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 (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.

two common market fallacies

market cap/GDP

I was reading an article on Yahoo Finance the other day that cited what it claimed was a Warren Buffett rule to gauge whether the US stock market is under- or overvalued. The idea is that if the total market cap of US stocks exceeds annual GDP (of the US) then stocks are overvalued. If market cap is less than GDP, stocks are undervalued.

On the surface, this sounds like it might make sense, since it is the US stock market, after all. And the health of the Treasury bond market is tied to the vigor of the US economy. Also, the idea was big in the 1980s, when market cap/GDP was used by Americans and Europeans as a rationale for not becoming involved in the Japanese stock market during a decade-long domestic economy boom there.

Two issues this idea ignores:

–multinational companies. In the case of the US, a good guess is that half the earnings of the S&P 500 come from outside the US. In fact, a very simple but effective way of approaching structuring a portfolio in the US market is to ask whether the US economy will likely do better than the rest of the world in the year ahead or worse. In the first case, the portfolio should overweight domestic-oriented stocks; in the second, internationally-oriented.

–how much of the domestic economy is publicly traded. In the case of the US, big sectors like real estate and housing have little representation. Germany, whose market cap has seldom, if ever, exceeded half of the country’s GDP, is the biggest counterexample for the cap/GDP idea. Two reasons: almost nothing is listed in Germany, and German citizens have historically had little interest in stocks.

For the record, I can’t imagine Buffett thinks this.

strong stock market = strong economy

Typically, this is the case, in my experience. But there are exceptions, like Mexico in the 1980s–and Germany almost always. In today’s US, it’s easy to see, by comparing the global NASDAQ with the US-centric Russell 2000, that stocks are strong in spite of weakness in domestically-oriented issues. In fact, somewhat like Mexico back then, the US market is underpinned by the near-zero interest rates made necessary by our extreme economic weakness.

A side note: over the past three months, the R2000 (+22.7%) has held its own with NASDAQ (+24.5%). Both have far outdistanced the S&P 500 (+17.5%). Why the R2000 strength? Three possible reasons (translation: I don’t know): counter-trend rally; the worst of the pandemic is already baked into R2000 prices; anticipation that Trump will not be reelected. My guess is some combination of the first two. I think it’s too early to be trying to figure out the election, although belief in four more years of Trump dysfunction should translate into shorting the dollar and the R2000.

thinking about the US stock market

tactics

There’s a struggle going on in the market between secular growth stocks and business-cycle sensitives. This contest has two parts: valuation and concept.

valuation

If we look at the performance of NASDAQ vs. the Russell 2000 over the past 2 1/2 years, the former has outperformed the latter by an almost unheard of amount for a developed country. Relative valuation alone argues that the R2000 should have its day in the sun.

One would expect balance to be restored by some combination of NASDAQ losing relative ground and R2000 going up. The immense money and fiscal stimulus coming out of Washington suggests the central tendency of stocks will be up, so NASDAQ could conceivably do its part to restore valuation balance by simply standing still.

concept

On the other hand, this performance differential is arguably justified. Thanks to Trump’s epic incompetence, the domestic economy has been increasingly weak–both vs our own history and results in most other places (not the UK) since the effects of the 2017 tax cut have warn off. And the R2000 is much more closely tied to the US than the more global NASDAQ. Every recent rally attempt by the R2000 has petered out in short order–although the one now underway may have more legs than its predecessors.

Then there’s the pandemic. Washington has spent trillions of dollars, correctly so in my view, to prop up a country being ravaged by a deadly disease. Unfortunately for us, with his usual blend of insight and judgment, Trump has armtwisted states like Florida, Texas, Arizona et al into lifting quarantine restrictions much too soon. The result has been that while Canada and the EU have Covid under control and are revving up their economies, we’re seeing the virus flare up again with huge increases in new cases and red-state hospitals and funeral homes overwhelmed. He’s now, in inexplicable fashion, compounding his error by pressuring schools to reopen shortly, amplifying the risk of disease to both students and teachers.

All this implies both that another round of aid from Washington may be necessary to offset Trump’s gaffe and that the domestic economy will be relatively weak for longer than hoped–and longer than any other OECD country. (The financial press has begun to link Trump’s handling of the coronavirus with his disastrous foray into Atlantic City gambling, even though the fact that he’s done this sort of thing before isn’t a great explanation for why he should be doing it again.)

Other worries: the national debt is now higher as a percentage of GDP than it was at the end of WWII, and the budget deficit is already approaching $4 trillion.

Concept, then, argues that investors should continue to do what they’ve been doing for the past couple of years–stay as far away from the domestic economy as possible.

strategy: i.e., what happens next?

I think we muddle along for a while. But the two big questions that I see eventually coming to the forefront of the market’s consciousness are:

–in November, will the US reelect a white racist economic illiterate who has crushed GDP growth, who’s a fanboy of corrupt dictators, who seems to revel in the suffering of others and who appears to be unraveling mentally before our eyes? It says something about the parlous state of domestic politics that the answer is not clear.

–how/when/at what cost does the country begin to clean up the gigantic mess Trump, his administration and his enablers in Congress have created?

musings (iii)–the presidential election

If the US is to retain a leading position in world commerce today we need better infrastructure, better schools and the ability to harness the efforts of all Americans in support of economic growth. Washington has fallen down badly on all three fronts for a very long time. Discontent with the status quo has resulted in the election of Donald Trump as president, as I see it, on the idea that things couldn’t be worse.

Whoops!

Though a Barnum-like showman, Trump is, unfortunately, a popular former reality show host but not much else. He’s an incompetent businessman and a white racist who appears to relish the suffering of others. His economic “vision” is for a return to the TV sitcom world of the 1960s, to be achieved by creating a Depression-era tariff wall that will prevent better-made or cheaper products from reaching the US.

In my view, this is suicidally crazy. As far as I can tell, mine is the consensus view in the rest of the world, which is appalled by the severe turn for the worse in the US. Even now, though, my sense is that Americans in general have been surprisingly complacent the damage Trump is doing.

So far, the stock market reaction has been to shun stocks tied closely to the US economy and bid up shares of companies with global franchises or with intellectual property that could just as easily be held in, say, Canada. Over the past month or so, foreign stocks have also begun to outpace US equities for the first time in years.

What if Trump is reelected?

Let’s ignore the messy possibility the Financial Times, for one, is now beginning to discuss–that Trump will “steal” a close election, again losing the popular vote, in a contest marred by voter suppression in red states. Without that complication, the results of a Trump victory would be pretty straightforward.

First and foremost, it would be read worldwide as a national endorsement of his loony-tunes economics, as well as his racism, sadism and eagerness to use the military to violently suppress civil dissent. Not a pretty picture.

The current trend toward stocks with substantial non-US businesses, innovative technology and/or the ability to transfer operations elsewhere would likely continue. Presumably, we’d also begin to see downward pressure on the dollar for both economic and ethical reasons, as fixed income investors as well as equity holders sought to reduce their US exposure.

US brands would likely begin to lose their aspirational appeal, if they have not already. Tourism, both to the US and to US-operated attractions, would wane, even if the coronavirus is brought under control. Global businesses would feel pressure from customers and from employees to relocate. The working population of the US would begin to shrink, as a result and as 1930s Germany became a more plausible analogue for the US. Even Japan might start to look good.

US self-destructive impulses would also open the door wide to China to supplant the US as a cultural and economic world leader. At the very least, capital and portfolio investment diverted from the US would have to find a home somewhere.

more on Monday