The important question is what should investors do now, stay long stocks and bail on bonds? As investment managers we tend to ignore the noise, not chase the market and assess relevant facts. As we see it the rise of stocks and fall in bonds is speculation by investors of what may come. Logical yes, but we must sort out the underlying drivers of higher valuations to look at probabilities they can be sustained. First, we look at causation among the dependent variables. We are in a slow growth, global environment. Trade is down. Currencies of other nations are falling against the dollar’s strength making their goods cheaper to buy compared to US goods. A general lack of growth means all nations are angling for trade advantage. One nation’s advantage can cause another nation to take offsetting actions that create greater volatility and market uncertainty. If the US increases its debt to fund big infrastructure spending while also cutting taxes to spur business growth, interest rates may rise to attract investors financing for the new spending. Higher rates mean higher debt service. With a $20 Trillion national debt (this is what the US publishes but the total owed including GNMA, FNMA/FMAC, Soc.Sec., and unfunded Pension liabilities is estimated to be $85 Trillion) a 5% interest rate would mean $1 trillion in debt service annually. We can’t go there as growth would be stymied by government sector debt crowding out business demand. But what if the US repatriated all the US corporate profits held overseas and that money was used for investments to spur growth? Lower taxes to bring the money back home has been discussed. Perhaps a smaller infrastructure program would be made requiring less stimulus by the government. Not so fast and not likely. First of all banks in Europe never addressed their “too big to fail” bank issues and now have mounting heaps of central bank debt from eight years of stimulus spending. Should US corporations pull their deposit money from European banks to bring it home, that deposit money would need to replaced to maintain bank leverage ratios. Choices then would be to greatly reduce deposit-to-debt ratios putting the European financial system at greater risk or print money and get it into the banks to keep them solvent. While inflation might be expected which such action, the opposite would likely occur–Deflation. That’s because European government Treasuries would simply issue more debt to be purchased (and serviced) until it matures. The greater debt burden would further slow the European economy, further distort markets, and dampen investor confidence. The newly printed money would not be in circulation creating any growth. Such policy would knock out our trading partners and hurt US multinationals and US banks as well.
The policy we need to see then must foster greater global trade. Spending on infrastructure is relatively good stimulus; it creates jobs and you get something for you money–better roads, bridges, airports, etc. Much better than starting a war, which puts people to work, but is a zero sum game and people die. But cutting taxes in combination with with increasing spending seems wishful thinking for sustained economic growth. The hope of course is that the final bout of government stimulus would ignite growth creating a new expansionary business cycle. But that is not likely. When the projects are completed we are left with the debt and incomes have not risen. Such a “spend and cut” combo policy provides only temporary growth despite what the supply-side economist wish. The policies we need this time at the end of a debt cycle must cut wasteful spending and give rise to higher incomes so consumers have more discretionary spending. US demographics are against this happening. China and India are good prospects for increasing trade but they need credit expansion to borrow growth from the future as the US has always done. Besides international trade benefits multi-national companies and supplies jobs in regions where population bases are large and the goods are being produced. What the US needs is the wood (greater incomes) for their consumers to spend more which harkens to Trump’s call for making goods here at home. Yet America has been addicted to the “everyday lowest price” model which gives rise to the everyday lowest wages found overseas in emerging market countries. US Productivity is not rising because our working age population in in decline. Perhaps this explains our breakneck immigration policy of non-enforcement over the last twenty years? Whatever the case, an immigration, pro-growth, less regulatory environment will certainly help. Business will respond to opportunity when sound policies are laid out with clear rules and consumer demand is present. Businesses don’t spend capital without it.
So how will the GOP create demand and reinvigorate our domestic economy? This the all important question facing the new administration. In the past it has been through tech IPOs and credit expansion for housing. Both of these reached excesses and led to financial corrections. These options are off the table today as is expansion of credit card lending. What ProActive is looking for are policies that address the Demand and not only the Supply side of economic growth. Earned income credits to boost consumer spending by assuring a livable-wage for working families are preferable to capital equipment tax credits. Polices to lower corporate taxes inducing higher wages have efficacy as well because they create consumer demand.
Turning back to the investment question of what to do, we argue that understanding the catalysts and underlying drivers of growth while taking a global view is essential. ProActive evaluates policy moves as positive or negative in impact towards the value of the dollar, corporate earnings, interest rates and greater trade. Bailing out failed businesses with tax payer money or providing spurts of “Helicopter Money” in the form of tax credits works to deliver short term outcomes and has been necessary,but we don’t need these policies now. Sound growth polices are preferable today because they put the economy back on stable footing for the long term. The US has pent up demand. People want to move here. Doing a standard MBA Strengths and Weaknesses policy analysis tells you it is clear we do not need to bribe people to come here. US economic policy should exploit this demand to create US jobs.
With all this said then, this is a time for intelligent caution, but not the sidelines. Their are risks with all investments and at present and this is especially so with bonds. We do not think a 5% 30 year bond is coming any time soon, but as the chart above illustrates, a small upward rise in rates can many times offset what you can gain from interest payments at the levels interest rates have been set at by the Fed. The Trump rally is forcing the Fed to match the market rate to their official set rates. The concern remains managing expectations for investors. The world economy is weak and higher rates here mean a stronger dollar and a more difficult job selling US goods overseas. Deficit spending lowers the dollar so it may work out that we borrow our infrastructure money from foreigners who want the safe-haven dollar. Yet to do this at sub 4% rates on long term money it will be necessary to scare equity investors into making this purchase or using regulatory policy to force institutions to do buy. We think the reality will be some of both. Managing money in this kind of uncertain environment requires employing a combination of credit analysis and debt duration laddering with a focus on liquidity. That is, ProActive focuses on duration to maturity while managing liquidity risk to meet income needs and to take advantage of opportunity. Staggering due dates with investment grade bonds weighted to provide yield advantage and seizing upon opportunities when others are confused not having done the above kind of policy analysis is our forte. On the equity side we invest for growth favor quality and strive to keep money compounding. Here too we want liquidity, but having calculated risk exposures in our portfolios we can adjust our exposure upward or downward with policy decisions made by government. We call it our pro-active strategy (hence our name) and prefer being active and vigilant. We think it makes no sense to take a passive management approach gaining diversification but failing to managing market risk. How about you?