“May you live in interesting times” is a saying widely attributed as a Chinese proverb, typically used tongue in cheek when there is uncertainty or turmoil. A quick web search however tells a different story – only vague attribution to Chinese culture and instead the likely source an 1898 speech by British politician Joseph Chamberlin, perhaps based on a Chinese adage regarding… a dog. Irrespective of origin, we can observe that we are, indeed, presently living in very interesting times, and the confusing source of the phrase is an apt analogy to the bewildering cross currents of contradictory data and information we receive daily.
Consider – conventional economic theory suggests that the U.S. (and much of the developed world) is entering dangerous territory with massive stimulus spending. Pandemic-related relief efforts by governments have created increasing sovereign debt, rising debt-to-GDP ratios (currently 125% in the U.S.), and a chorus of warnings of escalating interest rates and out of control inflation. In classic terms, too much money, chasing too few goods and services. Yet, interest rates around the world remain low – the U.S. 10-year Treasury yield sits at 1.14% at this writing – and future inflation expectations remain under 2.5%, even all the way out to thirty years. And while stock markets are recently facing downward pressure, they remain up solidly for the year. In other words, the reality does not match the economic theory. What’s going on?
Some are crediting the dynamics of a disruptive but rising school of economic thought known as Modern Monetary Theory (MMT), which argues that countries with a sovereign fiat currency (such as the U.S.) do not need to be constrained by budget deficits. Thus, matching revenues with expenditures is not necessary, and spending can be covered by issuing more currency (i.e. printing money). Inflation can be controlled by withdrawing money from the economy via taxes or other “stabilizers.” We won’t dive down the rabbit hole here of dissecting and debating MMT. Suffice to say it has generated many critics, yet the current situation seems to lend at least some credence to the premises.
Looking through a more conventional economic lens goes something like this… The high level of spending may have been necessary to support the economy through the pandemic recession, but the current low levels of interest rates and inflation are not sustainable, and spending must be reined in, or we risk high inflation and an eroding currency. Post-pandemic labor and supply chain constraints are adding further kindling that could spark higher inflation. But, as noted above, rates in the U.S. have declined from earlier this year, and inflation data, while rising throughout the year, is now showing signs of slowing. Indeed, the Federal Reserve has called the inflation pressures “transitory,” and while preparing to taper their open market bond purchases, are leaving interest rates at extremely low levels.
It is possible that the 125% debt-to-GDP ratio is sustainable, and could be brought down over time, through a combination of economic growth and restrained spending as the pandemic wanes. Unlike a consumer household that has a finite life expectancy, the United States Government does not have one, so temporary “spikes” in debt-to-GDP can be accommodated in the short run. Debt-to-GDP immediately after WWII was nearly 110% and was brought back under control by strong economic growth and fiscal restraint. Economic growth should not be an issue, it will be the fiscal restraint that will be harder to manage.
So, where do these juxtapositions leave us? Economics has been called the “dismal science,” and the unknown outcomes of today’s topsy-turvy environment certainly seem a bit dismal. Many forecasters are prone to say, “on the other hand,” always hedging their statements. Therefore, understanding the uncertainty and juxtapositions requires some mental gymnastics to interpret the data.
Stripping away the extremes, what seems likely is that workers will slowly return to the labor force now that unemployment benefits have returned to pre-pandemic levels, supply constraints will ease, and the sugar high of stimulus spending will fade. Look at it as a glide path back to the pre-pandemic trend of +/- 2% growth. Consider Japan, which is often used as an example by MMT proponents. Their debt-to-GDP ratio is 235%, yet interest rates and inflation remain low.
But along with that has been decades of anemic GDP growth as Japanese citizens squirreled away money after their stock market blew apart in the late 1980’s, a psychological dent that was replayed in the U.S. during the Great Financial Crisis of 2008-09 and persists to this day. Again, without getting bogged down in debating economic and cultural similarities and differences between the U.S and Japan, their slow growth model seems a reasonable vision for the U.S. High debt may not cause spiraling inflation in today’s evolving environment, but neither is it likely to support a high-octane economy. Bond markets are clearly signaling a benign rate and inflation forecast, and stock markets have performed well (again, noting the declines this week), signaling optimism for continued future profit growth, even if at a slower pace.
Of course, looking ahead is fraught with peril, and no-one has a crystal ball, or at least one that works. So, watching closely and avoiding overreaction is important for success in portfolios and financial plans. Core fixed income remains critical – stability and income to a portfolio in times of market drawdowns is especially important in portfolios for those approaching or in their retirement years. Yes, inflation remains a risk to watch, but it is a risk that can be managed. High-quality equities remain the source of future growth in excess of inflation, and the periodic rebalancing of portfolios between these asset classes is vital to keeping the allocation mix on target.
And while some areas of the stock market such as large growth appear expensive to historic measures, others, such as value stocks and companies outside the U.S., are attractively priced relative to history and the broad market. There will no doubt be bumps – some of them big – in the road for stock prices, yet as the Delta variant effects begin to fade, workers return to employment, and consumers continue to spend, it is reasonable to foresee positive future returns. Should inflation and/or growth dynamics change, that could suggest tweaks to both bonds and stocks. But for now, a steady portfolio aligned with goals and objectives from a financial plan is the recipe for long term success.