English economist John Maynard Keynes Photo: Getty Images
We are all Keynesians now, President Richard Nixon famously declared after his New Economic Plan was unveiled in 1971. The notion seems to be echoing now, with the two major parties’ presidential candidates calling for increased government spending, notably for infrastructure projects.
That’s not surprising coming from Hillary Clinton’s Democrats, who have long espoused expanded government initiatives. But Republican Donald Trump last week also declared that it would make sense for government to take advantage of today’s historically low interest rates to borrow to fund infrastructure spending—precisely the same point made by the New York Times’ über-liberal columnist Paul Krugman last week.
Talk about strange bedfellows. Yet it is not without precedent; Nixon’s pivot from orthodox Republican economic policies was arguably a more radical shift than his historic trip to open ties with China.
In one fell swoop, in a speech on a sultry Sunday evening exactly 45 years ago, Nixon imposed a freeze on prices, wages, and rents, a surcharge on imports, and an end to the dollar’s convertibility into gold.
The latter move had the longest-lasting impact, as it marked the beginning of the end of the Bretton Woods system of fixed exchange rates and augured the shift to the system of floating currencies that the world has had to cope with ever since.
As for Trump, who has called himself the “king of debt,” he said in a CNBC interview last week, “Normally you would say you want to reduce your debt, and I like to reduce debt as much as anybody. The problem is, you have a military problem, you have an infrastructure problem—a tremendous infrastructure problem—and you have other problems. The asset is, your rates are so low.
“What’s going to happen when the rates eventually go up and you can’t borrow, you absolutely can’t borrow, because it’s too expensive?” Trump continued. “It would destroy our balance sheet, totally destroy the balance sheet.”
Not to nitpick, but rising interest costs would actually play havoc with the nation’s income statement, that is, the budget deficit, as interest expenses boost the deficit. As for the balance sheet, if the nation ends up with long-lived, productive assets, along with the bond liabilities, at least we’d have something to show for the debt. Think such New Deal projects as the Hoover Dam, or the roads and bridges in the New York area overseen by Robert Moses, who commandeered the dough from D.C. to become the controversial master builder of the Big Apple. Hillary’s call for universal broadband access recalls the rural electrification program of the 1930s.
The cost may not be quite as paltry as Krugman claimed in his column, where he cited the yield of just nine basis points (0.09%) on 10-year Treasury inflation-protected securities. (By Friday, 10-year TIPS’ yields were down to just five basis points.)
But that doesn’t take into account the annual inflation adjustment to TIPS, based on the consumer price index, which is likely to be more than the energy-depressed 1% rise in the CPI in the past year.
Still, with nominal Treasury yields near historic lows of about 1.5% for 10 years and 2.25% for 30 years, borrowing to build (as opposed to just spend) would appear to be a sound investment strategy.
That’s based on economics. Politically, it has been a different story. In the years since the financial crisis, debt crises from Greece to Detroit to Puerto Rico have pushed governments toward fiscal austerity rather than expansion.
Given the political opposition to borrowing and spending, monetary policy has been the main tool to spur economies in the U.S., Europe, and Japan. That has taken the form of ever-more-radical measures, including massive securities purchases and negative interest rates, which have proved to be more successful in boosting asset prices than economic growth and incomes.
The politics may be changing toward favoring a more balanced mix between monetary and fiscal policies, argue Bank of America Merrill Lynch strategists Michael Hartnett, Brian Leung, and Jared Woodward. That means investors also should shift their asset mix.
In the next two years, the strategists see the political tide moving policies “from the monetary abundant, fiscally austere mix of the past eight years to a more balanced mix of monetary fine-tuning and easier fiscal stimulus.” Indeed, they point out that as the Federal Reserve’s balance sheet has ballooned since 2008, real (inflation adjusted) U.S. government spending and investment has declined.
The diminishing returns from unprecedented monetary policies are apparent abroad where negative interest rates have been imposed. My colleague William Pesek scathingly details in his Aug. 11 Up & Down Asia column “Why Negative Rates Are Killing Growth.” While academics say monetary stimulus should make people spend and bankers lend, they reacted to zero and negative rates by pulling in their horns.
The tight-fiscal/easy-monetary mix has worsened income inequality, the BofA/ML team contends, with Wall Street soaring while Main Street lags behind, as reflected by the fall in the labor-force participation rate to the lowest levels since the late 1970s. In response to the resulting political changes, they see a shift in the opposite direction for policies.
“Electorates appear increasingly inclined to prefer policies that address wage deflation, unemployment, immigration, and inequality,” they write. As those policies shift from monetary to fiscal stimulus, investors similarly should move from “over-owned deflation winners back toward under-owned inflation winners,” they conclude.
That means shifting from growth to value stocks; from bonds to commodities; from U.S. equities to stocks from the rest of the world; from staples to banks; from the U.S. dollar to gold; from financial assets to real assets; and from Wall Street to Main Street.
As this week’s cover story shows, the election will have important implications for investors. And while the occupant of the White House can set the tax and spending agenda, it’s up to Congress to enact the measures.
In any case, investors will have to take into account potential policy shifts in structuring their portfolios.
A LEGEND WITH A NEARLY UNMATCHED RECORD hung up his spikes last week, while another parted ways with the team he was a part of for more than three decades.
Alex Rodriguez played his final game with the New York Yankees on Friday, ending his controversial on-field career that featured a one-year suspension for performance-enhancing drugs and left him, at press time, four home runs short of the 700 mark. But he’ll remain a consultant with the Yanks, getting $21 million in 2017 for the final year of his $275 million, 10-year contract. That’s on top of an additional $6 million for the remainder of this unproductive season.
Bill Miller, the mutual fund manager legendary for having beaten the Standard & Poor’s 500 index for 15 straight years from 1991 to 2005 while overseeing the Legg Mason Value Trust fund, last week parted ways with Legg Mason, where he had worked since 1981. He bought out Legg Mason’s 50% stake in LMM, which provides management services to the $1.3 billion Legg Mason Opportunity Trust (ticker: LGOAX), plus other portfolios, leaving him with full ownership of that vehicle.
Both departures marked ends of eras. We will leave aside the moralizing of performing-enhancing drugs in baseball. However, the investing public is increasingly looking askance at portfolio managers who are paid handsome salaries but deliver mediocre performance.
That has been especially true of hedge funds. Multibillion-dollar pension funds, notably in the state of California and New York City, have dropped pricey hedge funds, rather than pay their 2%-and-20% fees. There has also been the widely advertised mass investor exodus from actively managed funds to passive index funds and exchange-traded funds.
According to Morningstar, there was a swing of over $1 trillion from 2009 through mid-2016. While actively managed mutual funds lost $728.9 billion in assets, ETFs alone gained $342.8 billion. In other words, investors (and their advisors) were becoming aggressively passive.
The cost savings add up quickly, especially for institutions such as smaller endowments. They frequently can’t get past the velvet rope to get in the superstar hedge funds, so they’re stuck with second-tier performers. And given the modest level of prospective future returns from both stocks and bonds, wringing out every basis point from expenses takes on even greater importance.
In another era, that didn’t matter so much. Last Thursday, the Nasdaq Composite, the S&P 500, and the Dow Jones Industrial Average all closed at records, something that hadn’t happened since 1999. That was the halcyon era for the dot-com bull market and the middle of the outperformance streak for Miller’s Legg Mason Value Trust.
It will also be remembered as the steroid era in baseball, when hitting records that had stood for decades suddenly fell. For his part, Miller compiled his extraordinary record not by any nefarious means, but by making big, concentrated bets; they were homers in the bull market but costly strikeouts in the financial crisis.
Apparently only A-Rod these days can manage to get paid big bucks for lousy performance.