Happy Monday!
Let’s take a break from all of the angst about Brexit, about the US shutdown, and slowing global growth and look at some overarching macro policy debates that are relevant to this economic cycle. I’ve put forward my own views on those three topics. And specifically I see a delayed Brexit as a base case, the shutdown sapping Q1 growth, eventually leading to a potential emergency declaration and growth leading to pressure on equities due to a worsening outlook amid already hard to beat comps.
Today, I want to briefly touch on three macro policy debates instead. And I will be very brief.
When should the Fed have raised rates and how quickly?
Since I tend to talk about what will happen rather than what should happen, it’s hard to tell where I stand on the should – not that it matters since my opinion won’t change outcomes. But still, it might help inform how I see the world, giving you more insight into my macro mental model.
Here’s how I see it. Most modern advanced economies are dominated by the neo-liberal philosophy that says activist governments are bad. And this is a direct result of staginflation and the difficulty of the 1970s. After that period, the defining macro policy paradigm saw governments selling off state assets, reducing fiscal intervention, keeping deficits down and generally trying to maintain as tight a fiscal position as possible. In that context, countries like Greece are seen as profligate, deserving of poor macro outcomes.
But, of course, in the US, the Federal Reserve has a dual mandate that means not just keeping prices stable, but also trying to attain maximum employment. And so, in downturns, that puts an onus on the Fed to act more aggressively than if the fiscal agent were more activist. In this past downturn, even after the immediate crisis had past, there was considerable un- and under-employment. And so, to fulfill its dual mandate, in the face of Obama’s gradual fiscal tightening, the Fed was forced to fill the void.
My preference would have been for higher deficits early, leading to the Fed raising rates much sooner. And that would also have meant that the ‘neutral’ interest rate for the real economy and the employment situation would have have been more in line with the ‘neutral’ rate for the financial economy. So, instead of forcing the Fed to blow bubbles just to get unemployment down, unemployment would have fallen faster, forcing the Fed to raise rates sooner, avoiding market excess.
The Fed should have raised rates much, much sooner than it did. But it couldn’t because its institutional mandate forced it to delay. Had it not delayed recession would have been staring us in the face in 2016. And its naive or reckless for people to say otherwise. I know a lot of people give Yellen a hard time for that. But, it was the right call given the Fed’s mandate, though I wish it were otherwise.
What asset class mirrors the subprime market from a decade ago?
No asset class has to be the new subprime because debt crises don’t happen every time there’s a recession. But I happen to think the abundance of BBB rated paper is a disaster waiting to happen in a world in which corporate leverage is at all-time highs.
I’ve written about this before. 40% of corporate bonds value come from BBB. And a lot of these bonds shouldn’t be BBB at all. They should be junk-rated. And so, what will happen when the credit cycle turns down is that their inherent ‘junkiness’ will crystallize as increased credit risk. And all at once, they will be downgraded to high yield.
When that happens, funds that hold these bonds but that can only invest in investment grade securities will have a big problem. Moreover, these same funds will face redemptions as clients rotate out of corporate bond funds into government bond funds and cash when they see the ‘junkiness’ unexpectedly hurting their returns in what they thought were safe investment grade bond funds. And when redemptions happen, you sell what you can, not what you must. And that’s going to hurt, not just the junkiest BBB issuers but other corporate bonds as well.
This is a $3 trillion universe – BBB. That’s subprime size in nature. And so, I think you can legitimately talk about ‘almost-junk corporate bonds as this cycle’s subprime. That’s my thesis.
Will we have a garden variety recession or another financial crisis?
In the context of distress in corporate bonds (and in municipal finance, auto loans, leveraged loans and student debt asset-backed securities), you could see what should be a garden-variety recession be much worse. Banks are much better capitalized this go round. But you have some large asset classes that will suffer and you don’t have the policy tools to deal with that.
Monetary policy will be limited by the zero lower bound. Cutting 2 and 1/2% isn’t a lot when 6% was the average for the last several downturns. And when Trump is also blowing monster deficits to fund tax cuts for the rich and corporations, having Nancy Pelosi, who wants to restrict deficits via PAYGO rules, as the Speaker of the House is going to put political hurdles on loosening fiscal policy.
So I think the likelihood is that we will have a deeper recession, if not a financial crisis. And that’s due solely to the lack of policy space to deal with what is likely to be serious credit issues in multiple fixed income sectors.
And, as always, I see 2019 as a pivotal year for these trends to become evident.
Happy Monday indeed!