“There is nothing more permanent than a temporary government program” – Milton Friedman.
First is was the financial crisis of 2008 that “forced” the Fed to perform unnatural acts. It was at this time that the Fed introduced Quantitative Easing (“QE”). QE was to be a “one-and-done” program. That program remains part of the Fed’s day-to-day operations today. In 2020 the Coronavirus was the Fed’s excuse for continued QE, continued fiscal deficit monetization and for introducing a series of lending and asset purchase programs. We do not expect the Federal Government to curb spending. We are in a new “Fiscal & Monetary Normal” that will widen the Federal deficit and mute GDP growth.
Here is how we believe this will play out over the next decade. (Hint: align yourself with high-quality management teams).
GDP: Real GDP will hover around zero, perhaps a bit lower should we have a two-term Biden Presidency and a Democrat Congress. The combination of tax increases, expanding fiscal deficits and elevated corporate and consumer debt levels will act as a wet blanket on corporate and consumer discretionary spending. A national 5G network, “green” power initiatives and expanding social welfare budgets are several areas where we expect the Federal government to spend heavily over the next decade under a Biden two-term Presidency. We estimate that U.S. Public Debt could expand from 136% of GDP to 200% of GDP over the next 10-15 years if not before then. A 200%-plus Public Debt to GDP ratio would look like Japan (charts below).
Corporate Earnings and Tax Increases: Current valuations suggest that corporate tax increases are the last thing investors are thinking about. Trump will raise taxes should he win a second term. A Biden victory combined with the Democrats winning the Senate will result in much higher taxes. We believe tax increases will take effect in 2022 regardless of who wins the General Election on November 3rd.
Record Corporate Debt Will Hamper Innovation and Revenue Growth: Corporate America has record debt levels outstanding ($11 Trillion as of Q2 2020), which applies downward pressure on innovation investments and revenue growth. Much of this debt is variable rate which means companies must squeeze every last bit of profit from operations to meet share repurchase and dividend commitments while having some dry power remaining for internal investments and M&A. There is an inverse relationship between debt outstanding and corporate innovation.
The Fed’s Dilemma – Low Rates, CPI Inflation and A Declining Dollar: At some point the Fed will be forced to decide how low it is willing to allow the Dollar to go as a result of expansionary fiscal and monetary policies. For now, the Fed says it welcomes 2%-plus CPI inflation and that it is prepared to ramp up QE to maintain near zero interest rates. The Fed thus far is not prepared to take interest rates negative (in nominal terms). Zero interest rate policy and CPI inflation will further harm the Dollar. Given the amount of Federal and Corporate Debt outstanding it would be difficult for the Fed to increase rates beyond 1% over the next few years but a modest rate increase may be necessary before 2023 should inflation get out of hand. Runaway inflation is entirely possible given policymakers’ cavalier approach to spending. Our bet is for a declining Dollar until we have a moderate and sustained increase in rates.
Invest Opportunistically: Management team quality will matter more than ever. This next fiscal “stimulus” package will likely further inflate the market bubble once it is executed. Post stimulus round two, it is difficult to predict what may drive company valuations higher, especially where valuations have exploded in 2020. Earnings growth as a catalyst for higher valuations? I doubt it. We have pulled forward too much price appreciation to make it up with one or two years of earnings growth. Further, the market has not contemplated a Biden tax increase which will materially impact earnings growth.
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