Economic and financial trends that have been in place for years and even decades oftentimes reverse with major catalysts. In life, this reflects Sir Isaac Newton’s first law of motion: an object at rest or in motion will stay in that state unless acted upon by another force. These catalysts or forces can be a political event, an economic event, or the introduction of a transformational technology. This brings us to today. Our belief is that the COVID-induced recession and political regime change from President Trump to President Biden are two forces that have broken trends in place for over a decade. Our job is to position client accounts to benefit from these structural trend changes when they have clear long-term impacts on various asset classes and sectors of the market.
Time and time again, recessions lead to major changes in the economy and financial markets, such that the trends that led into a recession often reverse coming out of them. This often occurs because of the major impacts that recessions can have on consumer sentiment and savings, as well as corporate attitudes as economic and tax policies often change in response to the recession. Think back to the Great Depression. Those that lived through it saw the pain and suffering that came as US households took on too much debt and speculation only to see it come crashing down. In response, Americans became strong risk-averse savers throughout the Great Depression and for decades following.
Or, even more recently, think back to the change in consumer behavior in which the US consumer leveraged their balance sheet to levels never seen before by taking on unprecedented levels of mortgage debt and buying multiple homes in the mid-2000s. We relived to a small degree the 1920s which showed the dark reality of what happens after a bubble bursts and one has taken on too much debt. After the “Great Recession” of 2007-2009, even as interest rates continued a secular decline by falling year after year, lower rates were not enough to entice the US consumer to saddle themselves with more debt. How American households viewed debt had fundamentally changed and we spent the following decade rebuilding our balance sheets rather than leveraging them.
Related: Avi Gilburt: We’re Heading into a ‘Roaring Twenties’ Setup in Stocks
One measure of leverage is looking at how much households carry in debt relative to their assets. The more debt we borrow relative to our assets the more leverage we carry and vice-versa. The American household debt-to-assets ratio peaked in early 2009 at 19% and has spent the last decade falling consistently to the point in which American households have not had their level of leverage this low since 1983. We are talking about the healthiest balance sheet for Americans in four-decades, as shown in the image below. Clearly, with the benefit of hindsight, 2007-2009 saw a major regime change in which the motion of households leveraging their balance sheets year after year ended as the force of a major economic recession and asset bubble collapse created a new trend.
The USD Is Key
To illustrate my point that recessions often bring about regime changes, look at the US Dollar Index shown below going back to the early 1980s. Highlighted by the red vertical bars are the last four recessions and at least with the benefit of hindsight you can see the last three occurred near turning points in the USD Index. The 1990 and 2007-2009 recessions were associated with a bottom while the 2001 recession was associated with a top. Our belief is that the recession induced by COVID-19 is likely to bring about a regime change with a prolonged decline in the dollar over the coming years.
The U.S. economy will be getting another boost stemming from President Biden’s COVID relief package. Biden proposed $1.9T on top of the $900B spending bill passed last month, which, combined, amounts to roughly 15% the size of the economy as measured by gross domestic product (GDP). By far, the U.S. is running one of the world’s largest budget deficits, even larger than third-world countries, and is also expanding its money supply at rates often associated with banana republics. This can be seen in the table below which shows various countries around the world and their budget deficit relative to the size of their economy and the growth of their M1 money supply aggregate.
The 2001 terrorist attack on the U.S. led to a spike in deficit spending to finance the Afghanistan and Iraq wars that weighed on the US Dollar for years to come. We believe the spike in government spending related to COVID-19 coupled with a dramatic rise in government spending on Social Security and Medicare payments are setting the stage for a secular decline in the dollar. In our client letter late last year (Returning to Ground Zero), we made the case that we are being presented with a generational buying opportunity in commodities. We argued that, while commodities were cheap, a bull market catalyst was needed and we felt that the global money printing last year was such a catalyst.
In addition to the historic money printing occurring on a global scale, we believe the eroding fiscal picture of the U.S. relative to developed and emerging market countries will lead to a weaker USD and provide further fuel for higher commodity prices. Historically, rising government transfer payments to citizens have been associated with rising commodity prices as shown by a chart from Goldman Sachs below. The recent spike in government transfer payments is the highest since the late 1960s to early 1970s.
In the table above, we compared the budget deficit and money supply growth of the U.S. to various countries. What we did not include was the massive supply of U.S. debt being issued relative to other countries. Of the $21.91 trillion dollars of outstanding Treasury debt obligations, $7.78 trillion of it is coming due this year, representing just over 35% of total debt. There is no country on the planet that even comes close to rivaling the tsunami of debt the U.S. has maturing this year. Back in 2009, foreign countries owned 76% of all outstanding US Treasuries. Today, that number stands at 59% and the U.S. either needs to lean on the kindness of strangers to purchase our debt or we will be dependent on the Federal Reserve to step in as the buyer of last resort to prevent long-term interest rates from spiking and killing the economic recovery.
Considering the amount of USTs set to be issued this year and in coming years, there is a good chance the Federal Reserve will be forced to absorb the debt to keep financial markets stable. Even members of the Fed itself have admitted this. Here's what Randal Quarles, the Fed vice chair for supervision, had to say about this state of affairs as reported in a recent Bloomberg article, The Treasury Market May Be So Big That the Fed Can’t Step Away:
“It may be that there is a simple macro fact that the Treasury market being so much larger than it was even a few years ago, much larger than it was a decade ago and now really much larger than it was even a few years ago, that the sheer volume there may have outpaced the ability of the private market infrastructure to support stress of any sort there.”
The eroding financial position of the U.S. is evident to all and spurring foreign countries to shift away from a dollar-dominated global monetary system. A recent article in Reuters (EU seeks to cut reliance on U.S. dollar, other financial centres) highlights Europe’s desires to move away from the influence of the USD and is considering starting a digital euro project later this year to serve as a means to accomplish their goal.
Central bank digital currencies are playing a vital role in this transition and China is by far the leader in this race. A digital yuan may not replace the US dollar entirely as a global reserve currency in the foreseeable future but could certainly provide competition to the dollar among its trading partners, especially within Asia. We've covered the evolution of the digital currency space numerous times on our weekday FS Insider podcast over the years with a variety of analysts, including our most recent with Aditi Kumar, Executive Director at Harvard's Belfer Center for Science and International Affairs (see The Geostrategic Importance of China’s Digital Yuan).
Reversal of US Performance Domination
Since the bottom of the 2007-2009 financial crisis, the S&P 500’s total return (appreciation plus reinvested dividends) through the end of 2020 is 607.9% while the MSCI World Excluding US Stock Index is up 267.4% and the MSCI Emerging Market Index is up 247.3%. The U.S. stock market has nearly provided double the return of developed and emerging stock markets over the last decade, marking one of the longest and largest periods of outperformance. What we often see historically is that there are prolonged periods in which the US market will underperform and outperform developed and emerging markets and often at times one of the biggest catalysts for these regimes is the long-term direction of the dollar.
In the late 1990s, we witnessed a strong dollar coupled with US stock market dominance, which flipped during the 2001 recession before the S&P 500 began nearly a decade of underperforming foreign markets. The 2007-2009 recession ended this regime as the dollar bottomed and US stocks began to outperform foreign markets once again. As highlighted above, we believe that the USD is entering a secular decline and associated with it is our belief that emerging market and developed country stock markets will outperform the US in the years to come. The directional similarity of the USD (shown in green) vs the performance of the S&P 500 relative to emerging markets (top panel in black) is shown in the image below with recessions highlighted by the red vertical regions.
We are already seeing echoes of the early 2000s which saw a US consumption boom that in turn fueled an Asian manufacturing boom led by China. As US consumption grew rapidly in the 2000s, we had a leaking financial system in which, rather than circulating within our borders, USDs were circulated in foreign economies as we exchanged our dollars for foreign goods. This flood of USDs led to a widening trade deficit and a weakened dollar during the period. The trade deficit in November was the largest deficit on record, exceeded only by levels seen in 2006. It is no coincidence that China’s trade surplus with the US hit an all-time record last November. Unlike the 2000s, which saw a consumption binge financed by US households using their homes as an ATM, Uncle Sam this time around is footing the bill by leveraging its balance sheet with transfer payments to US households to fuel spending that has benefited foreign exporters.
Investment Implications & Near-Term Outlook
Given our views of a weak USD in the years to come, we have been progressively shifting client accounts towards commodities and foreign stocks. In our more stock-heavy accounts we have raised some cash recently by taking profits in extended positions and our plan is to use a pullback in the markets to further increase our allocation to these areas. We are overdue for a correction which we feel would be healthy and afford us the opportunity to pick up companies at lower prices. We do not see a normal market correction turning into something more sinister as the amount of stimulus and pent-up consumer demand are likely to support the economy and financial markets throughout 2021.
Currently, the Federal Reserve is expanding its balance sheet by $120 billion a month which works out to just under $1.5 trillion dollars a year. U.S. household and non-profit organizations (NPO) have seen their checkable deposits and currency balloon by more than $1 trillion dollars since late 2019, which will likely find a home in financial assets and the economy. Further, the US Treasury has over $1.6 trillion dollars sitting as cash on the Fed’s balance sheet just waiting to be spent. To modify former Senator Everett McKinley Dirksen’s famous quote, “A trillion here, a trillion there, and pretty soon you’re talking real money.”
In addition to trillions in potential financial support, we believe we will see a prolonged manufacturing recovery as businesses get back to capacity to replenish inventories. We have data going back nearly forty years and current retail inventory levels relative to sales hit their lowest level ever, indicating how barren inventories are relative to demand. Outside of retail, overall business inventories are the lowest they have been in six years relative to sales. Clients have likely witnessed this first-hand when placing an order to hear it's back-ordered for weeks if not months.
We are likely to slowly see the country get back to work as we move closer to herd immunity relating to the COVID-19 virus. Just this week, California Governor Gavin Newsom lifted the state's stay-at-home order as we are finally seeing some light at the end of the tunnel. Across all regions of the U.S., we are seeing the 7-day average daily case numbers decline as it appears we may have seen the peak in the second wave of infections.
As case numbers lead hospitalizations and deaths, the consecutive weekly decrease in new cases is now leading to a peak in hospitalizations in nearly all regions of the U.S. with a peak in hospitalizations in the Northeast too soon to call.
One of the great investment lessons 2020 taught us was to keep it simple. Every potential reason given for a major market top over the last few months has been met with a yawn from the market as these concerns have been papered over with trillions and trillions of stimulus looking for a financial home. As Warren Buffet said, “Only when the tide goes out do you see who has been swimming naked.” The tide of global liquidity continues to rise and with it will likely be asset prices and is why we remain bullish until we begin to see this sea of stimulus start to recede.
If you have any questions regarding our portfolio strategy, please do not hesitate to reach out to your wealth manager.
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Copyright © 2021 Chris Puplava
