THIRD QUARTER ECONOMIC OUTLOOK – August 2, 2021
Cloudy With a Chance of Sun
Halfway through the year and the US economy continues to rally despite a surge in the Delta variant of Covid-19. Business confidence is strong, financial conditions are loose, and expectations for future growth are likely still to pick up. Factories are finally getting products out the door faster as supply chain constraints begin to ease and these are helping ease inflation pressures.
Worldwide, the near-term economic outlook is tied to contagion rates, particularly of the Delta strain, and to what extent restrictions might be imposed again on activities (England is the best test case). Overall, the world economy is expected to expand at 6% this year however, there is a striking divergence between recovery rates in developed vs emerging countries. The IMF has lowered its forecast for emerging and developing countries where the Delta variant contagion has surged and vaccination rates are lower.
While inflation has advanced in 2021, headlines tout it is driven by prices of items such as lumber, used cars, gasoline, and air travel but inflation has also shown up in surging housing rents. Nationwide, rents are up 7.5% so far this year according to data from apartments.com.
The strong economic recovery and supply chains that continue to lag in efforts to meet mismatched demand for goods and services support rising inflation. It is likely that consumer inflation is near its peak and should recede in months to come yet will likely be higher than we have experienced over the last 12 years of very low inflation following the GFC. Lumber prices have already fallen precipitously and chip manufacturing is just beginning to pick up. Adding to the normalization of inflation is the fact that real-time stimulus is near the end of the cycle. Future stimulus in the form of infrastructure spending is expected at lower spending levels and over multiple years. This will allow supply chains to normalize and keep up with demand since supply chain interruptions lifting commodity prices is more to blame for inflation than “super-cycle” outsized demand. With more infrastructure, a stronger supply chain, and the easing of labor shortages, prices should stabilize. While wages have been spiking as workers are slow to return to work and switching jobs for better pay, there is enough slack in the labor market to offset outsized pressure on wages. There were approximately 9.3 million job openings in Q2 2021.
In the current historically low rate environment, money has few places to go and therefore both equities and real estate are ripping. Investors purchased $144.7 billion of US commercial real estate in Q2, which far exceeds the $127.2 billion average seen between 2015 and 2019, according to Real Capital. With our US debt level so high, real yields will likely stay low for longer. Currently using spot yields and inflation, real yields are -4.15%. This is the lowest since 1980 and not far off of 70-year lows. Clearly, the market does not believe 5.4% inflation is sustainable. The prospect of falling so far behind inflation through lending at such low rates drives investors to higher-risk investments. Additionally, positive US real yields for any length of time would likely set off debt crises around the world so the Fed will likely stick with the low rate regime. They can blame elevated unemployment levels for what looks like several quarters to come and tapering asset purchases will precede lifting rates.
China is the real wildcard with a crackdown on tech companies and entrepreneurs. While military engagement between East and West remains an unlikely event, China could face an economic war that rolls back its access to the West, and with it a severe interruption of the global economy in which China, and its people, will suffer most. China seems worried it is losing control over its internet and what its citizens can access and do online. The US could be the largest beneficiary, as trade needs to go on but with friendlier allies. Meanwhile, expect continued focus on onshoring supply chain activities that were significantly interrupted during the COVID crisis.
Modern Monetary Theory in Action
As we continue to evaluate whether the inflation we are seeing now is transitory or a harbinger of what is to come, I think it’s important to recognize the roles that monetary and fiscal policy have traditionally played in balancing out the impact of their dual mandates. Historically the separation of how responsibilities are shared between monetary and fiscal authorities is that the Fed/Monetary policy has exclusive control over the stabilization of demand and inflation, and the Treasury/Fiscal policy has exclusive control over the stabilization of public finance as measured by the deficit and debt ratios. Although this relationship has always modified over time, it has never until now begun changing so drastically.
Under the traditional convergence of policies, an increase in interest rates tends to reduce demand as there is a shift of resources from borrowers to savers, and as a result, there is a lower propensity to consume. Further, there is no net transfer of wealth from the public to private sectors since the additional interest expense incurred on public debt is eliminated by a reduction in the primary deficit as the Treasury absorbs the fiscal impact of monetary policy. In addition, in a scenario where the Treasury starts a public spending initiative, the Fed must absorb the monetary impact of fiscal policy by purchasing or facilitating the purchase of that public debt. The risk, however, is that raising rates – without a counteracting reduction in the primary deficit – generates a net transfer from public to private sectors that can increase inflation through the ‘interest income’ channel. In other words, the inflationary consequence of raising the policy rate depends on how monetary and fiscal policy interact and, specifically, on the attention paid by Treasury to fiscal reference values.
This preconceived concept of the interrelation of fiscal and monetary policy appears to be declining, as the emerging idea from the new Modern Monetary Theory (MMT) is that government spending faces an inflation constraint, not a budget constraint. The result is we can be less sure of the inflationary impact of raising the policy rate and that the Fed has all the modern tools to address pressures if they do arise. MMT believes central banks have monetary policy upside down and that inflation has remained below target because of, and not despite, low-interest rates. Their view sees positive interest rates as generating basic income for people who already have money but leaving out the wider populace of consumers. Subsequently, when rates are lowered the entire populace comes into play and the pool of demand widens to encompass the wealthy and the working class, who are then enticed to spend, and hence inflation goes downward, and vice-versa for raising rates.
It has also been argued that quantitative easing removes interest income from the private sector and thereby functions much like a tax and a source of what is called fiscal drag as it takes net dollars out of the economy and can then reduce the federal deficit. However, the impact on inflation through the interest income channel for monetary policy is offset if the Treasury counteracts by reducing the primary deficit. And, indeed, this is what occurs in principle under the traditional responsibilities between the monetary and fiscal authorities: the stabilization of demand and inflation is the exclusive preserve of the Fed; and the stabilization of government finances, as measured by fiscal reference values such as the debt and deficit ratios, is the exclusive preserve of Treasury. MMT rejects this idea by arguing that government spending faces an inflation constraint, based on the real resource capacity of the economy, and not a budget constraint based on fiscal balancing. As a result, it argues that the stabilization of inflation is not the exclusive or even proper mandate of a monetary authority. This raises the question of how inflation will react to rising rates if the primary deficit does not absorb the fiscal impact of higher interest expense.
In other words, the inflationary impact of rising rates depends on how monetary and fiscal policy coordinate and, specifically, on which is in the driver’s seat. Is the Fed is stabilizing output and inflation whilst the Treasury is accommodating monetary policy by adjusting the primary deficit to absorb the fiscal impact of changes in government interest expense – or is the Treasury pursuing a fiscal policy independently of fiscal reference values and counting on the Fed to absorb the monetary impact of changes in government spending? As of now, there is a case that we are in the latter regime as almost the entire year from June 2020, the variation in total deposits at the Fed – across bank reserves, non-bank reverse repo (RRP) balances, the Treasury General Account (TGA), and other deposits including from GSEs – varied from low-to-high by only 5% on a base of $5T.
Regardless of which monetary policy proves true, we have already seen the political constraints preventing action from taking place. In the realm of possibility that fiscal policy remains frozen by political infighting, monetary policy will continue doing double duty by artificially keeping interest rates low and the cost of borrowing lower to further support the increasing deficits and lower tax revenue. Moving ahead, it will take the coordination of both fiscal and monetary policy to ensure one effort compliments and does not offset the efforts of the other.
In today’s ultra-low-rate environment, it is difficult to find fixed-income instruments with meaningful income without assuming excessive risk. While fixed income has a place in a portfolio, we believe looking outside of traditional asset classes is warranted for clients to meet their investment goals. This has led the investment committee to set our sights on various alternative investment solutions that produce healthy yields coupled with low volatility and low correlations to other assets: Greenbacker Renewable Energy Company (GREC) and Blackstone Private Credit (BCRED).
Greenbacker (GREC) is a premier owner/operator of commercial-scale renewable energy power facilities in the US having invested over $1 billion in 259 renewable energy products in North America. Their investment focus is on solar, followed by wind and biomass/energy storage. We believe GREC offers a compelling opportunity in today’s environment; renewables are at 17% of US capacity today and are expected to grow to 25% capacity in 2025 and 64% in 2050. An enormous amount of capital ($5-$10 trillion) will be required to meet these projections. Lastly, 37 states now have targets or mandates to increase their renewable energy generation. GREC’s business plan is straightforward: acquire commercial and utility-scale renewable power generation facilities and sell that power to investment-grade counterparties (utilities, municipalities, and corporations) via long-term contracts. GREC has a stable and reliable stream of revenues that are classified as “return of capital” when paid out as distributions. Because of the status of the distribution, it is untaxed at the federal, state, and local levels for up to 10 years or more.
BCRED is Blackstone’s institutional private credit platform that was created for individual investors. Private credit is a growing area of the debt space that was historically only available to institutional investors. It has risen from 8% of the total loan market in 2005 to 20% in 2020. The reason for this is due to banks reducing their commercial loan businesses (25% participation in 2005 to 13% in 2020) and middle-market businesses choosing to have one lender instead of many (referred to as a syndicated loan). The strategy of the fund is to lend to middle-market companies with revenues between $50 million and $2.5 billion. Many of the positions that are taken are senior secured, which means that Blackstone would be the first to be repaid if an adverse event such as a bankruptcy were to occur. A smaller allocation of the portfolio can be allocated towards second-lien, unsecured, and mezzanine debt when opportunities arise. Having an allocation to private credit helps boost income in a portfolio with lower risk and lower correlations to other asset classes. We feel confident in Blackstone’s ability to execute its strategy due to its long-term track record and experience investing in the industry since 2005.
Both GREC and BCRED provide high income that has low risk and low correlation to traditional assets. They add value to portfolios on a risk-adjusted basis and can help investors meet income goals without putting principal at undue risk. As both strategies begin to roll out, we look forward to giving you additional details about them.
The Freedom Challenge: John Muir Trail
In July, the Optivest Foundation sent 3 women on two legs of The Freedom Challenge relay to hike the epic 211 mile John Muir Trail. The Freedom Challenge is a movement of passionate women dedicated to freeing oppressed and enslaved women and children all around the world. We do this by participating in physical challenges that test our limits while raising funds and awareness to combat these dark, social injustices and set women and children on the pathway to freedom.
Regardless of the path and duration of inflation or the fallout from COVID & variants, an Optivest portfolio is built to continually produce income and growth over moderate time frames via either the correlated or the uncorrelated investments and, most often, from both in unison. Diversification is both durable and tax-efficient. There is a great benefit derived from owning an “all-weather” mix of investments and Vanguard seems to agree – from their 2021 mid-year economic update:
“Even with our upward revisions, returns from bonds in most markets are likely to be modest. We nonetheless still see their primary role in a portfolio as providing diversification from riskier assets rather than generating returns.
Keep in mind that return forecasts change in response to evolving assessments of economic and market conditions, but that does not mean your investment plan should change. In fact, long-term investors often have the best chance of investment success by staying the course if their investment plan is diversified across asset classes, sectors, and regions and is in line with their investment goals and risk tolerance.”
Leslie, Matt, Ryan & Ashlee