As the Street parsed Powell’s Jackson Hole speech and obsessed over whether the Fed would raise an additional quarter-point, the annual Fed symposium at Jackson Hole is meant for central bankers to consider Big Ideas which reflect the concerns of the day.
The centrepiece of such ideas was usually an academic paper. As an example, the Big Idea in 2020 was “flexible average inflation targeting” and the now quaint problem of persistent low inflation. A paper by University of California at Berkeley academic Yuriy Gorodnichenko argued that the Fed needs clear, simple and transparent communication to create the link between higher inflation expectations and actual spending behaviour.
The Big Idea in 2023 is fiscal dominance, or the problem of big government deficits and skyrocketing debt around the world.
How should investors position themselves in an era of persistent deficits, rising sovereign debt, and fiscal dominance?
Living with high public debt
The Big Idea paper was presented by Barry Eichengreen, another Berkeley academic, called “Living with High Public Debt”. The paper made the case that “high public debts are not going to decline significantly for the foreseeable future. Countries are going to have to live with this new reality as a semi-permanent state of affairs.”
The paper makes for grim reading. Eichengreen went on to lay out possible solutions, none of which are very feasible in the current circumstances.
- Grow out of it.
- Implement austerity programs and run primary surpluses.
- Inflate out of it.
- Financial repression.
In addition, Eichengreen highlighted global financial stability problems as emerging market and developing economies are far more vulnerable to high debt than advanced economies.
Let’s explore each of these solutions, one at a time.
Cam
1. “Stormy weather is ahead”. Sure, until September end, stormy weather is obvious. Are you suggesting this continues thereafter? For how long?
2. “Investors may want to re-think how they approach risk in portfolio construction”. How do you suggest portfolios be rejigged? I suppose, one could make a case for higher portfolio allocation to short duration fixed income (US treasuries laddered to less than 5 years), gold for the longer term, underweighting EM s despite lower valuations, underweighting US small caps (?), underweighting US tech sector, underweight US banks, and overweighting US value and Euro equities. Thanks.
“growth potential has declined and is expected to remain low in the future”
Based on the above, it would appear high growth tech stocks is where money would flow into.
It seems to me that over time people will realize that the old paradigm, bonds are equivalent to a future stream of taxes is no longer valid. Bonds will be paid with other bonds or printing money. How will it affect the credibility of the asset or the underlying currency I have no idea. I do feel that when people have no confidence in monetary assets, tend to invest in non monetary assets, like real estate or stocks. This will not happen in the short term. Nowadays politicians who propose to pay debt lose the elections. I congratulate Cam for bringing this matter to the table.
I would look to Japan as an example of high % national debt/gdp.
The absolute time of great risk related to deficits is after the Presidential election. Currently running a 6% debt to GDP ratio is absurd. That is what should be done during a financial crisis not when the economy is doing well like now.
The deficit will be priority one in 2025 after the election. GOP winning will have no tax hikes but rather slash spending to reduce the deficit.
DEMs winning will raise taxes on the wealthy and corporations and continue spending (Green Revolution likely). This will have a lessor impact on the economy and companies (read stock market).
Both will lead to a bear market but the GOP win would be a VERY nasty one.
This is reminiscent of 1937 after the 1936 Presidential election when FDR won a second term. He listened to economists that convinced him to balance the budget because they thought the New Deal spending was inflationary. In 1936 the economy had recovered with the Depression behind them. But 1937 with budget austerity led to a 50% drop in the stock market. It took WWII to get the economy out of the renewed Depression.
Also, Richard Koo’s theory of Balance Sheet Recession predicts nasty stock markets declines when stimulus is pulled. This happened in Japan whenever politicians listened to experts that said the deficits were too much and cut spending. What happened is a recession meant lower taxes and higher social spending that led to HIGHER deficits not lower.
The high deficit spending we now have will lead to the economy and possibly the stock market doing fine until after the election. I understood the Tea Party negotiations coming up are only for 100 billion, small potatoes compared to the trillions agreed to in the debt ceiling deal. Then hell breaks loose in 2025.
BTW Government spending will likely be Green Revolution targeted. This is supportive of commodities especially industrial metals and metal mining stocks.