Uncommon Sense

Tomorrow, and Tomorrow, and Tomorrow

“There would have been a time for such a word.
Tomorrow, and tomorrow, and tomorrow,
Creeps in this petty pace from day to day
To the last syllable of recorded time,
And all our yesterdays have lighted fools
The way to dusty death. Out, out, brief candle!
Life’s but a walking shadow, a poor player
That struts and frets his hour upon the stage
And then is heard no more: it is a tale
Told by an idiot, full of sound and fury,
Signifying nothing.”
 
— Macbeth (Act 5, scene 5, lines 17 to 28)

Chief Investment Strategist

This is a tale told by an idiot, alright. More than eight months into the COVID-19 pandemic, and heartwarming stories of heroism and human resiliency continue to flourish. However, there are also daily reminders of the long road ahead and many challenges that must be overcome until the pandemic is defeated. On October 24, the US added 83,718 COVID-19 cases. According to the Johns Hopkins Coronavirus Resource Center, that was the second-highest single-day count after the record 83,757 infections reported on October 23. The US has roughly 8.7 million confirmed cases, with more than 226,000 deaths.

During the final presidential debate on October 22, President Trump claimed, “We are rounding the corner” on the pandemic, while his Democratic opponent, former Vice President Joe Biden, warned that the US is “about to go into a dark winter.” Depending on the day and the status of my legendary moodiness, I find myself inclined to agree with either Trump or Biden on their respective outlook for the pandemic. Regrettably, in an election year defined by ugly discord, the pandemic has become a political hot potato. Look no further than the ongoing fiscal stimulus negotiations. Both Republicans and Democrats agree that more fiscal spending is required to aid in America’s recovery from COVID-19 but, shamefully, the lame excuses and bipartisan nastiness continue unabated. Sadly, the true victims of this fiscal failure are the families and small businesses that are least able to combat the pandemic’s negative health, social and financial hardships. Our elected politicians are supposed to be fighting for them, not fighting against each other.

Fair is Foul, and Foul is Fair

All of this makes my heart and mind ache. Pandemic fatigue has me in its grip. I’ve tried many things to shake myself free — hiking, sampling red wines and, wildly, three times during the pandemic I have completed a 3-day juice cleanse — just to name a few. You know it's bad when I’m daydreaming about ending the country’s two-party system of government and taking up meditation at the same time. The novelty of working from home has long expired for me. Quietly mumbling, I’m bargaining with anyone or anything that can help return things to the way they were.

Put away your world’s smallest violins. Save your crocodile tears. My family and I know that, so far, we have been insulated from the harshest realities of COVID-19. We are blessed, grateful and humbled by our good fortune to date. Yet, I can’t help but pine for a return to normalcy. I keep experimenting with new ways to end the daily monotony. But I remain trapped in a series of never-ending tomorrows, pleading for a return to a more normal environment.

As my hurried mind races from topic to topic, I can’t help but wonder if politicians and policymakers are doing their own bargaining and experimenting, waiting to address these three mad policy outcomes under post-pandemic conditions:

1. Ballooning debt and deficits
2. Generous monetary policy
3. Asset prices that have become disconnected from their fundamentals

The challenge remains that with each new day delivering more of the same, the commitment to change weakens with each passing tomorrow. The path of least resistance remains the easiest path. Alas, tomorrow is always another opportunity to do the right thing. But, will we?

Neither a Borrower nor a Lender Be

Yes, I know this subtitle isn’t from Macbeth; it’s from Hamlet. But it works well for this section. So please cut me some slack, will ya?

The US national debt is now more than $27 trillion. It will surpass the
$30 trillion threshold by the end of 2021. At the turn of the century, the US national debt to GDP ratio was 56%. Today, it’s more than 137%. In early September, the Congressional Budget Office (CBO) projected a federal budget deficit of $3.3 trillion for 2020, more than triple the shortfall recorded in 2019. It’s the largest deficit relative to GDP since 1945. Regardless of November’s election outcome, most observers expect Congress to pass another roughly $2 trillion pandemic relief bill. That will push next year’s federal budget deficit to more than $4 trillion.

Providing families and businesses much-needed assistance during the pandemic is the right thing to do. It’s not a time for the US government to become fiscally frugal. However, profligate borrowing and spending by both Republicans and Democrats during good economic times have long-term consequences that should not be ignored. According to the CBO, the last time the US government had a budget surplus was 2001. Back in May 2018, when both US debt and deficits were much smaller than they are today, the Committee for a Responsible Federal Budget (CRFB) forecast that US GDP would have to grow at an average annual rate of 5.9% for 10 years to balance the budget. The CRFB claims that level of annual growth has only been achieved in a single year once in the past 50 years. Averaging it over 10 years would be impossible. And, with debt and deficits increasing in recent years, the economy would now likely have to grow at an average annual rate of more than 6% over the next 10 years to balance the budget. Ain’t happening.
 

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Modern Monetary Theory (MMT) proponents and other big government spenders suggest that rising debt and widening deficits don’t matter. That the US dollar’s status as the world’s reserve currency and the seemingly insatiable demand for Treasuries enables the US to spend infinitely. I’m here to tell you that they’re wrong. As debt and deficits have increased, US economic trend growth rates have declined. A growing portion of the US government’s budget goes to interest payments on debt and massive entitlement programs (i.e., Social Security, Medicare and Medicaid). This leaves precious little discretionary budget dollars for spending on more productive, pro-growth policies. Unless, of course, the US government borrows even greater amounts by issuing more Treasuries — which is exactly what it has been doing for years.

Not to worry, when the pandemic passes and conditions return to normal there will be plenty of time to address the country’s growing debt and deficit challenges. Or so goes the thinking. Tomorrow will be different. You’ll see. Until then, the vicious cycle continues and the potential problems intensify.

Things Bad Begun Make Strong Themselves by Ill

Enormous piles of debt and yawning deficits aren’t possible without a little help from the Federal Reserve (Fed). The US government needs a sucker, um I mean a buyer, to purchase Treasuries. And, the Fed has obliged by purchasing $80 billion in Treasuries each month. For good measure, the Fed is also buying $40 billion per month in agency mortgage-backed securities (MBS). I was never any good at math, but by my count that’s $120 billion in Fed asset purchases every month. The Fed doesn’t care about price or the issuer’s creditworthiness, and they have let anyone who is willing to listen know that they stand ready to buy even more Treasuries and MBS if needed. Not surprisingly, the Fed’s balance sheet has soared by more than 70% this year to $7.2 trillion as of October 19. Make no mistake about it, the Fed has been complicit in the US government’s debt and deficit dilemma by providing a portion of the funding. In fact, Chairman Powell and other Fed officials have been begging Congress to spend more to address the economic challenges presented by the pandemic.

The Fed’s aggressive monetary policy actions this year aided in the smooth functioning of markets, provided much-needed liquidity and probably saved countless jobs and businesses. Their swift and bold actions should be applauded. Nobody is suggesting that the Fed be stingy with monetary policy today by prematurely tightening financial conditions. It’s all those tomorrows that I’m worried about.

In May 2013, the mere suggestion by then-Fed Chairman Bernanke during an appearance before Congress that the Fed would eventually have to wind down the asset purchase program known as quantitative easing sparked the famous “taper tantrum.” The Fed again tried to do the right thing from 2015 to 2018 by slowly raising interest rates while also reducing the size of its bloated balance sheet as the economy grew steadily, unemployment fell and inflation rose. Ultimately, investors concluded that the Fed had moved too far too fast to tighten monetary policy and markets plummeted in the fourth quarter of 2018. The Fed quickly reversed course, and by the summer of 2019, they were cutting rates again.

Today, the Fed is doing the right thing. Its bold and decisive actions have been instrumental in the economy and market’s remarkable recovery. But tomorrow, when the pandemic has passed and economic conditions are on firmer footing, can the Fed be trusted to do what is required and normalize monetary policy? Based on recent history, I’m not convinced.

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What’s Done Cannot Be Undone

Like a Shakespearean plot twist, just as the US government can’t have soaring debt and deficits without the Fed’s help, asset prices can’t become detached from underlying fundamentals without the extraordinary monetary policy distortions provided by the Fed. They are inextricably connected.

Most of us learned that the intrinsic value of almost any investment asset (i.e., stocks, bonds, real estate, etc.) is simply the present value of the future cash flows discounted at the discount rate. The lower the discount rate, the higher the present value of the future cash flows. Plainly, the lower the rate, the higher the asset’s value. The Fed’s target range for the federal funds rate is 0%-0.25%, and inflation remains mostly absent. You can’t get much lower than zero. So, what’s the value of an investment asset when the discount rate is zero? This has led some market watchers to describe the current environment as the “everything bubble.” The logic suggests that when the discount rate is zero, all risk assets are in a bubble.

This is great news for holders of financial assets. Mergers & acquisitions (M&A), initial public offerings (IPOs) and special purpose acquisition companies (SPACs) are all skyrocketing this year. Private equity and debt assets are at all-time highs. The stock market rallied throughout the summer while the economy and earnings plummeted. Market multiples are elevated and remain notably above historical averages.

It’s not surprising that when asset prices are so disconnected from underlying fundamentals, active managers struggle. No longer understanding the rules of the game, many famed investors have thrown in the towel in recent years.

The discount rate isn’t supposed to be permanently set at near zero. Yet, the Fed expects to keep interest rates near zero for the next few years. Sure, today, that’s a fantastic reason to own risk assets in an investment portfolio. But what about tomorrow? What happens to asset prices when the discount rate is no longer zero?

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I Bear a Charmed Life

Despite the obvious challenges of the COVID-19 pandemic, investors have led a reasonably charmed life this year. And with negative real interest rates, generous monetary and fiscal policies, the remarkable rebound in the economy and corporate earnings, and the inevitable defeat of COVID-19, the good times are expected to continue next year.

However, those feel good vibes are based on today’s investing environment. But what about tomorrow? The stock market is a forward-looking mechanism. Battling pandemic fatigue makes it a struggle to plan for tomorrow. We’ll keep fighting the good fight, working to be a little better than the day before and making promises for when things get back to normal. But for now, the easiest path is the current path. There’s no catalyst to change our behavior during a never-ending series of tomorrows.

The question is whether we will be able to pivot and change our behavior when a new, post-pandemic day dawns. Today, aggressive fiscal and monetary policies are required to aid in America’s ongoing recovery from the pandemic. It’s the right thing to do. However, when this extraordinary period ends and life returns to normal, will politicians and policymakers have the discipline to rein in their programs? Recent history suggests that they won’t. And without policy changes, expect financial asset values to remain disconnected from their prices. Maybe that’s the silver lining in this modern-day Shakespearean tragedy.

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