Is stagflation in our future?

Posted by Cam Hui -
Last week, I pointed out that the Citi Inflation Surprise Index was turning up around the world. While one month doesn’t make a trend, what if the Fed is making a different kind of policy error? Instead of over-tightening into a recession, what if the U.S. economy achieves a soft landing or no landing and the Fed is under-tightening and never achieves its 2% inflation objective?

 

 

The probable outcome of that path is stagflation.
 

 

Rising stagflation risk

An analysis shows that market leadership is starting to discount a stagflation scenario. I have lamented the lack of strong market leadership. The relative performance of megacap growth stocks, which led the latest bull phase, has gone nowhere since June.
 

 

As one sector or group falters, another usually rises to the occasion and assumes the mantle of market leadership. This time, the relative performance of the cyclically sensitive value industries is weak.
 

 

The only sign of emerging leadership can be found in the relative performance of inflation hedge vehicles, such as energy, mining and golds. As clarification, I use global mining and global agricultural producers in my analysis instead of their U.S. counterparts because of the lack of breadth in those industries in the U.S.
 

 

Normally, strength in inflation hedge vehicles is a sign of a reflationary rebound or a late cycle inflation boom. However, the lack of relative strength in cyclical industries is the market’s message that it is anticipating stagflation.
 

 

Vibecession = Politicized slowdown risk

Additional economic and political risks are emerging in the current environment of elevated inflation. The Economist recently highlighted a possible “vibecession” in the air. Modeled U.S. consumer sentiment based on economic variables is diverging significantly from actual consumer sentiment.
 

 

What could account for the discrepancy? More detailed analysis of economic factors that go into the model shows that inflation and petrol (gasoline) prices are negative correlated with consumer sentiment (annotations are mine).
 

 

Here is how economic risk translates into political risk with negative growth implications. The Economist also highlighted in a separate article how the hard right is getting closer to power in Europe and cited rising inflation as one of the causes: “Populists…tend to do well in times of economic upheaval, and so are benefiting from the high inflation that has plagued Europe for the past two years, and especially from soaring energy prices.”

 

Here is the economic threat. An upcoming academic paper by Funke, Schularick and Trebesch found that populism tends to depress economic growth. Here is the abstract:

Populism at the country level is at an all-time high, with more than 25% of nations currently governed by populists. How do economies perform under populist leaders? We build a new long run cross- country database to study the macroeconomic history of populism. We identify 51 populist presidents and prime ministers from 1900 to 2020 and show that the economic cost of populism is high. After 15 years, GDP per capita is 10% lower compared to a plausible non-populist counterfactual. Economic disintegration, decreasing macroeconomic stability, and the erosion of institutions typically go hand in hand with populist rule.
 

The paper, which defines populism as “as a political style that centers on an alleged conflict between ‘the people’ vs. ‘the elites’”, found that populists depressed economic growth from its potential when compared to a synthetically modeled growth path of similar countries without populists in power, though left and right-wing populist governments tended to exhibit different growth patterns.

 

 

The study had other interesting findings. Debt-to-GDP rose for all populists, regardless of ideology.

 

 

The one key difference was that inflation was significantly worse under left-wing populists.
 

 

As inflation remains elevated and above central bankers’ 2% target, the risk is that vibecessions cause the electorates of different countries to turn to populism and depresses the long-term economic growth path. While these political developments are not necessary for stagflation to occur, they would exacerbate the effects.
 

 

An IMF inflation warning

Independent of the paper by Funke et al, the IMF published, “One Hundred Inflation Shocks: Seven Stylized Facts”, as a warning to policy makers. The IMF studied inflation shocks in the past and came to the following generalized conclusions.

  1. Inflation is persistent, especially after a terms-of-trade shock.
  2. Most unresolved inflation episodes involved “premature celebrations”.
  3. Countries that resolved inflation had tighter monetary policy.
  4. Countries that resolved inflation implemented restrictive policies more consistently over time.
  5. Countries that resolved inflation contained nominal exchange rate depreciation.
  6. Countries that resolved inflation had lower nominal wage growth.
  7. Countries that resolved inflation did not experience lower growth or higher unemployment over the 5-year horizon.

Coincidentally, the Fed has reacted to the risk of stagflation, in a fashion. The September Summary of Economic Projections showed that the median assessment of the economy had improved and indicated a soft landing, but FOMC members raised their median rate projections for 2024 and 2025 by a full 50 basis points and opened the door to a higher r-star, or neutral interest rate. The WSJ summed it up best with an article headline of “Higher Interest Rates Not Just for Longer, but Maybe Forever”.
 

 

As a consequence, the 2-year Treasury yield surged to a new cycle high. Historically, peaks in this yield have either been coincident or led peaks in the Fed Funds rate.
 

 

 

Hedging against stagflation

Should the stagflation scenario become reality, how should investors hedge against such an outcome? Here are a few suggestions.

 

First, commodities and the shares of commodity producers are natural hedges against rising inflation. Historically, they have been inversely correlated to the USD, but USD strength hasn’t dented commodity prices, which is an indication that market expectations of inflation are rising.
 

 

This is a neglected asset class. The BoA Global Fund Manager Survey shows that global investors are underweight commodities (annotations are mine).
 

 

Stagflation is the combination of inflation and slow growth. In a growth-starved world, investors will pay a premium for growth stocks. The Artificial Intelligence revolution is real. It will disrupt the way we work in the coming years and U.S. megacap growth holds much promise as an investment theme.
 

Tactically, if the “buy growth in a growth-starved world” thesis holds any water, megcacap growth stocks need to break up and exhibit strong leadership. Here is what I am watching. The top panel shows the relative performance of U.S. large-cap value/growth, which is in a trading range. The second panel shows small-cap value/growth, which is turning up in favour of value as small caps don’t have much weight in AI-related plays. The acid test can be seen in the bottom panel. Can large-cap growth break out against small-cap value, which would be a signal of sustained megacap growth leadership.
 

 

From a trader’s perspective, it may be too early to buy growth stocks as they could need more time to pull back and consolidate their gains. The dark line in the bottom panel shows the relative performance ratio of the NASDAQ 100 to the S&P 500, normalized to its 52-week average. The NASDAQ 100, which represents growth stocks, was on a tear. Even though they pulled back on a relative basis, these stocks are still a little extended. Don’t be surprised to see a period of more relative weakness or consolidation before they can become the leadership again.
 

There is hope for Big Tech. Joe Wiesenthal at Bloomberg documented the appearance of green shoots. Salesforce and Meta (Facebook) are hiring again after well-publicized rounds of job cutbacks in Big Tech. In a separate report. Amazon announced that it plans to hire 250,000 seasonal workers at a higher pay scale of $20.50/hour to handle the holiday rush this year, up from a 150,000 last year.
 

 

Outside the U.S., which has relatively few AI-related plays, the factor return patterns are very different. The leadership has been in value and quality. Investors should therefore diversify their exposures with non-U.S. value and quality stocks.
 

 

In conclusion, stagflation is not our base-case scenario, but a review of market leadership shows that stagflation risk is rising and needs to be monitored carefully. In addition, stagflation could be exacerbated by disgruntled electorates turning to populist governments, which have shown to depress economic growth. Investors can hedge against a stagflation scenario with a barbell exposure to commodity producers, U.S. megacap growth stocks, based on the theme of buying growth in a growth-scarce world, and value and high-quality outside the U.S.

 

A hawkish pause, but don’t panic

Posted by Cam Hui -

Mid-week market update: It was a hawkish pause. The Fed’s decided to leave rates unchanged, but in the Summary of Economic Projections (SEP), it acknowledged that the economy is strong than its June projections. More importantly, the Fed Funds target for the end of this year remains unchanged, indicating that FOMC members expect another quarter-point rate hike, and raised rate expectations by a half-point for the next two years. In other words, higher for longer.
 

 

Moreover, the 2-year Treasury yield, which is a market proxy of the terminal Fed Funds rate, ended the day at 5.16%, a new cycle high.

 

Risk-off!

 

 

A typical market reaction

The stock market’s reaction was fairly typical of FOMC meetings. Bespoke observed that the usual S&P 500 pattern during FOMC decision days ends with a late day sell-off.
 

 

On the weekend, I pointed out the wedge patterns being formed by the S&P 500 and the NASDAQ 100. I would add that while the major large-cap indices were forming wedges, the mid-cap S&P 400 and small=cap Russell 2000 were not in wedges but near their August lows. The dam broke today. The S&P 500 and the NASDAQ 100 broke down through wedge support, and both the S&P 400 and the Russell 2000 broke the support as defined by their August lows.
 

 

Watch out below!
 

 

Not the Apocalypse

Don’t worry, I don’t expect any pullback to be the Apocalypse. While  market internals are not oversold and sentiment is not panicked indicate further downside potential, initial S&P 500 support can be found at the August lows, or about 4350 level.
 

Looking ahead, the market may show further concern about the possibility of a government shutdown. As of this writing, the House hasn’t passed a Continuing Resolution to fund the U.S. government past September 30. It even failed to pass a bill to fund the military, which is unprecedented. Analysis from Yahoo Finance found that stock market returns tend to be choppy during shutdowns, but they tend to be non-events overall.
 

 

My inner trader is waiting for the point of maximum panic as an opportunity to enter the market on the long side. Be patient.
 

A battle royale for control of the tape

Posted by Cam Hui -

Preface: Explaining our market timing models 

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

 

The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.

 

 

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

 

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
  • Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
  • Trading model: Neutral (Last changed from “bearish” on 03-Aug-2023)

Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real time here.

 

 

Decision time

It’s nearing decision time. Both the S&P 500 and the NASDAQ 100 are forming wedge formations while testing their 50 dma supports. Will the market break up or down through the trend lines?
 

 

Upside or downside breaks would have strong directional implications. I believe the odds favour the bears. Here’s why.
 

 

Where’s the leadership?

Here’s what’s bothering me. The stock market advance in 2023 has seen three phases. The first phase was led by AI-related plays, as evidenced by the outperformance of NASDAQ 100 stocks (second panel). When enthusiasm for AI stocks began to stall in June, the S&P 500 continued to rise as leadership broadened out, as measured by the relative performance of equal-weighted to float-weighted S&P 500 and NASDAQ 100. Since then, leadership has narrowed again and the equal-weighted indices have lagged. But this time, the NASDAQ 100 is showing few signs of outperformance, which is disturbing.
 

 

Where’s the leadership?
 

The top five sectors by weight in the S&P 500 comprise over 70% of the weight of the index and it would be difficult for the market to meaningfully rise or fall without the participation of a majority. A detailed analysis of the relative performance of these sectors shows few signs of sustained outperformance or underperformance.
 

 

A detailed analysis of the cyclically sensitive value sectors shows only one sector exhibiting sustained relative strength. Energy stocks are rising on the back of higher oil prices.
 

 

Two potential worrisome chart patterns have appeared on my radar screen in the form of possible head and shoulder patterns with bearish implications. First, semiconductor stocks, which led the AI boom, are exhibiting a possible head and shoulders formation. While the neckline hasn’t broken and H&S patterns are incomplete and unconfirmed until the neckline breaks, the more disturbing development is the violation of relative support in the bottom panel.
 

 

A similar potential head and shoulders formation can be seen in the small-cap Russell 2000. While the neckline hasn’t broken to confirm the pattern, it has violated relative support with bearish implications.
 

 

It seems that commodity prices are the only part of the asset markets showing signs of life. In short, the only market leadership is in commodities – and energy in particular.
 

 

Bull markets simply don’t look like this.
 

 

Do valuations matter?

At the same time, Treasury yields are seeing upward pressure, which is an ominous sign for stock prices. Forward P/E multiples are already elevated. Rising 10-year yields are creating considerable competition for stocks. The 10-year Treasury yield is trading at a similar level as last October. Based on that data, the forward P/E should be about 15, which represents a -20% drawdown from current levels. Arguably, the forward P/E should be even lower based on a long-term history.
 

 

Even though the S&P 500 is facing valuation headwinds, it is enjoying a fundamental tailwind in the form of positive forward EPS revisions.
 

 

 

The week ahead

Looking to the week ahead, the macro highlight of the week is the FOMC decision on Wednesday. While the Fed is expected to hold rates steady, the risk is a signal of further rate hikes, or a hawkish hold.
 

The BoA Global Fund Manager Survey shows that expectations may be too dovish. Inflation expectations are rising even as respondents expect falling interest rates.
 

 

For what it’s worth, the coming week is the weakest week of the calendar on a seasonal basis.
 

 

In conclusion, I continue to believe the S&P 500 has unfinished business to the downside. The index can find support at its August lows at about 4350. Strong secondary support can be found at roughly 4200, which is about the site of the 200 dma.
 

How the USD could sink the S&P 500

Posted by Cam Hui -

Correlation isn’t causation, but the USD Index has shown a close inverse correlation to the S&P 500. The relationship partly ended when the S&P 500 surged on AI mania. However, small-cap stocks, which are less subject to the enthusiasm over the AI revolution, maintained their inverse correlation.
 

 

The USD Index is approaching a key resistance level. Assuming the inverse correlation were to continue, what are the bear and bear cases for the USD, and consequently U.S. equities?
 

 

Fiscal dominance is USD bullish

Did anyone notice that even as the European Central Bank raised rates by a quarter-point last week, the EURUSD exchange rate fell? All else being equal, the exchange rate should rise because the interest rate differential between the euro and the dollar has narrowed. So what’s not equal?
 

One simple explanation is the ECB signaled that this will be the last rate hike. The Fed has kept its options open for further hikes in the near future.

 

I highlighted last week the problem of fiscal dominance (see Investing during an era of Fiscal Dominance). Arguably, economies are being burdened by rising debt service costs. The U.S. has been more resilient so far. This may force other central banks such as the ECB to cut first, which narrows the rate differential and puts upward pressure on the USD.

 

 

 

The inflation threat

Another factor that could put upward pressure on the USD is the threat of further Fed rate hikes from a renewed inflation threat.

 

The August CPI report had something for everyone. Even though the print came in hotter than expectations, the optimists focused on the deceleration trend.
 

 

However, FactSet reported that the number of companies citing “inflation” on their earnings calls had fallen, but the rate of decline was decelerating.
 

 

Disinflation should be good news, but the Citi Inflation Surprise Index seems to be edging up everywhere around the world. What’s going on?
 

 

Mike Konczal at the Roosevelt Institute recently published a study which found that more supply, or the unraveling of supply chain bottlenecks, has driven most of the deceleration of inflation. He found that “73 percent of all core items, and 66 percent of services, see prices falling with quantities increasing.” In other words, disinflation could be transitory.

 

Indeed, an analysis of the monthly annualized changes in different CPI categories shows that goods CPI (in red) has been the major contributor to falling inflation. By contrast, core services CPI (in blue) has been sticky.

 

 

One major component of core services CPI is shelter, which has been strong because of how shelter inflation is calculated. Forward-looking indicators of rent have shown rapid deceleration. The Fed has taken notice and now focuses on its super-core CPI, which is services ex-shelter. This component has decelerated, but it’s stabilizing at a much higher level than the Fed’s 2% target.
 

 

This brings us to the risks to inflation, which appear in the form of higher energy prices and potentially higher wages. The decision by Saudi Arabia and Russia to cut oil production has boosted Brent prices to $90. As the accompanying chart shows, the annual rate of change (bottom panel) is turning positive from negative, which has eliminated a tailwind to the disinflationary trend in headline CPI. Should higher energy prices continue, they will put upward pressure on consumer inflation, which will provide ammunition for the hawks at the Fed.
 

 

As well, headlines of renewed union power is raising eyebrows on Wall Street. The headlines of the recent UPS settlement with the Teamsters, which allows full-time drivers to earn as much as $180,000 annually in the last year of the contract and raised the starting pay for contract workers from $16.20 to $21.00/hour, sounded excessive. UPS management went on the offensive in the media and characterized the contract as an annualized 3.3% increase over the life of the contract as fair.

 

 

The NFIB small business survey is insightful in this regard. The survey can be insightful as small businesses have little bargaining power and they are useful barometers of the economy. The latest survey of compensation trends shows a stabilization of increases and possible re-acceleration.
 

 

 The key risk is a scenario of stabilization in services CPI, rising energy prices and wage pressures combine to put upward pressure on the Fed Funds rate. The market is discounting no further rate hikes and cuts that begin next May. A higher-for-longer rate regime would be USD bullish and equity bearish.
 

 

 

Yen strength ≠ Equity bullish

As well, investors shouldn’t ignore the effects of the Bank of Japan’s (BoJ) signals of possible monetary tightening. Reuters reported that “Bank of Japan Governor Kazuo Ueda said the central bank could end its negative interest rate policy when achievement of its 2% inflation target is in sight, the Yomiuri newspaper reported on Saturday, signalling possible interest rate hikes.” As a consequence, even the 10-year JGB rate has risen well above the 50-basis-point yield curve control rate. bit the Yen rallied and pulled back.
 

 

JPY strength means USD weakness. While a retreat in the greenback should be equity bullish, a strengthening Yen may be a sign of funds repatriation, which would be equity bearish Japan has been a significant supplier of global liquidity. Should the BoJ switch a monetary easing regime to more neutral or even monetary tightening, this should reduce the flow of global liquidity, which would be negative for global risk appetite (see my previous discussion in The TARA risk from Japan).
 

In conclusion, the USD has historically been inversely correlated with U.S. equity prices. A number of risks are appearing to put upward pressure on the USD, namely the expectations of more fiscal room in the U.S. compared to other major economies will pressure other central banks to ease sooner than the Fed, and upward pressure on inflation. In addition, the possible reversal of the BoJ’s easy monetary policy, while Yen bullish and Dollar bearish, is bearish for global risk appetite.
 

EM contrarian and momentum opportunities

Posted by Cam Hui -
Mid-week market update: Instead of just focusing on the U.S. market, I offer these two mystery charts of EM markets. One is a contrarian play, the other a momentum play.

 

 

 

Mystery charts revealed

The top chart, the contrarian play, is MSCI China relative to MSCI All-Country World Index Ex-US. The latest BoA Global Fund Manager Survey shows that growth expectations for China is at a historic low. Is this the bottom? The relative performance chart shows a constructive pattern of holding relative support.

 

 

The other chart, the momentum play, is MSCI Mexico relative to MSCI All-Country World Index Ex-US. As the West de-couples from China, Mexico has been a significant beneficiary of near-shoring. This podcast outlines the opportunities in Mexico, as well as the growth constraints such as infrastructure and crime.
 

Pick your poison.
 

 

Incomplete correction

As for the U.S. market, I believe that the correction in the S&P 500 is still incomplete. The index tried to rally above its 50 dma but failed.

 

 

Equally disturbing are the definitive breakdowns in relative support of small-cap indices (bottom two panels).
 

 

As well, the semiconductor stocks, which are the leaders in the AI boom, are forming a possible head and shoulders pattern with the caveat that H&S formations are incomplete until the neckline breaks. The early bearish “tell” is the inability of these stocks to hold relative support.
 

 

In conclusion, I believe that the S&P 500 is undergoing a pullback. My base case calls for support to hold at the August lows of about 4350, though further downside is possible. In the meantime, investors can find both contrarian and value opportunities in emerging markets.

 

Tripwires to a deeper correction

Posted by Cam Hui -

Preface: Explaining our market timing models 

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

 

The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.

 

 

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

 

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
  • Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
  • Trading model: Neutral (Last changed from “bearish” on 03-Aug-2023)

Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real time here.

 

 

Where’s the bottom?

I highlighted how the 5-week RSI of the S&P 500 became extremely overbought. In the past, such instances have resolved with a correction (check), a relief rally (check), followed by a re-test of the correction lows. In three of the last four cases, the second re-test held at the old lows. The only exception was the COVID Crash of 2020, which was panic driven by macro fundamentals. If history is any guide, the next corrective low should terminate at about the site of the August low, which is ~4350.

 

 

While my base case is a bottom at about 4350, I nevertheless have to allow for the possibility of a deeper correction. Here’s what I am watching.
 

 

Leadership Is lacking

The lack of market leadership makes calling a bottom a difficult task. To be sure, the fever surrounding megacap growth and artificial intelligence has cooled. Last week saw the shares of Apple, which is the largest weight in the S&P 500, hit an air pocket. China announced bans on the use of non-Chinese smartphones in government offices and state companies as a security measure. Staff were instructed not to bring their foreign phones to work, which was a blow to Apple as the company derives about one-fifth of its revenue from China. In addition, the shares of C3.ai hit the skids after it reported earnings that beat expectations. The NYSE FANG+ Index weakened to test its 50 dma, but it remains range-bound relative to the S&P 500 (bottom panel), which is an indication that neither the bulls nor the bears have full control of the tape.
 

 

The relative performance of growth sectors revealed few market leadership trends. Technology had pulled back, and communication services and consumer discretionary stocks, which is heavily weighted in AMZN and TSLA, were trendless relative to the S&P 500.
 

 

Similarly, the relative performance of value sectors, which are cyclically sensitive, are showing neither leadership nor breakdowns with the exception of energy’s relative strength.
 

 

A closer look at the energy sector shows an upside breakout in the sector, but the stocks look extended in the short-term.
 

 

When stock prices pulled back that should have been an opportunity for defensive sectors to shine. Instead, they are showing few signs of relative strength, indicating that the bears haven’t seized control of the tape.
 

 

 

Not fearful and not oversold

Sentiment models have normalized from bullish extremes, which was contrarian bearish, but readings are not showing excessive bearishness. The weekly AAII bull-bear spread has turned bullish, but readings aren’t extreme.
 

 

Similarly, the 21 dma of the ISE Call/Put ratio came down from an extreme bullish level, but readings can only be considered to be neutral.
 

 

Conditions are not oversold, which opens the door to further downside risk in light of the negative price momentum exhibited by the market. The NYSE McClellan Oscillator turned down from a near overbought condition but readings are only neutral.
 

 

Small-cap stocks have violated key relative support levels (bottom two panels). These breaks could open the market up to further downside and a selling panic.
 

 

In summary, a review of market conditions leaves me highly conflicted. Initial S&P 500 can be found at about 4350, with secondary support at about 4200. While the S&P 500 holding at 4350 support is my base case, it could be argued that a lack of extreme fear and oversold conditions opens the door to further downside risk. I would prefer to see relative support broken on either megacap growth or small caps and monitor how market psychology evolves. Under such scenarios will the pullback be orderly, which would be bearish, or panicked, which would be contrarian bullish?

 

 

 

Investing during an era of Fiscal Dominance

Posted by Cam Hui -
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.

 

 

Growing out of debt

From a policy perspective, the most painless way to get out of debt is to grow out of it. Eichengreen characterized this as the r – g, where r = real interest rate, g = real growth rate. A country can grow its way out of debt if g > r.

 

From a big picture viewpoint, the U.S. debt situation isn’t as dire as the standard debt-to-GDP and other ratios depict. The nonpartisan Congressional Budget Office estimates that federal interest payments are still manageable. They are projected to rise to 3.3% of GDP by 2032, but the federal government saw similar levels of interest burden in the 1980s and early 1990s. What happened? It grew its way out of debt.

 

 

Here’s what’s different this time. The U.S. economy enjoyed a significant tailwind in productivity and demographic growth during that period, but growth potential has declined and is expected to remain low in the future

 

 

Other papers presented at Jackson Hole this year addressed the problems of productivity. Charles Jones documented that productivity growth had mostly flatlined since 2005.

 

 

Yueran Ma studied the link between monetary policy and innovation. She concluded, “Monetary policy can influence innovation activities by changing aggregate demand and correspondingly the profitability of innovation, and by changing financial market conditions…Our findings suggest that monetary policy may affect the productive capacity of the economy in the longer term, in addition to the well-recognized near-term effects on economic outcome”
 

In short, Eichengreen pointed out that it’s difficult to find a more favourable r – g environment today and further improvements would be challenging to achieve.

 

 

The challenges of austerity