The Economic Experiments Have Begun

Having now practiced macro investing and asset allocation professionally for over 35 years, I am often asked, “Have you seen this before?”. Being a data hound, I am constantly looking for historical analogs to current macro-economic conditions. But, increasingly, I answer the question, “Yes, I have…. But not in the way you think”. What I have seen before, and increasingly see more often now, are human actors, generally politicians and pseudo-economic scientists, using their blunt tools more aggressively to repair or change some ill they perceive in society. The tinkerers are in the lab now using massive scale stimulus and money printing to solve real problems like income disparity, educational disparity, and racial division. The intentions may be honorable but the outcomes of the experiment aren’t entirely predictable. For example, the goal of bending time-honored lending rules so everyone could own a house in 2006 was admirable Was the subsequent misery of the GFC (Great Financial Crisis) caused by a mortgage market collapse expected? Of course not. I think we are entering just such a pseudo-science experiment again but with much bigger tools. Buckle your seat belts.

First some context. From a capital-markets perspective, COVID is over. It ended in November with the Pfizer vaccine announcement. Look at the chart of the SP500 – straight up – and its mirror image the 10-yr Treasury bond rate (yields up). They knew then what the news is catching onto now. It is a good lesson on the market as a discounting mechanism. The markets increasingly see a second quarter 2021 economy that may be the strongest nominal quarter in my lifetime. Russell 3000 equity earnings growth will be epically strong. Sure, the so-called ‘base effect’ (comparisons to a weak 2Q20) is somewhat responsible but the powerful lagged effects of the Cares act, nearly $1T Dec. ‘20 stimulus, massive Federal reserve money printing, and a weakening dollar are really kicking in.

OK, then, problem solved? Real science cures COVID with a vaccine, and the largest stimulus ever turns the economic cycle, which eventually solves an unemployment problem that always lags. Seems normal. Why all the drama? Because we humans, and hence the tinkerers in DC, have fallen in love with overspending, fiat currency printing, and zero interest rates. We are about to unleash the largest stimulus in history into the strongest recovery in history. What could possibly go wrong Dr. Frankenstein?

Darius Dale, super-quant par excellence from HedgeEye, helped us look through 60 years of data and he found that it is indeed quite rare for the Fed to be easing into a period of both rising GDP and rising inflation. Rarer still is adding in a Congress and President that will take the Federal Deficit to 20% GDP during the same boom time. The experiment may work and we will cure unemployment, social inequality, and income disparity through borrowing, printing, and income redistribution. Let’s hope there is a first for everything because failure threatens a cycle that leads to a bout of inflation that could shake the US Dollar from its reserve status. And, that, is the Frankenstein outcome.

The Inflationistas are stirring. Darius predicts that second quarter inflation will be 3% but even he can’t predict what the $1.5 Trillion stimulus expected in mid-March will add to that. Meanwhile, commodity prices are roaring and the push for higher minimum wages may start an upswing in Unit Labor Costs. The bond market and currency markets have not yet demanded compensation for inflation. So far, they are reacting to reflation. If these markets demand compensation for higher inflation, the dollar will sink and government bond rates have a long way to climb. When, and if, that happens, something always breaks in the financial markets. We don’t know what or when but we will work to avoid some of the likelier targets.

For the next several columns, I will outline the risks and rewards in each of the major asset classes as we enter the boom zone and watch the experiments come to fruition in DC. For now, we continue to ride the boom, but have capped equity at 45% of portfolios. Risks are escalating. We have our lowest fixed income levels ever and have immunized the remaining bonds against any interest rate rises. Finally, as written in several prior columns, we are staunch supporters of currency diversification recommending Bitcoin, Silver, Platinum, non-USD currencies, and gold. The pseudo-scientists are in the laboratory and the experiments have begun. Stay tuned.

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