Finding Balance
Effective vaccines have finally appeared on the horizon and are in the early stages of being administered. Presumably these vaccines will ensure a return to normalcy sometime in the near future. Restrictions on group gatherings will be lifted. Countries will open their borders for travel. And eventually the pandemic nightmare will fade into history like SARS, MERS and other prior viral outbreaks. That won’t mean the threat of Covid will be over, but it will fade into the background.
Even so, the Covid economy will continue to present challenges. The possibility of resuming conventional activities doesn’t mean that life will, in fact, return to normal this coming year. Both demand and supply shocks will continue to affect the economy. Surely, some will be reluctant to gather in large groups, others will be reticent to travel. A portion of the population will prefer to continue to isolate and maintain social distance. This means that, to some degree, demand will decline. Supply too. Some businesses have shut their doors forever. Some workers have become discouraged and dropped out of the labor force. The declines in demand and supply make the timing of a return to regular activity uncertain.
Most agree that government borrowing to fund programs for those impacted by lockdowns was necessary. The fact that 25% of all US dollars ever created were printed in the last nine months well illustrates the staggering rate at which the Fed injected money into the economy. And we are on the verge of even more borrowing. But once the need for government assistance comes to an end, the question remains: what to do about deficit spending and consequent accumulated debt?
The global financial crisis (GFC), which we experienced during ’08 and ’09, can shed some light on our current situation. Recall that the root of that crisis was loans given to home buyers who could not afford to make the loan payments. In turn, these loans were sold to careless loan buyers, who failed to understand how risky the loans were. As a result, homeowners started to default on their loans at a rapid rate. This led to concerns about the stability of the banking system. Banks failed, the stock market plunged, and the government stepped in to provide massive assistance, mostly in terms of the Fed pumping money into the economy. Before the ’08-’09 GFC, the government deficit ran at less than 2% of Gross Domestic Product (GDP). At the peak, the deficit was 10% of GDP before falling back to just a bit more than 2% of GDP as the economy recovered.
Our GFC experience can also help us understand the unprecedented amount of debt we now carry. Prior to the GFC, the ratio of debt to GDP was a steady 60%. As the economy limped back from the GFC to full recovery, it required more pump-priming. Our debt rose to over 100% of GDP, where it remained on the eve of Covid. In other words, even after years of prosperity, we were not able to make a dent in our debt.
Before Covid, deficits were running at just over 4% of GDP. At the peak of the Covid crisis, the deficit zoomed to 15% of GDP and has remained there even as the economy has started to improve. The supplemental aid package recently implemented will produce further deficits. Deficits lead to a further ballooning of debt. The International Monetary Fund estimates that US debt as a percentage of GDP will have risen from 109% pre-Covid to 131% by year-end 2020, a near-20% increase. Not only have we not yet dealt with the debt accumulated from dealing with the GFC, but we now additionally have Covid debt to deal with.
All that debt seems like a problem, but is it really?
Some argue that it isn’t the amount of our debt that should be of concern, but our ability to make the payments of principal and interest as they come due. Somewhat surprisingly, in spite of the growth of our debt subsequent to the GFC, our debt payments have remained around 1.5% of GDP. Even more surprisingly, this payment rate is expected to fall over the next few years as low interest rates more than offset added Covid debt. For perspective, during the ’80s and ’90s, our debt payment burden was around 3% of GDP.
As we consider the “cost to service debt” argument, one puzzle is why the Fed seems intent upon generating higher inflation. Yes, inflation is one method which some indebted economies have employed to deal with their large debts. Paying back debt with inflation-cheapened dollars is less onerous than paying debt back in today’s undeflated dollars. But inflation leads to higher interest rates, making the debt harder to service. Further, one of the largest constituencies in our population is made up of twenty-somethings who prefer low rates and low inflation as they are making life’s major purchases of homes and furnishings.
The other large population constituency is the about-to-retire boomers. They are frustrated that their retirement savings are only earning low rates. But, to some extent, their disappointment has been tempered by the consequent soaring stock market.
Many fear that such high stock prices can’t persist due to seemingly stretched valuations. However, the “excessive valuation” argument has proven wrong over the past five years. If valuation isn’t providing a limit to rising stock prices, is there any other curb?
The value of the dollar can potentially serve as a brake. A cheaper dollar means that our numerous imported goods are more expensive. So a delicate balance exists between maintaining the low interest rates, which help service our debt, and maintaining the value of the dollar. The dollar is already shooting up warning flares that our current interest rates may be too low. Its value has declined by 10% from its pre-Covid peak.
Our newly elected government will have its hands full trying to maintain equilibrium between low interest rates and the stability of the dollar. Over the years, I’ve used the term “muddle through” to characterize my description of how we navigate economic difficulties. Muddling through is how I see our future economic path—not an auspicious plan, but it should get the job done.
Sincerely,
Sam Stewart,
Partner
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