Economic ramblings

Two interesting Bloomberg interviews recently:

1. 22/6/2020: William Dudley (ex NYC Fed President) https://www.youtube.com/watch?v=I5GUQ3Qugvg

2. 25/6/2020: Bob Price (co-CIO Bridgewater) https://www.youtube.com/watch?v=fnn6jTVN_Wo&list=WL&index=2&t=0s

In the Dudley interview, the key points are:

• $10trillion Fed balance sheet is likely

• Fed's primary focus is on fighting the present crisis - better to stave off full blown recession today. But there will be a hangover in the future

• Don't know what will happen - this has never been done before

• Current liquidity pushes up Asset prices but these prices will fall when Fed eventually withdraws the liquidity

• Fed taking risk on its balance sheet by holding LT assets financed by ST rates - when they eventually raise rates, the financing cost will be greater than the LT asset yields. Note: there is also credit risk from Fed's corp bonds not mentioned here

• Fed has tools for illiquidity, but there are limits to companies' taking on new debt and servicing that debt (June was highest ever junk bond issuances). Fed has limited ability to mend damaged household and corporate balance sheets

In the Price interview, the key points were:

• Current monetary policy 3.0 is mix of fiscal and monetary. We've already reaching limits of the other monetary policy tools: 1.0 lowering interest rates and 2.0 QE

• Current fiscal spending bridges ST lost wages but virus duration likely much longer than a few months. Future depends on government willingness (and financial markets?) to fund the income gap. Some governments (emerging) will have difficulties financing future gap

• The individual stimulus payments haven't driven consumer spending as much as in the past. Therefore the economic benefits have been smaller vs the liquidity increase in the system

• Collapse in income, especially low incomes, may persist for a long time and mean lower levels of corporate profitability and cashflows

• Studies of past recessions and deleveraging has seen: 1) monetary stimulus, 2) fiscal stimulus, 3) debt restructuring, 4) currency devaluation. We have done the first two but is it enough? Do we need to restructure and/or see FX devaluation?

The US has spent and pledged an enormous amount on fighting the virus. On the fiscal side, the virus relief package is ~$2.4trillion and the Fed estimated it would spend $4trillion. Note: Fed spending isn't counted as Gov debt and these were numbers from May 2020 which may adjust upwards later this year. Even on these numbers the US gov debt will rise to $26-27trillion ($3.5bn 2020 budget deficit + $23trillion 4Q19 gov debt) which is 123% Debt/GDP using FY19 GDP or 131% using IMF estimate of 2020 US GDP. According to KKR, they estimate 150% Gov Debt/GDP as the tipping point so based on this US's limit is ~$32trillion using FY19 GDP. That's only one or two fiscal stimulus programs away and who knows how long the subpar growth will last. Also this figure doesn't include Fed's ballooning balance sheet to $10trillion on which they are likely to incur unknown future losses.

One has to wonder:

• Can the US raise rates? And what will the Fed do if inflation rises?

• Can the US gov deleverage? Is there political will to do so?

• The limits of financial markets' willingness to finance the US deficit in the longer term?

It seems inevitable to me that the next US government will need to raise taxes. Growing out of this situation doesn't seem possible. They should also carefully reconsider Trump's trade policies which is reversing globalisation and promoting localisation. Such policies will decrease global trade and financial flows velocity and may be LT negative for US assets (and financing the US budget). Yes localisation means an investment inflow into the US but this is one-off while at the same time it decreases other countries' willingness to hold US financial assets and incentivises them to localise too. Also localisation can create local US productive assets but it won't mean they are cost competitive and it doesn't change Demand. Just look at the Fuyao documentary on Netflix: American Factory. Productivity of US manufacturing has been lower than other parts of the world for a long time and no amount of money or training will change that. Will the US government then double down with protection tariffs to support these zombie factories? Low interest rates and political interference in the free-market is a long term recipe for disaster. This populist policy could end up worsening things for workers and consumers alike. Capital should create productive assets where efficiency is high and close to growing Demand markets: that place today is Asia.

Maybe the burgeoning US debt doesn't matter since so many other countries are in the same boat and the USD is the reserve currency after all. But if we think about the US economy as the global heart pumping the blood (the USD) to drive trade and financial flows, then intuitively the combination of the budget stress and US trade policies is very negative for this current global construct. If the US can't maintain long term confidence and demand, then at some point its system will be replaced. It could be when the world realizes US debt isn't sustainable (although this has happened in the past and the US system survived, Europe then is unlike the China today), it could be when trade no longer needs USD facilitation. If I were a European, Middle East or African nation selling industrial, energy or mineral exports to China, why would pricing in USD make sense given the future is centered around the Chinese and Asian markets? The next logical step would be holding RMB assets. There is the big question of confidence but this is built slowly (I doubt anyone in the early 20th century guessed the US would overtake Europe so quickly as the nexus of trade, innovation and finance). China's opening of its financial markets and its trade route investments are the first steps. They need to continue building a stronger independent and transparent legal system with matching oversight to protect asset owner rights. Fair and open market access policies needs to be enacted and the local pool of quality investable assets needs to grow. The later can only happen if structurally China changes to give the free-market greater rein in allocating capital and allow evolution to select the fittest companies and industries. Lastly the RMB needs to float and currency controls lifted. Not an easy laundry list!

This is just my macro ramblings and I'll be first to admit I know very little about economics. But intuitively it makes sense and seems to fit historical patterns. Fortunately I don't rely on my macro calls to drive my direct investment returns and I have little confidence in my ability to profit off Market moves even if I was right about the above. But thinking about these things helps prioritise and plan for potential future risks. Some of these include:

• Inflation: very unlikely in the short term given the greater risk of collapsing incomes. But continuing large scale liquidity injections increases the likelihood and magnitude of this risk. If the economy recovers next year and with it income stability, we could see pent up Demand and excess liquidity combine to cause a big spike in inflation. A devaluation of the USD, typical in a recovery, could also contribute to inflation

• Earnings uncertainty: it seems policy uncertainty (stimulus, tax) will play a large role in US company earnings for awhile yet

• Normalising earnings: I think Bridgewater is right: the new economic norm could be lower employment rate, lower economic velocity and higher taxes. Valuation should be evaluated based on a lower normal expected level of earnings

• USD holdings: the US equity market could still be fantastic (over a limited time frame) even in a declining USD scenario but is it wise to concentrate excess cash liquidity in the USD?

A skilled Trader may be able to surf future Market waves without changing anything today. But as a fundamental Investor I need to prepare my Portfolio and myself mentally for these risks today. The eventual change of Fed and US government policies + inflation expectations could bring in a tsunami of new Market moves and opportunities.