Can Fed + Treasury Extend the Recovery?

“The Stock/Bond Dilemma” outlined the current reality of the market within its historical context—a combination of extremely overvalued stocks and bonds leaves a balanced portfolio with the worst yield in observed history. Forecasting future returns from current levels creates a dire problem for pension managers and retirement investors alike, IF past history sets the stage for future asset class returns. These current valuation conditions have come at a time of high uncertainty around the future path of the economy. The most recent BofA Global Fund Manager Survey, however, shows the economic clouds may be parting, at least from the vantage point of professional investors. The percentage of respondents who think the US economy has emerged from recession now slightly exceeds those believing the US is still in one.

What is driving this optimism? There are numerous positives behind a cyclical upturn for the economy; namely, a bifurcated K-shaped recovery (some not experiencing negative impacts from the recession), supportive short-term policy measures (initial jobless benefits and eviction moratoriums for many of those initially impacted, coupled with massive monetary support) and improved treatment outcomes for Covid and hopes for a vaccine by Spring.

There is also a pronounced, longer-term source of optimism—a marriage between fiscal and monetary policy to tackle the next phase of a recovery. The number of Americans considered permanently unemployed rose to 3.4 million in last month’s job report. Even after an initial snap back in growth, a significant gap will remain to reclaim the prior level of economic output pre-Covid. There is a growing consensus from those on both sides of the political spectrum that the synchronized approach using QE to support US Government spending in the initial response to the lockdown may also be the best solution to combat the structural damage inflicted by Covid. Government fiscal expansion and MMT economic thinking may become the “cheat code” for successful economic policies.

According to a recent paper by investment manager Blackrock, sustained integration of fiscal and monetary stimulus may provide a credible demand for capital and support risk taking in the private sector—a necessary step in preventing a deflationary spiral similar to the one Japan has experienced. Even pre-Covid, nominal GDP had been trending lower, given aging demographics in much of the developed world. The sole remedy to combat the low GDP environment thus far has been for central banks to continually lower rates. The result, a supply of capital exceeding demand, leaving rates at rock bottom levels. Can government involvement spur productive investment? According to Blackrock, “There is no player with deeper pockets than a government, funded by its central bank, in its own currency, and both U.S. and European governments have shown a commitment to taking on this role. Some ongoing debt monetization could have tremendous efficacy as a means of catalyzing a virtuous investment cycle – provided the proceeds are used wisely.” 

There is a historical precedent for this kind of government intervention—after the Great Depression, during World War II, government debt expanded rapidly while the Federal Reserve intervened to control borrowing costs. From mid-1942 to 1946, real interest rates fell to -2.98% and the S&P 500 rose 80% after inflation, according to a recent study by Fidelity. There are meaningful differences between the 1940s and today—namely, starting debt levels are much higher today, and fiscal spending thus far has been targeted to support consumption (fiscal spending during WW2 focused on production). Most importantly, and to finish where we started, starting valuations are much higher today with the S&P trading at 27.5x trailing earnings, vs. 7.4x in 1942.