“The intelligent investor is a realist who sells to optimists and buys from pessimists.”
Benjamin Graham The Intelligent Investor
While 2020 has certainly been full of surprises, at least the traditionally volatile month of September could be counted on! After a very strong August, markets began to price in some risks in September that had been largely ignored throughout the summer. Suddenly the US election entered the market’s consciousness as well as a reluctant acknowledgment that maybe “normal” was further away than we had been lead to believe. In any event, markets stumbled a bit but then found their footing as the third quarter closed off.
I continue to be impressed and somewhat amazed by the willingness of market participants to ignore the economic realities on the ground. I fully expected that we would have experienced much more volatility than we actually did in this last quarter but it seemed that the optimists have outnumbered the pessimists since the March 23rd market bottom. Or more likely, most of us really underappreciated the “wall of liquidity” that markets have been riding.
I keep talking about how “liquidity is winning” and I thought I should quantify that statement. In just the first 4 months of Covid19 taking center stage (from mid-March to mid-July) the Federal Reserve (the US central bank) pushed $2.3 TRILLION into the markets by way of Quantitative Easing bond purchases. Most of the purchases were of US treasury bonds but for the first time ever, the Fed also targeted some corporate bonds for purchases. To put that number into perspective, it was almost 20 times greater and implemented at a much faster pace than what was bought over 18 months during the financial crisis. That is just the US central bank! Concurrently, almost every other significant central bank engaged in monumental Quantitative Easing programs of their own that pushed cash into the markets. And on the fiscal front, each country implemented support programs like the Canadian CERB which sent money to those individuals directly affected by the economic shutdown. In addition, large corporations all the way down to small business owners almost all received government support. Estimates of the support rolled out over the last 6 months are as high as $20 Trillion in total global programs by central banks and governments.
Logically, many are asking how we possibly pay for all of this! In short, we are simply going into debt. But that only works because central banks are stepping up to finance the debt issuance with low interest rates and purchasing of government bonds. Essentially, governments are issuing new debt at historically low rates in order to spend knowing they have central banks willing to “print” money to buy the cheap debt. If central banks were not there to support that debt issuance, the cost of debt would most certainly go up and that would be harder to finance. In the short term, central banks are backstopping the system by using the seemingly unlimited firepower of their balance sheets and printing presses.
Given the pressure on budgets and the resulting deficits, Modern Monetary Theory (MMT) is making the rounds again. This approach postulates that deficits are an erroneous measuring stick and that governments who can borrow in their own currency (like the US) are wrong to try and strive for balanced budgets in the first place. The analogy of a government working like a family household and living within its means by spending only what it brings in is flawed according to MMT. This is because governments control the supply of their currencies and can tax them away and of course households don’t enjoy these benefits.
While Modern Monetary Theory is largely unproven as it has not been adopted as a key tenant of any government or central bank policy, it attempts to make sense of how the world’s economies have been propped up by seemingly unlimited government debt in recent years. It suggests that governments spend to pay for what society needs (like health care, education, defense etc.) and only throttle back spending when inflation shows up. Until the economy operates at full capacity, inflation will not be a limiting factor to create and spend! When inflation becomes an issue, raise taxes to reduce the spending power of corporations and individuals to dampen inflationary pressures. It is a seductive theory but it is predicated on correctly measuring inflation and then having the political backbone to raise taxes when necessary. On a side note, MMT also believes interest rate management can’t go as far as the might of government handouts and taxation. Long time readers know that I am in the camp that governments have every motivation to manage the posted inflation numbers and have been doing so for many years. If this approach successfully moves into the mainstream consciousness, all spending accountability will go out the window. Convenient that MMT is gaining followers at a time when deficits are blowing up!
Given the unlikely adoption of the MMT approach, government spending and deficits do have their limits and when we find those limits, governments will simply have to raise taxes and or cut spending. Both are politically challenging to implement and stay in power. The 3rd option has always been more palatable and that has been to monetize the debt by engineering negative real interest rates (after inflation). The USA adopted this approach after WW2 and the Vietnam wars to get their debt levels back in line with the economy. We have negative real interest rates currently and will have for some time. Debt monetization is already happening and nobody is even trying to deny it!
Bonds yield very little and cash yields almost nothing. We are being told that interest rates are going to stay low for several years and at the same time, central banks are trying their hardest to achieve a 2% inflation rate. This all argues for higher stock market exposure when many investors want less due to COVID19 and the impending US election uncertainties. Not an easy time to allocate capital!
Regarding the upcoming US elections, its seems the markets are convinced that no matter who is occupying the Oval Office next year, more stimulus is on its way. So it is only a matter of timing and scale. If the Democrats sweep Washington, a massive stimulus package including infrastructure is highly likely. Yes Biden will move to roll back Trump corporate tax cuts and possibly raise capital gains taxes and these will be headwinds but the markets seem to think the larger stimulus package will carry the day. And if Trump manages to retain the presidency and the Republicans hold the Senate, a huge package will eventually move forward. So another spending plan will either be massive or just huge.
While Biden is currently enjoying a handsome lead over Trump in the polls, we all remember the last US election and how wrong the pollsters proved they can be. But there is no denying that America is seemingly more divided and entrenched than at any other point in modern times. We can thank social media for much of this polarizing of America. If you have access to Netflix and have not watched it yet, I highly recommend The Social Dilemma which highlights how these platforms keep people entrenched and committed to their views. It reminds me of 2 sayings that are both attributed to Mark Twain. The first being “It is easier to fool people than to convince them that they have been fooled.” And the second being “A lie can travel halfway around the world before the truth can get its shoes on!” Mark Twain would have to be impressed with how our modern advancements have given new meaning to those words.
As always feel free to call anytime!
Derrick Lahey (905) 469-7090