July 14, 2024
The first topic for this issue focuses on the observation that the U.S. economy will likely be de-sensitized to interest rate cuts in the next business cycle, similar to how it was de-sensitized to interest rate hikes during this prior cycle.
The second topic examines what investing implications this might have.
As a housekeeping note, yesterday’s assassination attempt was massive news and has potential election outcomes and financial market impacts. Surely your news feeds and inboxes are already filled with hot takes and analyses regarding that. This newsletter is about trends that were occurring before that event, and that continue to be the case after that event, so I will remain focused here on the economy and financial markets and leave the political analysis to others.
Managing Two Time Horizons
As a long term investor rather than a trader, I mostly optimize for two time horizons in my analysis: intermediate term and long term.
The intermediate term time horizon looks out 18 months or so, to see if we’re likely in a rising cycle or a falling cycle in terms of liquidity, economic activity, and so forth. I use this time horizon mainly for setting expectations and risk management.
The long term time horizon, which is my primary one, looks out 5+ years to be on the right side of structural trends that grow throughout the rising and falling of the business cycle. This looks at what areas of the economy are underinvested in and will likely have a big production cycle ahead, or what emerging technologies will greatly re-shape the way we live and work. It also looks at major macro trends, like whether a given economy is in a structural state of monetary dominance or fiscal dominance, and what major sociopolitical shifts or geopolitical realignments are occurring.
For a while, a big emphasis that I’ve had in my analysis is the view that the United States is now in a state of fiscal dominance. This is a state where a country’s public debts and deficits are large enough that they begin to reduce the impact of monetary policy. When that occurs, the central bank’s interest rate hikes can increase the fiscal deficit by a larger absolute amount than they reduce private sector credit creation, thus dulling the effect of monetary policy.
There’s no single best way to quantify it, but if I had to point to one set of charts, I would say that fiscal dominance occurs when annual public deficits exceed the sum of annual net bank lending and annual net corporate bond issuance on a sustained basis, especially without having been caused by a recession.
Fiscal deficits can temporarily exceed bank lending and corporate bond issuance after major recessions and times of crisis, but where it really becomes sustained in a developed economy is typically when public debt gets to over 100% of GDP, interest rates reach zero and start to trend sideways or up, and thus the government’s interest expense starts to become rather large even at modest interest rate levels. It becomes a slow-motion fiscal spiral at that point, unless or until the debts are significant devalued vs other assets. The only times that U.S. fiscal deficits exceeded private sector credit creation outside of a post-recession period within the past 70 years were in the recent green boxes in the charts above.
Relatedly, when fiscal deficits as a share of GDP are rising during a period of falling unemployment over a sustained period of time, that is another sign of fiscal dominance. This type of breakdown in correlation has occurred rarely within the past 70 years:
There are some common characteristics of fiscal dominance in the economy. Mainly, we can expect higher average inflation than the prior decade, and business cycles might be shallower or more stagflationary because the up-and-down cycles of private credit creation are dwarfed by the size of sustained fiscal deficits pouring into the economy.
However, fiscal dominance doesn’t eliminate cycles entirely; there can still be various ebbs and flows even in an economy that is in a state of fiscal dominance. Since fiscal dominance is a spectrum, how far into fiscal dominance an economy is matters quite a lot.
Analyzing the Current U.S. Cycle
This decade began with the pandemic/lockdown shock in early 2020, and then as fiscal and monetary stimulus efforts were launched, the remainder of 2020 and into 2021 saw a major boom/recovery period, followed by the onset of broad price inflation. The travel/restaurant/hospitality industries were slow to recover due to waves of repeated lockdowns and travel restrictions and virus fears, but the durable goods category did great. Basically, people couldn’t consume many types of services, so they stayed home and loaded up on goods and housing improvements instead.
As fiscal activity reduced and central banks tightened monetary policy, the years 2022-2023 were defined mainly by contracting manufacturing activity and contracting real estate turnover, while the labor market, travel and hospitality industry, and overall consumer spending continued to strengthen. Pent-up demand for services resulted in a shift from durable goods to travel and restaurants. Non-urgent surgeries that were previously delayed started to get done, and other details like that started to mean revert or overshoot.
We can see this in the weak manufacturing purchasing manager’s index since 2022:
Chart Source: YCharts
And we can see it in commercial real estate prices (which for certain subsectors like office space are far worse than that is shown here):
The strength since 2022 shows up primarily in consumer spending, which accounts for about 2/3rds of U.S. GDP:
There are a number of things that kept consumer spending strong, and two that are worth highlighting in particular are fiscal deficits and fixed consumer and corporate interest rates.
Item #1: Fiscal Deficits
U.S. fiscal deficits were huge in 2020 and 2021, but contracted in 2022 as most of the emergency programs dwindled.
However, by 2023, fiscal deficits began rising again, mainly due to increased interest expense. This is where fiscal dominance became rather sustained: the Fed’s interest rate hikes, which were meant to slow down the private sector with slower credit creation and higher borrowing rates, also had the effect of pouring more money into the private sector from the public sector, in the form of higher public sector interest expenses. There are various individuals, companies, and foreign governments on the receiving side of that interest, and in many cases that interest income is spendable money for them.
The average duration of federal debt is about six years, but much of it is front-loaded at two years or less with a tail that goes out to 30 years. So, two years of high interest rates can make quite a bit of federal debt get refinanced at higher levels, and that’s what has happened.
Item #2: Fixed Consumer and Corporate Rates
Homeowners and investment-grade corporations termed out their debt a lot longer than the federal government has. Many homeowners have locked in 30-year mortgages. Many corporations have average corporate bond durations of ten, twenty, or thirty years as well. As interest rates rise, these homeowners and corporations are not very sensitive to rising interest rates, in the sense that their interest expense doesn’t change much.
Junk-rated corporations with lower average debt durations, and small businesses that rely on shorter-duration bank lending, are indeed hurt by the higher interest rates more quickly, since theirs aren’t really “fixed” to the same degree. Similarly, lower-income consumers with credit card debt and other types of variable rate debt are negatively impacted by higher rates too. But all of that is a minority of the total private debt compared to mortgages and investment-grade corporate bonds.
Putting Them Together
The United States is running larger fiscal deficits than most other countries, and its private sector has a higher proportion of long term fixed rate debt than most other countries. This means that in an interest rate hiking cycle, the United States has been rather de-sensitized to rising rates compared to other countries that experience more downward pressure on consumer finances and corporate finances from those rising rates.
In the United States, there has been quite a big gap between haves and have-nots with this fiscal and monetary mix. Those who don’t have much assets, like mainly a house, have been largely locked out of owning assets. Meanwhile, those who have assets and who have locked in those low rates, are generally in great shape, save for the fact that many of them are now kind of “stuck” in their existing home. And since the top 50% of consumers spend a lot more than the bottom 50% of consumers, the fact that the top half is doing pretty well has been a strong engine for overall consumption.
Consider the example of an upper-middle class homeowner couple in their 50s or 60s. They’ve got a 30-year fixed mortgage on their house, which they refinanced to a low rate back in 2020 or 2021, and they’ve got a decent amount of savings in stocks and a money market fund. Every time the Fed raises interest rates, their money market fund pays them more in interest, while their mortgage payments remain fixed. Higher rates are outright stimulatory for them in most aspects; they can literally go and buy more stuff if they want to.
Now consider a cash-rich tech corporation with fixed-rate debt locked in at low rates, and plenty of cash equivalents. Again, every interest rate hike means that their cash positions pay them more, while their long-term debts remain fixed. And if they are selling products mainly to the top half of consumers, then they’re probably doing decently well in terms of corporate income. And if those top half of consumers own these corporate stocks, then their stock portfolio is up, which gives them a positive wealth effect.
Globally, during this cycle:
-China has had strong industrial production, but weak consumer spending.
-Europe has been relatively weak both in industrial production and consumer spending.
-The United States has been strong in consumer spending, but relatively weak in industrial production.
Forecasting the Next U.S. Cycle
Trees don’t grow to the sky, and indeed the strong parts of of the U.S. economy are starting to soften.
The official unemployment rate has risen from 3.4% to 4.1%, which while still low in absolute terms, is headed on an upward trajectory. Payroll growth is slowing. The trade deficit is widening. As more and more private sector debt refinancing gradually happens, it is starting to weigh down on more people and businesses, especially the ones that weren’t able to term out their debt very far.
As inflation moderates for the moment, and as the labor market softens, the Fed’s mandate is shifting from being entirely focused on fighting inflation, to a more balanced approach of managing employment vs inflation. Therefore, they have signaled that they could begin to cut interest rates even as inflation remains above their 2% target, which is what some other developed market central banks have already done.
However, similarly to how the United States was rather de-sensitized to rising interest rates this time, there’s a good case to be made that we will also be de-sensitized to falling interest rates this time. If there’s so much locked-in fixed rate debt, why would rate cuts really matter for the economy?
I think most of it comes down to one main question: will mortgage rates reach a lower-low in this cycle than the prior cycle, or no? My base case is no.
Whenever mortgage rates drop to new lower-lows, homeowners have a big incentive to refinance their mortgage rates. Paying off a previous 6% mortgage with a new 4.5% mortgage can free up a lot of disposable income each month, and without increasing a homeowner’s overall debt load. And then, years later, paying off that 4.5% mortgage with a newer 3% mortgage can free up a lot of disposable income each month again. It’s basically a free lunch.
So naturally, we do see a burst of mortgage refinancing activity when mortgage rates reach lower-lows. That boost in disposable income among homeowners has historically been one of the major stimulatory catalysts for the economy from periods of lower interest rates:
And there were a ton of mortgage originations during the low-rate period of 2020 and 2021, and rather limited mortgage originations in the higher-rate environment of 2023 and later:
If we do not get a lower low in mortgage rates in this cycle, then there likely won’t be many mortgages on the market worth refinancing. The rather small number of people who took out high-rate mortgages in 2023 and 2024 would be able to refinance theirs, but that’s about it.
With the ongoing fiscal dominance condition of deficits equaling 6-7% of GDP or more, along with various trade tensions/tariffs, ongoing wars, and higher average oil prices, I think it’s unlikely that mortgage rates will reach a lower-low in this cycle. It’s not impossible that they could, but it’s not my base case. The prior low in mortgage rates occurred after a long period of zero short-term interest rates and a pandemic/lockdown contraction. We already saw higher-highs in interest rates this cycle, and my expectation is that we’ll likely see higher-lows as well.
Secondary mortgages could come to the rescue, but I think the stimulatory effects from them are likely to be underwhelming. Freddie Mac proposed, as a new product, the ability to buy secondary mortgages. They received limited approval by the Federal Housing Financing Agency. This could be expanded and used as a form of homeowner stimulus in the next downturn. House prices have gone up a lot in recent years, and so nationwide home equity is equal to over $32 trillion now, compared to about $20 trillion at the start of 2020. Some of that home equity could be levered and spent.
However, unlike refinancing a primary mortgage, obtaining a secondary mortgage on a home is not a free lunch, and many homeowners would likely be reluctant to do it. A secondary mortgage provides a cash injection but adds on extra debt to be repaid. It’s simply not as powerful or as sustained of a homeowner stimulus as refinancing a primary mortgage at a lower rate.
And so, an assumption I am working with for now, is that the U.S. economy will be more de-sensitized to interest rate cuts during this upcoming cycle than normal. Unless we reach lower-lows in mortgage rates, there will likely only be a small primary mortgage refinancing wave, and thus not much stimulus to be had from loser monetary policy alone.
Small businesses and commercial real estate would get some relief from those lower rates, and we’ll still have ongoing background stimulus from big fiscal deficits. So in nominal terms, I think the combination of a weak refinancing cycle along with fiscal dominance and other relief would result in a mixed bag, and kind of an economic malaise.
Investing Implications
I’ll be monitoring this trend to see if it plays out as described here. If we assume for a moment that it will, we should then ask what the investing implications would be. An investor might correctly forecast what happens to the economy but then still be wrong in terms of selecting investments to profit from that correct economic forecast.
In recent years, a ton of global money has flooded into U.S. capital markets, and especially large-cap U.S. equities. The United States runs structural trade deficits to the rest of the world, and the rest of the world takes those surplus dollars and buys our stocks and other assets with them. The pandemic, and the wars, and the outperformance of U.S. tech monopoly stocks have all further exacerbated the move into U.S. capital markets, as basically the only game in town.
And as previously described, the fact that the U.S. was 1) running larger fiscal deficits than its peer countries and 2) had a private sector with more locked-in fixed rates than its peer countries, made it more de-sensitized to this global cycle of rising interest rates than its peer countries.
In the downcycle, we could see exactly the reverse. As multiple countries cut interest rates, the countries that have private sectors with more variable-rate debt can get a consumer and corporate stimulus more readily from those lower rates, while the U.S. economy already has most of its private debt fixed at lower rates, and wouldn’t get much of a stimulus from a moderate cut in interest rates.
And emerging markets could benefit the most, from the starting position of significant weakness. Many of them have quite a bit of dollar-denominated debt, which hurts them when the U.S. runs tight monetary policy with high interest rates. If the United States goes back to rate cuts and balance sheet expansion, then even as it fails to stimulate the U.S. economy much due to the lack of homeowner primary mortgage refinancing, emerging markets could get a lot of relief on their dollar-denominated debt, and experience an economic boom similar to what they enjoyed during the 2003-2007 period.
Likewise, I think gold and bitcoin could do well in that environment. Right now, the U.S. is running a combination of loose fiscal policy (big deficits) and tight monetary policy (high interest rates and ongoing balance sheet contraction), which is a mix that is hard to sustain for very long. Eventually, perhaps around 2025 or so, the large fiscal deficits and a weaker consumption economy will likely lead the Fed to go back to balance sheet expansion to keep U.S. Treasury markets liquid and stable, and to keep the banking system smooth and well-functioning with ample reserves. When the U.S. is running large deficits, with looser monetary policy, and yet homeowners are not getting stimulated much for a new wave of domestic consumption due to a lack of lower-lows in mortgage rates, then the U.S. might not be too attractive of a place to invest, and global capital might look elsewhere. I suspect some of that capital will go toward emerging markets, but in addition, it can go into scarce globally-traded assets that are not tied to any jurisdiction, like gold and bitcoin.
Americans invest more into their stock market than people in many other countries, and thus benefit quite heavily from the rising wealth effect of stocks. If global capital starts looking elsewhere and the virtuous cycle toward ever-higher U.S. stock prices stops feeding on itself, that too can contribute to a slowdown in U.S. consumer spending and an economic malaise.
It’s not to say that capital will flee the U.S. in large amounts, but rather to say that it may happen on the margins in terms of relative flows compared to what we’ve become accustomed to. The marginal global dollar might look elsewhere in that environment, and the rate of change of capital inflows may diminish for the cycle, similar to the 2003-2007 period.
This is still a framework I’m thinking through for the intermediate term time horizon within the longer-term fiscal dominance trend, and it’s my base case for now. As always, we need to be data dependent to constantly re-adjust expectations based on the preponderance of incoming data.
I’m happy to hear thoughts from readers on social media or elsewhere as to how justifiable these assumptions are, what events or details might challenge them, and how we might use this information to navigate the Fed’s next easing cycle.
Portfolio Updates
I have several investment accounts, and I provide updates on my asset allocation and investment selections for some of the portfolios in each newsletter issue every six weeks.
These portfolios include the model portfolio account specifically for this newsletter and my relatively passive indexed retirement account. Members of my premium research service also have access to three additional model portfolios and my other holdings, with more frequent updates.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I dollar-cost average in over time.
It’s one of my smallest accounts, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
And here’s the breakdown of the holdings in those slices:
Changes since the previous issue:
- No recent changes.
Bitcoin Note:
I use allocations to bitcoin price proxies such as MSTR and spot bitcoin ETFs in some of my brokerage portfolios for lack of the ability to directly buy bitcoin in a brokerage environment, but compared to those types of securities, the real thing is ideal.
I recommend holding actual bitcoin for those that want exposure to it, and learning how to self-custody it. I buy mine through Swan.com.
I don’t have a firm view on the bitcoin price over the next few months, but I am bullish with a 2-year view and beyond. And notably, the German government just sold 42,000 bitcoins within the span of one week from various asset seizures, which as a particular case of selling pressure is now finished.
Other Model Portfolios and Accounts
I have three other real-money model portfolios that I share within my premium research service, including:
- Fortress Income Portfolio
- ETF-Only Portfolio
- No Limits Portfolio
Plus, I have personal accounts at Fidelity and Schwab, and I share those within the service as well.
Final Thoughts: Three Pillars Reiterated
I continue to view a three-pillar portfolio as an ideal framework for risk-managed investing.
A classic “60/40” stock and bond portfolio consists of two asset types that both prefer disinflation. Stocks generally prefer disinflationary growth, and bonds generally prefer disinflationary contraction. They’ve both enjoyed the four-decade period of structural disinflation and structurally falling interest rates.
However, there have been four inflationary decades for advanced economies in modern history. They were the 1910s, the 1940s, the 1970s, and the 2000s. They were defined largely by 1) more rapid than average currency debasement and/or 2) rising energy prices for one reason or another, and during those four decades neither stocks nor bonds performed particularly well.
Big disinflationary growth assets generally don’t do well when input costs and interest rates are rising sharply. A combination of energy stocks, commodity producers, and gold historically performed better than stocks and bonds in those decades.
Data Sources: Robert Shiller (CPI), EIA (oil)
Chart Source: Multpl
For the remainder of this decade and beyond, I think it’s prudent to have inflation protection in a portfolio, and so rather than use a 60/40 stock/bond portfolio, I use a three-pillar portfolio which is more balanced.
-The first pillar consists of domestic and global stocks, which generally benefit from disinflationary economic growth.
-The second pillar consists of cash-equivalents, short-term bonds, and TIPS, which at currently high rates generally tread water against inflation and protect against liquidity contractions and recessions.
-The third pillar consists of energy/commodity producers and hard monies, which generally do well during those structurally inflationary periods of high energy prices and/or high rates of currency debasement.
Together, these three distinct grouping of asset classes can help a portfolio navigate a broad variety of market conditions.
Best regards,
