Go Big or Go Home

Go Big or Go Home

The opening quarter of 2024 started with a bang. Despite a historically prolonged yield curve inversion, the U.S. economy outperformed expectations, showcasing growth. However, the labor market began to show cooling signs, with a slight uptick in unemployment. Inflation, while somewhat moderated, stubbornly exceeds the Federal Reserve’s (Fed) target. Despite these factors, the economy skirted recession, fueled by BIG government spending and BIG immigration. Risk assets extended the rally on the prospect of lower interest rates in the near future. Yet, inflation has historically come in waves, and the key to avoiding a resurgence of inflation will be balancing labor market dynamics with excess government spending and continued productivity gains.

Inflation is not quite settled, can the Fed prevent a second wave?

In the fight against inflation, it may be said that the easy part is over --- for now. The first stage saw the effects of subsiding “transitory” effects of supply-chain blockages. This low hanging fruit led to advanced economies experiencing steady drops in inflation from 6 – 12% highs down to more recent 4 – 6% ranges. The next stage, reducing inflation to the 2% target and keeping it there, is proving more difficult. To this point, the Fed has held the course on keeping interest rates higher, but there has been growing speculation that we may see the first cut to the Fed Funds rate in the summer of this year. While rate cuts are typically utilized to spur economic growth, this should be balanced with the emerging concerns that a premature loosening of monetary conditions could spark a resurgence in inflation (e.g., the 1970s.)

The February reading for the Fed’s preferred indicator of inflation - the price index of personal-consumption expenditures (PCE) - rose at a relatively tame rate of 2.5% annualized. However, beneath the surface, the trend is less benign. The core PCE indicator, excluding food and energy, climbed by 3.5% on a three-month annualized basis. Facing stubborn and sticky inflation readings, recent comments from members of the Fed conveyed doubts that a rate cut is imminent. In just the first few days of the second quarter, we have already seen interest rates rise markedly. For example, Fed governor Christopher Waller recently stated “[t]hese shorter-term inflation measures are now telling me that progress has slowed and may have stalled. In my view, it is appropriate to reduce the overall number of rate cuts or push them further into the future.” While higher for longer rates may be helpful in the fight against inflation, this must be carefully balanced against eventually causing too much economic contraction. In the face of prolonged high rates, the economic engine will eventually run out steam and risk assets, like equities, will falter.

Deficit spending stimulates the economy, but how much is too much?

Comparing today’s inflationary environment to that of the 1970s stagflation period begins with analyzing the large Federal spending programs present in both. When faced with a sluggish economy, it is common to see an uptick in government spending (i.e., widening government deficits) used to provide additional fiscal support and to stimulate economic growth. Less common, however, is experiencing expanding federal budget deficits alongside positive economic growth. This is even more uncommon at the low levels of unemployment we see today. At the current run rate, Federal debt is rising by $1 trillion every 90 days, and U.S. government spending, as a percentage of GDP, is near levels last seen during World War 2.

When a country issues debt solely in its domestic currency, budget deficits don’t become problematic until the interest service cost is well in excess of the growth rate of the economy. To manage sustainable levels of borrowing, a budget constraint should be considered in terms of the ratio of debt to nominal GDP (i.e., Real GDP + Inflation). When debt levels rise faster than the economic activity needed to support it, corrective action must be taken to avoid a sovereign debt crisis. One action involves deleveraging. However, this often brings about austerity which slows growth and typically leads to a recession. The less painful, and therefore more populist, action is to try to increase economic activity to grow out of the problem. This policy could be considered the base case but assumes that interest expense does not continue to increase, and economic growth remains supportive of increasing tax revenues. Alternatively, interest expense could be controlled by reducing interest rates. However, this gives way to a concept called, “Fiscal Dominance.”

Fiscal Dominance refers to an economic condition that occurs when a country's debt reaches such high levels that monetary policy (i.e., interest rates) can no longer be afforded as an effective policy tool for controlling inflation. In effect, Fiscal Dominance establishes a perverse incentive to lower interest rates for the primary purpose of managing debt service cost, which comes at the expense of higher inflation. When does Fiscal Dominance become a reality? According to one study, the U.S. is in a stimulative fiscal policy framework when interest costs are below 14% of tax revenues. Conversely, when interest costs exceed 14% of tax revenues, fiscal policy moves into austerity. At present, we are bumping up against those limits as net interest costs currently exceed 14% of tax revenues.

The government is supporting job growth for now, but what is the impact of immigration?

Over the last year, nearly 25% of all U.S. job gains were attributed to government hiring, underscoring a significant reliance on public sector employment to sustain economic growth. The examination of job growth reveals a nuanced landscape of employment, raising questions about the sustainability and quality of job growth going forward. Further, the labor participation rate has been stuck below pre-pandemic trends and the baby boomer retirement stage is something the labor market will contend with for the next decade. Labor supply is one of the endogenous factors of production for economic growth. With organic demographics working against the U.S., we’ll likely need additional channels to support future growth.

Enter “big immigration” (i.e., more labor supply). There’s mounting evidence that immigration has allowed foreign-born labor supply to help fill the void left by retirees. It should be noted that U.S. immigration is tough to fully measure, and as a result the totality of reported data, in terms of economic activity and productivity, may be confounding. Further, state-level policy enacted to relocate migrants from the southern border to larger cities may have also had the (likely unintended) effect of matching individuals to regions where there was an ability to work, even if informally. If these labor dynamics change, this could have a meaningful impact on the effective unemployment and inflation rates.

Productivity gains improving, how long will it last?

On the other end, productivity growth is an exogenous factor of production for economic growth. Longer term, productivity (i.e., economic output per hour) is likely a key to stopping a second wave of inflation from picking up. Put simply, instead of addressing inflation from the perspective of having too much money chasing too few goods, we would prefer to see more goods & services produced. While productivity has shown signs of rebounding, it can be very choppy. Advancements in Artificial Intelligence (AI) bring about the real possibility of productivity enhancements, but it is likely a long-run phenomenon. While the prospects are promising, in the short run, we are racing against large U.S. budget deficits and an immigration policy that may be politically unstable.

Equity markets have been hot; can they sustain the heat?

The U.S. equity market has been on a hot streak. Rounding out the first quarter, we now have experienced five straight months of positive U.S. equity performance. Although there has been some indication of the U.S. market broadening out, the top of the market is becoming more condensed. In 2024, the Magnificent 7 has been reduced to 4 with Nvidia (NVDA), Microsoft (MSFT), Meta (META), and Amazon (AMZN) stealing the show. However, these higher priced ultra-mega cap companies have also proven sensitive to rising interest rates, making them a key group to watch as the Fed executes their plans. In reaction to this, we have taken the opportunity to reduce our exposure to interest rate risk by initiating a small position in an equal-weight U.S. Large Cap ETF. In addition to reducing our interest rate exposure, this allocation helps broaden our exposure to more reasonable valuations. At present, valuations, particularly of the ultra-mega cap companies, remain elevated. Absent of a recession, we view asset prices as quite expensive relative to history. Though corporate earnings have improved, they have been outpaced by equity price gains, ultimately leading to multiple expansion. These higher equity multiples indicate that bargains are few and far between. Moreover, they also indicate that much of the good news about the future is already being priced in – a goldilocks scenario.

Yield curve is inverted, but for how much longer?

In terms of fixed income, credit spreads in the bond market remain quite tight and below historical averages. The credit spread is the difference between what could be earned on two bonds of similar duration, one that is a risk-free bond and the other a bond of riskier credit quality. In other words, tight spreads indicate that bond investors are being compensated less for taking on additional risk. In a recession, we would expect this phenomenon to reverse. As a result, at this point we prefer to wait for an opportunity where the upside outweighs the downside. Additionally, we continue to prefer the shorter end of the yield curve where we are being compensated with higher rates and less duration (i.e., interest rate) risk. Related, the current combination of mixed economic data, restrictive monetary policy, and high valuations have led us to maintain higher than normal cash balances in client accounts. Now, with short-term treasury and money market fund yields above 5%, it’s hard to find any other asset class with a better risk return profile. In addition, if core inflation trends higher, even slightly, and the Fed does not begin to loosen monetary policy by June, we would expect these yields to move even higher. The recent move up in rates to start this quarter has reconfirmed this positioning.

Conclusion

As 2024 unfolds, we continue to contend with the economy exhibiting mixed signals of growth and underlying vulnerabilities. The interplay of inflation dynamics, government spending, and labor market shifts, coupled with geopolitical tensions, upcoming elections, and technological advancements, sets a complex stage for investors. While the equity markets have shown robust performance, the looming specter of inflation and the intricate interplay of monetary and fiscal policies demand attention. As the Fed continues to consider a potential recalibration of interest rates, our focus will remain on discerning the subtle shifts in economic indicators, helping to ensure our investment strategies are both proactive and resilient.