We celebrate entering spring hopeful that COVID’s worst blows are behind us, with renewed optimism from the fruits of fiscal and monetary support, and progress toward reaching herd immunity. As vaccination programs continue to accelerate and restrictions on business activity and movement abate, we anticipate a surge of economic activity from pent-up demand and a desire to return to some semblance of normalcy. In March, Congress passed a third stimulus bill, the $1.9 Trillion American Rescue Plan Act of 2021, which we anticipate will provide further tailwind for markets and the economy.
Equities fared well for the first quarter of 2021, with nearly all major global indices returning positive results. Among the large cap U.S. market, value stocks (Russell 1000 Value Index) shined, trouncing growth stocks (Russell 1000 Growth Index). This leadership was driven, in part, by dampening investor enthusiasm for “stay at home” stocks and upward trends in interest rates spurring a rotation favoring certain value names. Small cap stocks (Russell 2000 Index) extended their recent lead over large company stocks (S&P 500 Index), and real estate (Dow Jones U.S. Select REIT Index) exhibited an impressive rebound after a disappointing 2020. Abroad, developed (MSCI EAFE Index) and emerging markets (MSCI Emerging Markets Index) were positive, albeit at lower levels than their U.S. counterparts.
While fixed income was a bright spot for most of 2020, bonds (Bloomberg Barclay’s U.S. Aggregate Bond Index) posted a negative return for the quarter. Signs of recovery, along with rising interest rates, caused this weakness. The 10-year Treasury yield peaked at 1.74% during the past quarter, compared to a low of 0.51% in Aug. 2020. While this overall change in yield has had minimal consequences to markets thus far, the rate of change has caught the attention of some investors. For perspective, the 25-year average rate for the 10-year Treasury is 3.7%.
The cost of recovery
The Fed, grasping the magnitude of the COVID-19 pandemic, pursued one of the most accommodative monetary stances in our history by lowering interest rates, restarting their quantitative easing program, and creating a number of emergency lending facilities. Not to be outdone by the Fed, the federal government introduced major relief programs starting with the $2 trillion CARES Act in March 2020 followed by the $900 billion COVID-19 Aid bill in December 2020. The Biden administration wasted no time in continuing fiscal relief by signing the $1.9 trillion American Rescue Plan this past March, and has now pivoted to the proposed $3 trillion “Build Back Better” infrastructure plan.
With the pandemic appearing to be waning and the economy resurging, many Americans are turning their attention to the consequences of this massive fiscal and monetary experiment and wondering if the cure might be worse than the disease. This brings us to the topic of the consequences of excess spending, the threat of inflation, and the rise in popularity of an economic theory that supports these policies, Modern Monetary Theory (MMT).
“Nothing so weakens government as persistent inflation.”
– John Kenneth Galbraith
The Fed generally operates under two primary mandates: full employment and stable prices. At any given time, Fed policy reflects their consensus on the state and direction of the two. The Treasury measures the overall health of the economy and takes action when relief or investment is deemed necessary. Between the two, they attempt to create a “Goldilocks economy” where most are gainfully employed and price pressures are manageable, all within acceptable levels of federal debt and deficits. An unemployment rate between 4-6% is considered full employment with an inflation target of 2%.
What is deemed reasonable in terms of budget deficits and national debt is situational, and remains the subject of serious debate. Currently, the U.S. is running an annual deficit of $2.3 trillion with a national debt of $28 trillion and climbing. The U.S. economy has experienced an extended period of disinflation primarily due to globalization, demographics, and technological advancement. As a result, Fed policy has focused more on managing business cycles and staving off deflation threats. However, recent Fed and Treasury actions have prompted concerns about the resurgence of inflation.
The Fed is choosing to play a game of chicken with inflation by actually encouraging some “hot” inflation numbers (above the 2% target) through its stimulus measures. This is because it perceives any inflation surge to be the result of temporary transfers of payments (stimulus checks, unemployment benefits, PPP loans, etc.) or supply chain disruptions due to COVID. The Treasury has equal conviction about its recent spending spree and proposed infrastructure bill, as it considers this spending necessary to pull Americans through the COVID-created recession, and the infrastructure spending a worthy, if not essential, investment in our future. They project both to normalize over time, with a long-term return on investment in infrastructure.
However, some pundits are fearful something far more insidious is brewing. Specifically, they fear that future runaway inflation is a real possibility and our national debt is reaching levels where the safety and dependability of Treasury securities and our status as a reserve currency could eventually be in jeopardy. If one believes this, then the recent spike in interest rates, despite the Fed’s accommodative stance, is seen as a canary in the coalmine. Chairman Powell assured the public in his recent March testimony that they remain confident in their policy stance, and vigilant in monitoring inflationary pressures in order to act quickly if they observe anything more than a transitory blip.
Fiscal debt hawks have been declaring the sky is falling for many years. The relative health of this measure is usually expressed as a percentage of a country’s annual output, GDP. What is an acceptable ratio? According to a study by the World Bank, if the debt-to-GDP ratio exceeds 77% for an extended period, it can begin to stunt economic growth. Every percentage point of debt above this level costs the country 0.017% in stunted economic growth. At the end of 2020, U.S. debt to GDP stood at 129%! If it is any consolation, Japan has the highest global debt to GDP currently at a staggering 234%.
MMT to the rescue
Is there a tipping point with monetary policy and fiscal excess where our economic system is in jeopardy? No one really knows, but some say we are destined to find out. Yet, Modern Monetary Theory (MMT), an economic theory, which challenges conventional wisdom about debt, deficits, and monetary policy, says “no”. While the theory has been around for over 100 years, there is a new face to its advocacy: Stephanie Kelton, a former chief economist on the U.S. Senate Budget Committee, professor of economics at Stony Brook University, and author of the controversial book, “The Deficit Myth”. Advocates of the book say Kelton presents the wisdom of MMT eloquently, and opponents say she presents absurd premises in a deceivingly eloquent way.
MMT is a complicated economic theory with details and doctrines far beyond the scope of this letter, so we will limit our discussion to Kelton’s basic claim that we need to change our thinking about how we run our country’s “household”. She contends, Congress has the power of the purse and can spend whatever money it deems necessary to promote the long-term health and wellness of our society. Kelton suggests it is a fundamental mistake to compare the government to a household living within its means. Unlike a household, the government, so long as it does business in its own sovereign currency, can get the money it needs in concert with the Fed, with no practical limit other than causing sustained inflationary pressure or testing the limits of its resources within the real economy. Armed with this supposition, MMT rationalizes bold spending on everything from eliminating poverty, Medicare for all, free college, combatting climate control, and an array of other issues without bankrupting our country. In fact, if the money is spent prudently, MMT proponents claim we will be far more prosperous from having done so, regardless of significant debt and deficit spending.
The political stereotype is Republicans are more fiscally conservative than Democrats. However, all politicians like to please their constituents regardless of party. The national debt increased by $7.8 trillion under the Trump administration, and so far, the Biden administration seems content to follow suit. Further, the COVID pandemic provides the perfect excuse to promote any number of spending programs while Americans have the appetite for it in the name of recovery. Whether called by name, it appears Congress is embracing some aspects of MMT, for better or for worse.
Managing in a post-COVID MMT world
At Wealth Dimensions, our diversified portfolios are designed to adapt to market conditions, as we diligently monitor for rebalancing opportunities when they present themselves. In the case of mitigating inflation, equities have proven to act as a reasonable hedge because companies can increase prices to keep pace with inflation pressures. Many also distribute dividends, which investors can reinvest throughout these periods. Real estate (REITS) is also a specific component of our equity allocation that typically performs relatively well in inflationary times. With fixed income, inflation and interest rates go hand-in-hand, so our bond portfolios are constructed to attempt to reduce this risk through a balance between short- and intermediate-term duration holdings. This also allows us to pivot accordingly during periods of volatility.
The markets and the economy will continue to present challenges and opportunities. Regardless of circumstances, through our ongoing financial planning, we help you manage the dynamic components of your financial lives, recalibrating investment allocations, utilizing current tax and estate planning strategies, and other aspects of your plan. In concert with you, our goal is to put you in a position to live your life to its fullest.
For informational purposes only. Not intended as investment advice or a recommendation of any particular security or strategy. Information prepared from third-party sources is believed to be reliable though its accuracy is not guaranteed. Opinions expressed in this commentary reflect subjective judgments of the author based on conditions at the time of writing and are subject to change without notice. For more information about Wealth Dimensions, including our Form ADV Part 2A Brochure, please visit https://adviserinfo.sec.gov or contact us at 513-554-6000. Please be advised that this material is not intended as legal or tax advice. Accordingly, any tax information provided in this material is not intended and cannot be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer.