While Jim is away on vacation, other members of the TBA Investment Committee will write the market comment. Today’s comment is from Chris Gildea.
Stocks declined and the benchmark 10-year Treasury yield fell amid news that Speaker Pelosi is opening a formal impeachment inquiry of President Trump. Investors are concerned that the already slowing economy could be further damaged by all the mudslinging and distraction that could reasonably be expected during such proceedings. Oil prices also declined and have now almost completely erased the gains that followed the attack on Saudi Aramco’s processing facility just over one week ago.
While news of a forthcoming impeachment inquiry by the House is disturbing, it only reinforces my conviction that our political disfunction in Washington is not going away anytime soon. And, while prices of stocks and bonds react to news headlines such as yesterday’s impeachment inquiry, there are bigger concerns that keep me awake at night as far as potency potential for future market dislocations. Today, I will highlight one.
Central bankers around the world are convinced that lower interest rates and looser monetary policy is needed to fight deflation. But, as Jim’s previous commentaries have accurately noted, these policies have encouraged companies to borrow and invest in capacity to deliver goods and services far in excess of actual demand. Capacity underutilization contributes to both disinflation and deflation and thereby counteracts the inflationary outcomes that central bankers are seeking.
Now, rather than investing in more physical plants and equipment, companies have used lower interest rates to fund acquisitions, share buybacks, and dividend increases. These are rational decisions on the part of boards of directors. But the fact is that U.S. corporate debt has grown 65% to roughly $10 trillion since 2010 and, at more than 46% of GDP, is more today than it was prior to the Great Recession.
It is not just corporations; government spending is rising as a percentage of GDP even while the economy is good. The United States is now running a $1 trillion+ fiscal deficit at a time when we have full-employment. Imagine what will happen if we actually slip into recession. If government revenues decline as they do in a typical recession, it is not inconceivable that the budget deficit could balloon to nearly $1.8 trillion. Under normal monetary conditions, we expect interest rates to rise when governments become less restrained in their spending. However, the central bankers’ aggressive monetary policies have removed market signals so politicians have reacted logically, and spent even more.
Lower interest rates have stimulated demand from all types of borrowers and for even larger amounts of debt. In fact, the global bond market has grown from roughly $10 trillion to $110 trillion since 1990, a rate of nearly twice global GDP growth. Now, global debt has become so large that it is almost impossible for central banks to raise interest rates for fear of facing a violent market reaction which serves as investors’ collective fear of a severe recession. In fact, we witnessed such a reaction one year ago when the Fed indicated its tightening actions were expected to continue on “auto-pilot.”
Ultimately, U.S. Treasury short-term rates are determined by the Fed and set the bar for hurdle rates that investors must earn on riskier investments. Based on my observations of history, if rates are kept too low for too long, investors will do stupid things. We have seen this with WeWork and its failed IPO. As Jim noted recently, there are likely dozens more WeWork examples trapped within the portfolios of venture capital and private equity firms.
The Fed has created an investment environment where borrowing costs are too low and there is simply too much liquidity and capital. This capital has prevented bankruptcies and ensured excess capacity remains in some industries rather than being rationalized. Ironically, low interest rates and money printing may actually be causing deflation rather than inflation. It has also caused good businesses to be priced like great businesses. And, while businesses can continue to grow their intrinsic value over time, macroeconomic forces cannot be ignored. These same forces may very well propel valuations much higher and for much longer than anyone anticipates. So, the message is not to become a bear just yet.
So, what is my point? We are collectively (all investors) being forced to invest in assets (stocks, bonds, real estate, etc.) at prices that are affected by low interest rates because “there is no alternative” (i.e. TINA). For public market investors like us, we must be cognizant of the low interest rate environment we are in. Moreover, the debt fueled growth will have to be dealt with by politicians, central bankers and the citizenry at some point. We must remember that cycles do turn, liquidity dries up, and confidence reverses. However, market timing is not a reliable option either. So, it all comes down to balancing “fear and greed” by being prudent with asset allocation.
Chris Gildea, 610-260-2235