 1991?

–interest rates will likely remain low for a long time. This is a distinct plus for stocks, for three reasons: they will remain attractive vs. the two other liquid asset classes, cash and bonds; bonds are unlikely to fall in price because of rising short-term interest rates, a development that would lead investors of all stripes to rebalance away from stocks; and the cost of carrying the mammoth amount of debt run up under Trump–with more possibly needed to repair damage he has done–will remain low. In fact, as I’m writing this, there are reports that the Fed will soon announce its intention to retain near-zero interest rates for the next half-decade

–income taxes will certainly go up, both for wealthy individuals (this doesn’t matter so much for the economy as a whole because the rich don’t tend to change their spending very much as income goes up and down) and for corporations. This latter means the 50% or so of S&P earnings that come from US operations will fall by, let’s say 8%. The resulting 4% drop in overall earnings is not good, but it comes closer to being a rounding error in analysts’ estimates than a serious shortfall. In today’s volatile stock trading, it amounts to maybe two or three down sessions in a row

–on the other hand, there’s lots of low-hanging economic fruit begging to be picked. The Trump economic program is a hodge-podge of wackiness, whose effect has been to please rich donors but to retard overall GDP growth, not foster it. Closing the borders to immigration, for example, shrinks GDP expansion by more than a third. Placing tariffs on imports has squeezed real incomes; retaliation has decimated the revenues of exporters, especially farmers. Trump’s central concept–restore low-wage manual labor jobs to the US while driving computer and engineering firms out of the country because they employ non-white foreigners–is about as loony as it gets. So too encouraging Detroit to keep on making gas-guzzlers while the rest of the world turns electric. Hard to quantify, but just ending insane programs has got to be good

–there are thornier issues to face, as well. Trump left actual tax reform both out of the name and the provisions of the Tax Cuts and Jobs Act of 2017, which did nothing to address sweetheart industry tax breaks that have long since passed their sell-by date. National infrastructure is four years older and creakier without having been touched …nor have Social Security or Medicare problems been addressed

–then there’s other senseless Trumpish stuff, like the ultra-strange attack on the viability of major domestic research universities, a national treasure, by denying deep-walleted foreigners access to them. The point is there are enough shoot-yourself-in-the-foot Trump things to just stop doing, for the resulting positives to dwarf the losses from a higher corporate tax rate and reversal of the tax giveaway to the rich.

my preliminary conclusion

Delegitimize white racists and let foreign workers back in and the country will be on the road to economic expansion again. No more crazy gains like in 2020 so far, but a shot at +10%. Maybe all the running next year will be in domestic consumer names.

end game (ii): Keynes, Kondratiev and Schumpeter

The nineteenth century in Europe ushered in a deep change in the metaphor used to explain how the world works. The earlier (Enlightenment) view was that the universe was like a magnificent watch, made in the dim past and kept running by God, the ultimate craftsman. What you see is what you get.

By 1820, the metaphor was already moving quickly from mechanical to biological–evolution; conflict, sometimes violent, driving the process; the unconscious nature of much of what happens, both on an individual and a social level.

Yes, more stuff changes in the 20th century, but what’s important for us as investors is that these are creative fictions created to explain the world of 200 years ago continue to live in economic theory.

cast of characters

The nineteenth-century thoughts enter 20th century economics in a number of ways:

–Nikolai Kondratiev (1892 – 1938). His take on Hegel, formulated in the 1920s, was that the western world follows a 40- 60-year economic cycle. The first half exhibits robust growth. That’s followed, however, by a secular decline and, at least in the version I learned as a young analyst, the destruction of existing production apparatus through world war. Rebuilding from the rubble would start a new long cycle in motion. Some Kondratiev theorists also suggest there’s also a “super” Kondratiev cycle lasting a century+, the high point of which was reached in rebuilding from WWII. (In other words, my whole life would be on the downslope. Very depressing)

–Joseph Schumpeter (1883 – 1950). His version of Hegel is “creative destruction.” In his view, entrepreneurs ultimately use loose credit as a way of continually expanding their businesses to the point where supply of goods/services completely outstrips demand. This causes severe recession–a mini-Kondratiev experience. But like a phoenix rising from the ashes, a new upcycle emerges from the destruction of the old.

In both these cases–as with Marx–the precondition of the new cycle starting is the utter collapse of the old. Recessions are bad, but the cleansing they do is important for progress to happen.

–John Maynard Keynes (1883-1946). Keynes’ interest was more practical, and perhaps more modest, than his Continental contemporaries’. His main focus was on the Great Depression of the 1930s and how to prevent a recurrence. In other words, his intent was to use monetary and fiscal policy to forestall the economic peaks and valleys that the others thought was the inevitable price to be paid for evolutionary progress.

relevance for today’s stock market

A preliminary point: Trump’s incompetence in office, both before the pandemic (his tariff and immigration policies had reduced real GDP growth from 2%-ish when he took office to near zero), and especially during it, is the main reason the US is in so much worse economic shape than other OECD countries. Getting him out of office would seem to me to be the #1 economic goal for the country.

The nearer-term question is whether Washington should go all in with fiscal support to blunt the negative effect of the pandemic on the domestic economy. Here’s where the clash of economic theories comes in (as well as another Trump blunder).

Conventional economics, represented by Keynes, argues that stopping the economic bleeding is the top priority. Among Trump’s financial backers, especially on Wall Street, however, Kondratiev/Shumpeter seems to me to be the prevailing view. I think the idea that greater destruction now will lead to better growth later is why the Senate is balking at providing further financial support.

What complicates the issue somewhat is Trump’s income tax “reform” enacted in 2017. That bill did a good thing by reducing the highest corporate tax rate from 35% (highest in the world) to 21%–something that was necessary to stem the flood of US companies fleeing to lower tax-rate regimes. But it did harm by failing to offset that loss by eliminating special interest tax breaks, and it lowered personal income taxes for the ultra-wealthy. The result was a $1 trillion federal deficit expected for this year, pre-pandemic. As things stand now, the deficit will likely hit $4 trillion.

Under Trump, the national debt has already increased by almost $7 trillion, to around $27 trillion, making the US one of the most indebted countries in the world. At some point, creditors will begin to worry that the country will not be able to repay. In the signature fashion that led to his companies’ multiple bankruptcies, Trump made this situation worse by suggesting the US is willing to default on debt held by foreigners. Typically, worry shows itself first of all in currency weakness of the type the dollar has seen over the past few months.

my take

First of all, you should realize I’m really out of my comfort zone with the politics here. For what it’s worth, though, I think the Kondratiev/Schumpeter crowd believes that withholding government help and letting people fend for themselves is conceptually the right move. This group seems to have the ear of Senate Republicans. The fact that their personal wealth will suffer most severely from currency weakness probably colors their thinking as well. Trump says he’s in favor of more government aid and could probably persuade Republican senators to change their minds. But he chooses not to.

So we’re kind of in no man’s land. I think this means that we’ll remain in the current “capital flight” stock market, no matter how long in the tooth it appears, for a while yet.

thinking out the end game (i)

The Trump presidency has been an almost incomprehensibly huge disaster so far, both in terms of core American values and the operation of the economy–even before Trump’s worst-in-the-world handling of the pandemic.

Looking solely at narrowly economic factors, real GDP had flatlined, pre-COVID, as a result of his senseless tariff and immigration policies (I’m not necssarily anti-tariff, but at least try to have an objective and think out possible consequences–like destroying US agricultural exports to Asia–before putting them in place). On a longer view, he’s continuously undermining global faith in the dollar and the American banking system, as well as sowing the seeds for Shanghai to replace Wall Street as the world’s stock market capital. This will “hurt” China by speeding its ascent to world economic leadership.

In vintage Trump fashion, those damaged most badly by him have been his supporters.

In addition, Trump’s cognitive fastball, never of more than sandlot quality, seems to me to have regressed over the past year or so to somewhere south of mid-level Little League and slightly north of tee ball.

Despite all this, and in spite of his deeply anti-American cultural values, he may still be reelected.

As a citizen, this is not the outcome I want. As an investor, however, the implications are more straightforward. As I see it, initially:

–the Fed would continue to compensate for Trump’s bungling by running extra-stimulative money policy. In fact, the Fed has just signaled that it would be willing to let inflation run for a considerable while (we should be so lucky) to make up for the damage done by years of price level stagnation

–voter endorsement of Trump’s racism would reduce the attractiveness of American consumer brands in foreign markets; we could no longer say we didn’t know what he stands for

–ultra-low interest rates will underwrite continuing stock market strength

–the pattern of strong performance of stocks with the least connection to domestic GDP and deeply sub-par performance from those with the greatest GDP ties, would continue–as domestic capital continues to flee his incompetence and racism

–technology companies will maintain their Wall Street listings but would begin to shift their highest value-added operations to other countries, if for no other reason than to be able to hire based on talent. If Trump’s current attack on domestic research universities continues, this move could be surprisingly swift. The only plus here is that Xi’s attack on Hong Kong removes the SAR, the obvious non-US destination, from consideration for dual listings by US firms. Singapore?

–investment in cutting edge plant and equipment in the US by multinationals would likely decline.

The stock market I’ve been using as a very rough template for the US today is Mexico in the 1980s. A second aspect of this model, something that would have been unthinkable a few years ago, is the eventual loss of faith in the local government. This shows itself in a number of types of financial behavior: the “capital flight” character of the stock market that we’re now seeing in the US; a deteriorating currency; and eventually, capital controls imposed to prevent citizens/residents from shifting assets out of the country. We’re not there yet. Signs for worry: accelerating trade/current account deficits, national debt so large that potential buyers no longer believe they’ll be repaid in full.