The Big Picture continued from page 16
climate change is curtailing the availability of certain goods — the supply of homes in Florida and North Carolina just shrunk meaningfully , and the construction workers who might have built new houses are likely being diverted to rebuild existing residences . Meanwhile , the geopolitical crises in the Ukraine , the Middle East and potentially the South China Sea are not the kind of developments that are going to help ease inflation .
What about the internal dynamics of different sectors of the bond market ? In a virtual meeting with financial advisors and other clients on October 2 , Vanguard Group ’ s global head of fixed income , Sara Devereux , spelled out the firm ’ s tactical strategies in detail .
Vanguard is favoring late-cycle trades and long duration bonds , she said . As of early October , she indicated the firm was using a “ yield-curve steepener ,” basically a bet that short interest rates would fall faster than long rates .
In the credit markets , “ fundamentals and earnings have been very strong ,” she continued . Furthermore , the “ default cycle is muted , but we are late cycle . We want to have dry powder .”
Spreads , the yield differential between Treasurys and corporate bonds of similar maturities , are historically tight . The demand for additional yield is formidable . Despite the strong fundamentals on corporate balance sheets , Tipp says bond issuers have been wary because they are spooked by the non-stop predictions of a recession for the last three years .
The Elephant In The Room
One issue that continues to alarm many advisors ’ clients is the federal budget deficits of $ 1.8 trillion . The pandemic is over , and the economy is relatively strong ; we ’ re at a point in the business cycle when common sense says it ’ s prudent to limit debt growth . One can only estimate what the deficit would look like if recession struck .
That trajectory is unsustainable , yet neither candidate addressed the topic in a serious fashion during the 2024 campaign for the U . S . presidency . Former President Trump said he would eliminate taxes on Social Security , though they are currently paid only by seniors with outside income . The date when Social Security recipients will have to take a 21 % reduction to their benefits is now only a decade away . Medicare ’ s problems are even more intractable . In all likelihood , the entitlements crisis will become a major political issue in the next presidential election cycle in 2028 .
But if politicians are ignoring the looming entitlements shortfall , the bond market is almost as oblivious . Gundlach has said several times that when the next recession strikes and the Federal Reserve slashes interest rates , at the same time the federal deficit climbs toward $ 3 trillion , he would not be surprised if long-term rates defied past recession experiences and actually rose as investors questioned the reliability of long-term financial promises .
But intuitive expectations don ’ t always materialize . Lacy Hunt , the chief economist of Hoisington Investments , has studied Japan ’ s experience with aging demographics and the accumulation of government debt over 30 years . The results are somewhat counterintuitive .
As Japan issued more and more debt , the “ marginal revenue product of debt fell ” as the multiplier effect of each additional dollar of debt actually went negative , Hunt explains . That ’ s the opposite of what Keynesian economics contends . But in contrast to what one might expect , deflation , not inflation , took over the nation and economic growth declined and struggled to stay in positive territory .
America has more favorable demographics , so the parallels are somewhat different , if not encouraging . As U . S . government debt went from $ 5.6 trillion in 2000 to $ 21.6 trillion in 2020 , Hunt says its trend line GDP growth declined from 2.0 % to 1.3 %. That ’ s a 35 % decline .
What was different during the pandemic was that fiscal and monetary policy were coordinated “ like never before ,” Hunt continues . Unlike the quantitative easing policies of former Fed chair Ben Bernanke , which Hunt maintains fell within the confines of the Federal Reserve Act , Powell ignored many of the rules set forth by politicians in 1913 ( the year the law was enacted ). There was “ a huge expansion of money in 2020 and 2021 and a huge contraction since then ,” Hunt says , adding it ’ s a surefire formula to generate inflation .
Would the Fed do it again ? If it doesn ’ t , Hunt expects the inflationary trend in the U . S . to be downward . And for now , the U . S . and many other developed nations have experienced increases in excess capacity and decreases in the average workweek .
In his view , wave after wave of monetary and fiscal stimulus simply inflates asset prices , exacerbating wealth disparities and social discord . The “ consequences for people in the bottom 8 deciles [ of the wealth spectrum ] is very hard ,” he observes .
Not everyone is so pessimistic . For most of the 40 years PGIM ’ s Tipp has been managing assets , he ’ s heard very intelligent people depict apocalyptic scenarios about America ’ s chronic budget deficits and burgeoning debt . These conditions are hardly optimal , but they haven ’ t been a huge headwind either .
Waiting for a disaster isn ’ t particularly helpful , in Tipp ’ s view . “ There is a certain amount [ of money ] people want to save , and interest rates affect that to some extent ,” he says .
Developed nations enjoy certain luxuries that emerging nations don ’ t , he argues . For instance , in the U . S . and other mature nations , corporations and households have been relatively prudent borrowers , while governments have been more aggressive , but these nations have displayed an ability to shift excess borrowing between the private and public sectors . That ’ s why they are less likely to experience the vicious cycles endured by developing nations , where investors attack their currency and debt , causing capital to flee .
Still , how this plays out for the U . S . remains to be seen . Both Gundlach and Fuss expect the dollar to suffer a substantial decline in the next decade . And that alone will cause inflation in certain goods to stage a comeback .
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