Bridge Perspective – April 2024

Q1 2024 Market Perspective

Returns: [1]

Summary:

  • Government Spending: US deficit spending remains a potent economic driver, fostering job creation in government and healthcare, and stimulating a construction boom that bolsters GDP growth.
  • Employment: Labor markets have shown resilience, maintaining unemployment below 4% and labor force participation steady above 62.5%. Beneath these headline numbers, however, lie significant nuances.
  • Inflation: CPI measurements suggest inflation has reached a cyclical low of approximately 3.5%. With energy prices increasing, persistent shelter costs, and surging shipping rates due to supply chain disruptions, achieving the 2% inflation target remains challenging.
  • Monetary Policy: The Federal Reserve insists on maintaining interest rates at current levels until a consistent 2% inflation rate is sustained. Concurrently, the maturation of treasury and mortgage-backed securities on their balance sheet is exerting upward pressure on long-term interest rates.
  • Money Supply & Bank Lending: Despite prevailing views, the money supply sustained robust growth in Q1. Bank lending has slowed from its 2023 peak yet remains in positive territory.

Details:

US Economic Picture:

  • Government Spending:

The process of deficit spending effectively stimulates the economy in the short to medium term by increasing its net worth. Let’s illustrate this with a simple example:

Consider an economy with two players: you and the government. Initially, you have $100, and the government has $0, making the economy’s total net worth $100.  To fund its expenditures, the government issues a treasury bill valued at $100, which you purchase with your $100 of cash.  Consequently, your net worth remains $100, but now it consists of the treasury bill instead of cash.

With the $100 from the cash you traded for the treasury bill, the government spends on various needs such as government salaries, defense, social security, healthcare, infrastructure, and subsidies. This injection of money raises the economy’s net worth from $100 to $200, even though the government now has a $100 deficit to you.  The only way to reverse this is for the government to pay you back or for them to tax you more than they are spending.

Expanding this model to reflect trillions of dollars of annual deficit spending reveals how such actions profoundly stimulate the economy. The chart below demonstrates the increasing trend in the United States’ deficit spending.

Source: FRED

Exploring a particular aspect of real-world government spending and how it flows through the economy will show its stimulating effects.  Following the enactment of the $1.2 trillion infrastructure bill in 2021, by February 2023, nearly $200 billion had been allocated across more than 20,000 projects or awards. [2] This substantial investment has significantly boosted construction, manufacturing, healthcare and highway development expenditures. [3]

The surge in spending and the subsidies provided by this and other packages have notably increased the growth rate of job creation in the government (federal, state, and local), healthcare, and manufacturing sectors.  Over the past year and a half, these sectors have seen faster employment growth than the rest of the private sector, showcasing the direct impact of targeted fiscal measures on economic and job expansion.

Source: FRED

We can observe the direct rise in spending, which, while not always correlating with job creation, boosts the economy’s overall net worth, especially when financed through deficit spending rather than taxation.  This method of financing is inherently stimulative because it injects additional resources into the economy without immediately withdrawing an equivalent amount from other sectors.  By increasing the net assets available, deficit spending enhances economic activity and potential growth areas.

Source: FRED

Moving from a particular bill to a more general point, this deficit spending also entails a component that proves stimulative under high initial debt levels: exponentially growing interest expenses for the government.  Having established that deficit spending stimulates the real economy by increasing net worth, it follows that rising interest rates on substantial debt levels accelerate the growth of private sector net worth even more swiftly.  As of Q4 2023, the federal government’s interest expenses exceeded its military budget, surpassing $1 trillion. With foreign entities holding about 30% of private treasury debt and the Federal Reserve approximately 10%, this configuration implies that 60% of these interest payments flow directly back to private savers within the U.S. economy, thereby boosting their purchasing power. [4]

Source: FRED

Overall, government spending significantly stimulates the US economy, and high interest rates, coupled with elevated debt levels, further enhance this effect.  This creates a fascinating dichotomy and potential feedback loop: while the central bank maintains higher interest rates to combat inflation, the government rolls over its debt at these higher rates, effectively increasing the net worth of the US economy and the increased net worth of the economy spurs further inflation which necessitates higher interest rates. This scenario highlights the complex interplay between fiscal policy and monetary measures in shaping economic outcomes.

  • Employment, inflation & Monetary Policy:

The Federal Reserve employs the Phillips curve framework, which outlines an inverse relationship between employment and inflation. [5] Under this model, they anticipated that increasing unemployment would be necessary to reduce inflation. [6] However, the unique circumstances of the post-Covid economic recovery have complicated this approach.  High inflation has persisted, partly due to a reduced labor supply as individuals remained out of the workforce, leading to a high number of job openings. These conditions are still in the process of stabilizing.

Source: FRED

This situation meant that while the Federal Reserve aimed to increase unemployment to control inflation, a significant number of people were re-entering the labor force.  Consequently, the labor situation was improving, even as interest rates were raised.  Clearly, the Phillips curve framework, which the Fed relied on, proved to be an inadequate analytical tool for understanding and responding to these unique economic conditions.

Source: FRED

Now that the labor market has largely stabilized from the disruptions caused by Covid, the Federal Reserve has begun to acknowledge that a higher unemployment rate may not be essential to curb inflation.  They are considering the possibility of a “soft landing,” where unemployment remains relatively stable while inflation gradually returns to the 2% target.  This shift in perspective marks a significant adaptation in monetary policy strategy as the economic landscape evolves.

Source: FRED

Core CPI breakdown by Segment:

Source: FRED

However, a significant issue with the Federal Reserve’s approach is that their strategy of raising interest rates to dampen demand addresses only half of the inflation equation, and they still have not sufficiently tightened policy to succeed in that.  Despite their efforts to increase the hurdle rate for taking on loans, bank lending has continued to increase which is the other way, besides deficit spending, that new money is created.  This indicates that, based on the economic data, the Federal Reserve’s policy rate may still be too low to effectively manage the economic conditions and meet their targets.

Another aspect that is endogenous to consumer demand is the monetary supply.  There was plenty of confusion about why the money supply was decreasing despite deficit spending and bank lending, and that was simply because money has been leaving the banking system to go to money market funds and to buy treasures. [7] Essentially, people have been chasing the yield they could not get in their bank’s saving account.  Therefore, when the M2 money supply is adjusted for corporate money market funds and treasuries held, it shows a continued increase.

Source: FRED

Moving from the monetary world to the labor markets and credit markets, the increase in Federal Reserve policy rates has led to moderate disruptions, including a decrease of 1.847 million full-time workers since June 2023 and the bankruptcy of businesses reliant on 0% interest rates. [8] However, most businesses and individuals have managed their debt with long-term agreements, thus minimizing the immediate impact of rising interest rates. [9] In fact, many are seeing an increase in net worth due to the gap between higher costs of debt and the greater income generated from savings at these elevated rates.  Over time, those needing to refinance will feel more pronounced effects, which could pose broader economic challenges.  Yet, these developments still pertain mainly to the cyclical (demand-driven) aspects of inflation and not to the more persistent, new regime inflationary pressures that the economy is experiencing. [10] Consequently, achieving a stable 2% inflation rate strictly through Federal Reserve interest rate manipulations focused on curtailing demand seems increasingly improbable.

Supply-side pressures are originating from multiple sources, including the reconfiguration of supply chains, demographic changes, conflict, and fiscal spending (which also influences demand).  A current event illustrating the ongoing regime-based asymmetric upside risk to inflation is the Houthi blockade of the Red Sea.  This action has notably increased the cost of shipping globally, as evidenced by the rising prices of transporting a 40-foot container.  These elevated shipping costs are subsequently passed on, contributing to goods inflation worldwide.

Source: Drewry Supply Chain Advisors

The year-to-date attacks of ships that have been happening in the Red Sea are visualized below:

Source: UKMTO

This is just one of the conflicts contributing to an upward shift in inflationary pressures globally since the COVID-19 pandemic. In today’s multipolar world, where long-term geopolitical forces and national security priorities increasingly overshadow the principles of free trade and globalization, the asymmetric upside risk to inflation is likely to continue. [11] Fortunately, there are countervailing deflationary forces at play, such as artificial intelligence and other technological advances. [12] However, the demographic dividend gained from the integration of labor markets following the collapse of the Soviet Union is largely exhausted. [13]

Therefore, the implications of these dynamics are directly reflected in our investment strategies.  We believe that the neutral rate of interest is currently underestimated, which is why we have adopted a short duration stance in our portfolios.  We anticipate continued government spending, particularly in the healthcare and defense sectors, to act as a positive driver of economic activity.  Additionally, we expect artificial intelligence to catalyze significant productivity improvements across the economy, with smaller companies likely benefiting the most.  In response to a multipolar world, we advocate an active investment approach as the most effective means to safeguard and enhance your wealth. If you are interested in exploring our wealth management or asset management services, please do not hesitate to contact one of our advisors.

By: Nick Colletta, CFA, CAIA

Sources:

  1. https://www.morningstar.com/
  2. FACT SHEET: White House Highlights Infrastructure Progress in Every Corner of the Country, Updates State-by-State Fact Sheets | The White House
  3. Infrastructure Bill Has Impact on Healthcare Policy and Spending (natlawreview.com)
  4. The Important Role of the Foreign Investor in the U.S. Treasury Market – FEDERAL RESERVE BANK of NEW YORK (newyorkfed.org)
  5. What’s the Phillips Curve & Why Has It Flattened? | St. Louis Fed (stlouisfed.org)
  6. The Fed Wants Higher Unemployment Because It’d Bring Down Inflation (businessinsider.com)
  7. S. Money Supply Is Shrinking the Most Since the Great Depression. Is an Economic and Stock Market Meltdown on the Way? | The Motley Fool
  8. Employed, Usually Work Full Time (LNS12500000) | FRED | St. Louis Fed (stlouisfed.org)
  9. One Chart That Explains the Rate Resilience of the US Economy – Bloomberg
  10. Bankruptcies soar as high rates and end of Covid aid hit businesses hard (ft.com)
  11. Protectionism Is Failing to Achieve Its Goals and Threatens the Future of Critical Industries (worldbank.org)
  12. AI’s deflationary winds will blow away profits | Reuters
  13. What happens when a demographic dividend becomes a deficit? | Lombard Odier

Bridge Advisory LLC Disclosures

Bridge Advisory, LLC is an investment adviser registered with the U.S. Securities and Exchange Commission. Investment Advisory Services offered through Bridge Advisory, LLC. Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type. Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio. Information herein has been obtained from sources believed to be reliable, but Bridge Advisory, LLC. does not warrant its completeness or accuracy; opinions and estimates constitute our judgment as of this date and are subject to change without notice. This newsletter expresses the views of the authors as of the date indicated and such views are subject to change without notice.

Print Friendly, PDF & Email
No Comments

Post A Comment