The Burden of Experience in a Modern World
May 26, 2021
Image used with permission: iStock/sesame
The Burden of Experience in a Modern World
Those of us who started in the industry decades ago have witnessed enormous change. When I finished university in 1982, Japan was the world’s ascendant economic power and Japanese management techniques were taught in business schools. Economic policy was dominated by dealing with stagflation, a term coined to describe low growth and high inflation. And the dominant business figure of the time was 6’ 7”, cigar-smoking, Paul Volcker, Chair of the U.S. Federal Reserve.
Volcker was credited with almost singlehandedly reducing inflation from nearly 15% in 1980 to 3% by 1983. He raised interest rates to punishing levels, which sent unemployment in the U.S. above 10%. Canada was not spared the pain of this medicine either. Inflation in Canada crested just below 13% in the spring of 1981 and, under the low-key guidance of Governor Gerald Bouey, the Bank Rate reached 21% in June of that year. As the economy slowed under the burden of tight monetary policy, unemployment peaked at 13.1% in December of 1982.
Clearly, these were difficult times for all Canadians and Americans. But, to use a modern term, the “social license” for disrupting the lives of so many citizens was based on the promised improvement that low inflation would deliver to economic management. For the most part, that goal has been realized. We have spent more than 30 years in a world of well-controlled inflation.
These days the purview of central banks has broadened. They are expected to smooth the business cycle, keep markets liquid and functioning, and spare us the worst of the creative destruction that once was considered a natural consequence of vibrant, free markets. When combined with an ever-increasing role for government in our economic lives, we now accept the significant involvement of bureaucrats and academics in the operation of the economy. Volker’s degree of social license paled in comparison to the involvement of central bankers and governments today.
Fiscal Intervention + Central Bank Stimulus = ???
I learned my economics from the work of Keynes, Hayek and Friedman. So did today’s central bankers – only they were a lot smarter and worked harder! These days they appear surprisingly willing to incorporate the experimental world of debt monetization and zero interest rates from a reasonably new branch of economics known as Modern Monetary Theory. It’s a framework of thinking about the economy that I can’t get my head around, and I worry they have been backed into it by the pandemic.
For certain, a large, coordinated, fiscal and monetary response was required to address the effects of the pandemic. The amount of fiscal spending on both sides of the border is without precedent other than during World War II. Last year’s budget deficit in the U.S. was 17% of GDP, and the budget for the coming year will only be slightly less. In the U.S., the debt to GDP ratio has grown from about 80% at the end of the Great Recession to almost 130% at the end of 2020.(1) Similar alarming trends are evident in Canada. How these debts will ever be paid off is becoming a preoccupation of many investors – and it is a valid concern. But it is not only on the fiscal front that the situation has changed. Central banks are also more “in the fray” than ever before. The central bank toolkit includes ultra-low interest rates, forward-guidance, and quantitative easing policies. They are applied to suppress borrowing rates in capital markets and so stimulate investment and consumption.
Explicitly, the intervention of governments and central banks has been to manipulate markets and economic activity. This intervention has provided short-term relief, but may be sowing the ground for more serious problems in the future. One of these problems is a rekindling of problematic inflation.
In early November of 2020, Pfizer released efficacy data for their COVID-19 vaccine. It promised to change the course of the disease and with it, the trajectory of the global economy. Equity markets, alert to the prospect of recovery, moved higher and bond yields rose too, anticipating a future end to ultra-easy monetary conditions. But it was not just capital markets that celebrated. Commodity markets and housing markets also jumped in value. Central bankers have assured the public that tighter monetary conditions are not imminent and governments in both Washington and Ottawa have offered no sign that they will moderate spending. It is not surprising that, aided and abetted by cheap money and government support payments, a speculative mind-set has gripped the world. Cryptocurrencies have raced to new highs, speculative financing vehicles known as SPACs have raised billions of dollars, and digitized art, in the form of Non-Fungible Tokens on the blockchain, now command multi-million-dollar values.
Risks Differ – Depending on your Mandate
Increasingly, investors worry that the same speculative, animal spirits coursing through asset prices will do the same to consumer goods inflation. Those of us of a certain age have been conditioned over decades to the priority of keeping inflation low. It is a learned behaviour that is difficult to ignore. But it is not just out of habit that we worry. At Nexus, we define risk as a client not achieving their reasonable financial goals. An explicit goal when managing our clients’ wealth is protecting the spending power of their capital. So, these days, when central bankers seem so relaxed about higher inflation, we feel a little unsettled.(2)
If Governor Macklem and Chair Powell could be described as inflation doubters, it is because they see risk differently than we do. They worry that their respective economies generate only lacklustre recoveries and that growth wanes before economic slack (particularly labour) is fully absorbed. On May 12th, the U.S. April CPI was released. At an annual rate of 4.2%, it was the highest reading since 2008. More worryingly, the month over month increase in the Core CPI was 0.9%, the highest since 1982.(3) Central bankers believe these reports are within the realm of expectation and will be transitory. They are confident there is a world of difference between one-time price increases that arise from businesses regaining pricing power lost in the recession, and true inflation, a self-reinforcing, generalized increase in the price of goods and services. We understand that point of view, but our level of anxiety about inflation is high.
So, what is to be done?
As is often the case, there are very bright, experienced people who see today’s combination of easy money and free-wheeling government spending differently than I do. I try to keep my mind open to these points of view. I know that the preceding paragraphs stop well short of a thorough discussion of the prospects for inflation, possible central bank policy mistakes, the consequences of escalating government spending, and the future burden of today’s exploding deficits. Our job at Nexus is not to pronounce on such a debate. Instead it is to design portfolios that mitigate the risks that inevitably arise in this fast-changing world. Right now, accelerating inflation is definitely a risk. To that end, the Investment Committee recently reviewed each of our core equity holdings for their exposure to inflation. We created a heatmap of winners (dark green) and losers (bright red). To our relief, we discovered we own mostly green and amber names in the portfolio. With respect to our bond portfolio, our approach is unchanged. We foresee an increase in interest rates as inevitable, and we have a short duration portfolio to lessen the negative impact that will occur when this happens.
(1) FRED St. Louis Fed
(2) “I actually think that having a healthy level of inflation is a sign that the economy is healthy…” Fed Governor Rafael Bostic on CNBC. May 21st, 2021”
(3) Core CPI does not include volatile sub-components such as food and energy.