The Influence of Too Much Government Spending
The long reach of 'fiscal dominance'... When government spending goes into overdrive... The 1970s didn't even have this... Tips for navigating this market... Today's inflation report... Powell 'wouldn't call it hot'...
Lyn Alden has thoughts about 'fiscal dominance'...
Today, we're sharing a must-listen-to episode of the Stansberry Investor Hour... It's with Lyn Alden, a sharp macroeconomic analyst whose work I (Corey McLaughlin) have been following for years...
I think you'll understand why this week's episode is so important when you hear Lyn share her thoughts on the global economy today... particularly about why she thinks we're either already in or entering an era of "fiscal dominance"... and what it could mean for investors' portfolios.
The term "fiscal dominance" is finance-speak for when a government spends so much money – or lends it into existence – that it reduces the effect of "tighter" monetary policy on inflation.
As Lyn said, "The fiscal side becomes more important on the economy than the monetary side."
This scenario may sound familiar, as it has increasingly been happening in the U.S., which is running a multitrillion annual deficit as we speak. As Lyn pointed out early in our conversation...
The federal deficit is larger than the sum of new bank loans and new corporate bond issuance in a given year, at least in most years.
That nugget of knowledge came at just the start of our conversation...
What has already happened...
As Lyn – a former engineer-turned-macro analyst – went on to explain, today's fiscal dominance means that when the Federal Reserve raises rates – as it did in 2022 and into 2023 – it affects certain areas of the economy, but not as much as it would have if the federal deficit wasn't so high... like if Uncle Sam hadn't printed trillions of dollars into existence and sent millions of people checks and debit cards, then spent more as inflation was picking up. As Lyn said...
High interest rates are not really going to change what the deficits are doing. When you increase interest rates at a time when you have 100% debt to GDP held by the public, you actually increase those deficits even more than the rate that you slow down bank lending.
Although the higher rates did have a downward, disinflationary effect on the private sector money creation, the impact it had on the federal side is equal or bigger, so interest rates start having a more mixed result in dealing with inflation.
On one hand, they are recessionary and disinflationary when you raise them. On the other hand, they're stimulatory. If you're owning money markets, every time the Fed raises rates, you get a raise.
If you're ExxonMobil and you have long-term debt locked in, you have cash equivalents on your balance sheet, so you get a raise. That was not the case in the 1970s, or certain other periods.
Importantly, in the high-inflation 1970s, the federal deficit was substantially lower compared with GDP than it is today, so higher rates back then hit hard. Debt-to-GDP was around 30%, a 100-year low.
"There were monetary solutions to monetary problems," Lyn says. Now? Not so much, or at least not without higher-than-expected inflation as a consequence.
Lyn says today's deficit and inflation is closer to the 1940s and World War II era. The U.S. debt-to-GDP ratio is at 120%, its highest level since WWII ended. When a country gets above 100% debt-to-GDP, things change, Lyn says...
In general, [central banks are] unable to raise rates as high as they prefer because they start running into bank solvency issues that become systemic, and the effects that they have start to turn backward... If it gets bad enough, you can get to a situation where rate hikes are inflationary. The U.S. is kind of teetering on that range.
Where we are now...
The pace of inflation has come off its 40-year high from 2022, but price increases are still running above "normal" in the U.S. and the Fed's 2% annual inflation target, despite the sharpest rate-hike run in decades.
It's difficult to quantify how much government spending impacts inflation, but it's not zero... And as we've pointed out before – and Warren Buffett even mentioned during Berkshire Hathaway's recent annual shareholder meeting – Fed Chair Jerome Powell has recently hinted he thinks government spending is a significant issue... to which Congress says, "Hold my beer."
Compounding debt...
Like a person racking up credit-card debt at high rates, Uncle Sam is doing the same...
And higher interest rates (to "fight" inflation) are costing the government (and "We the People") more money because of the higher cost of paying U.S. debt holders. As we wrote last month...
The national budget racked up a more than $1 trillion deficit through the first half of the fiscal year, ending in March. Interest payments on public debt were up 36% to $522 billion.
Given that the unemployment rate remains low (below 4%), the only logical reasons for the Fed to want to cut rates, as it says it's intent on doing, are the compounding effect of debt costs and the stress that higher rates put on the banking system (like last March with regional banks, for example).
But if or when the Fed does cut rates, the central bank could reignite inflation – and fiscal spending plays a part. The U.S. government hasn't finished a year with a surplus since 2001, and the size of annual deficits has trended higher since then.
What to do...
The last few decades, the pace of inflation wasn't an outsized issue, or at least a widely Fed-recognized problem. Bank lending rates were generally trending lower or low, near zero in some cases. But prices for all kinds of things were certainly getting higher along the way.
The difference today is that with high(er) inflation out of the bag after the trillions of dollars of government stimulus during the pandemic, the government-spending part of the equation is more obvious. Prices are higher and rising, and the cost of borrowing is higher.
So what worked in the last few decades – like the conventional 60-40 stock-bond portfolio, which benefited from an environment of interest rates that were steadily falling over the long run – isn't the best recipe now, Lyn says.
Instead, she has some alternative suggestions for how to position a portfolio, like having exposure to the energy sector, precious metals, and other "hard" assets... and looking at companies with solid balance sheets that locked in debt at low rates several years ago.
Check out the full, free interview from this week's Stansberry Investor Hour to hear it all. I think you'll find it enlightening... And let us know what you think by e-mailing feedback@investorhour.com.
You can also listen to the full audio version of the podcast – which includes the interview, Dan and I discussing more about Lyn, along with other topics like what's been going on in Argentina and meme stocks – at InvestorHour.com or wherever you listen to your podcasts.
About inflation...
The April producer price index ("PPI") – which measures costs for businesses – increased by 0.5% month over month, higher than mainstream economists' estimates. Year-over-year growth was 2.2% in April, the highest percentage of the past year.
You could call this inflation report "hot."
Yet there are some nuances to consider... Energy prices accounted for a good chunk of the gains, up 2% in April for businesses. Other sectors showed more moderate price growth – which is still growth – and other areas (like food costs) were down.
What might matter most for the direction of the markets, though, is what the Fed makes of this in the grand scheme of the U.S. inflation story.
And lo and behold, we got to hear Powell's immediate reaction to the latest inflation numbers during a conference in Amsterdam...
Powell referred to this morning's PPI report as 'mixed'...
He said...
I would say it's actually quite mixed... I wouldn't call it hot.
In other words, he's saying that he hasn't changed his mind on the path of monetary policy right now – which means steady rates and an inclination to want to cut them.
The major U.S. indexes were also "mixed" for much of the day but moved higher in the late afternoon. The benchmark S&P 500 Index finished 0.4% higher, and the small-cap Russell 2000 was up 1%. Yields were little changed. Of note: Those headline "meme stocks" we discussed yesterday were up double-digits again.
The "inflation watch" parlor game will continue tomorrow... when April's consumer price index report, which typically gets more attention than the PPI, comes out in the morning.
New 52-week highs (as of 5/13/24): ABB (ABBNY), Arhaus (ARHS), Alpha Architect 1-3 Month Box Fund (BOXX), Dimensional International Small Cap Value Fund (DISV), iShares MSCI Spain Fund (EWP), Cambria Emerging Shareholder Yield Fund (EYLD), SPDR EURO STOXX 50 Fund (FEZ), Kinder Morgan (KMI), Coca-Cola (KO), Lockheed Martin (LMT), RadNet (RDNT), Sprouts Farmers Market (SFM), Teradyne (TER), Toast (TOST), and Texas Instruments (TXN).
In today's mailbag, feedback for our Director of Research Matt Weinschenk on the updated format of our Forever Portfolio... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.
"Matt, just a quick message to commend you on the new approach to the Forever Portfolio. I was pleased to see you'll now be spotlighting one of the 'Forever' businesses in each month's issue. Appreciated." – Subscriber Andrew M.
All the best,
Corey McLaughlin
Baltimore, Maryland
May 14, 2024