September 2021: Repressed, Not Impressed
Repressed, Not Impressed
September 28, 2021
Why are bond yields so low when inflation is increasing? Why is the cost of food, housing, automobiles, and rent all going up faster than incomes? Welcome to the world of financial repression. The U.S. government is a net debtor. They have borrowed, spent, and now they owe. Inflation reduces future purchasing power. This is bad if you own assets, unless their value increases even faster than the rate of inflation. The total U.S. debt is now over 130% of GDP, while it was under 100% less than ten years ago.
Annual Federal spending from 1953 through 2019 was between 16% and 22% of GDP per year. Generally, it ran below 20% if the economy was growing, and increased to slightly over 20% during recessions. It rose to 24% in 2009 before dropping back down, but spiked to 31% of GDP in 2020, the highest level since the Second World War. Debt and spending typically grows along with the economy, and that generally causes no fiscal issues or stress.
As the debt load has increased, the burden has been lessened by generally low interest rates. Interest expense for the Federal government as a percent of annual GDP was less than 2% until the 1981 recession and interest rate spike. It was between 2% and 3% annually from 1981 through 2000, and then moved back down below 2% per year as interest rates fell and Treasury debt matured and was reissued at lower interest rates.
With current debt levels at record high percentages of GDP, and enormous future spending commitments as the boomer generation retires, higher interest rates would endanger the fiscal position of the U.S. government. The Treasury (Janet Yellen) and the Fed (Jerome Powell) would like to keep interest rates below the level of inflation. While this is not a good deal for bond investors, it certainly helps the Treasury repay the debt as tax collections increase due to inflation but the cost of borrowing stays low. Financial repression is the ability of governments to borrow and pay interest at a rate below inflation. Repression helps them as the seller of Treasuries but hurts investors as the buyer of Treasuries.
So, Powell and Yellen like the current status quo; low bond yields and high asset prices. High asset prices and low borrowing costs keep the economy humming. If we could run with this kind of status quo for a while, maybe the debt to GDP ratio would start to come down.
Unfortunately, Congress wants to get in the game with an enormous spending bill. Both Republicans and Democrats are responsible for the current dire state of fiscal affairs. The Democrats increase spending and claim they favor fiscal responsibility through higher taxes, and the Republicans cut taxes and claim they favor fiscal responsibility through decreased spending. Both parties usually only get half of what they want, and deficit spending grows.
There are some economic and market positives. The employment picture is strong, and wages probably have to go up across many industries. Consumer confidence may continue to support the economy and the recovery from the impact of COVID-19. One big positive is that the employment situation looks positive across the spectrum. Professionals that sit in front of a monitor have seen increased flexibility with work from home and are hesitant to give it up. Many are demanding and getting greater flexibility from their new employers when they change jobs, in addition to increased pay. Skilled industrial production workers are in short supply and will be able to gain pay increases as well. Direct service workers, usually among the lowest on the pay scale, will gain greater pay as it is necessary to get them to return to the workforce.
As the COVID-19 Delta wave recedes, there should be another surge of consumer spending, travel, and confidence. This will serve to support earnings and the market. Our shorter duration fixed income strategies will provide some level of protection against higher rates, especially at the long end of the curve where the Fed has less of an impact. Municipal bonds have also been strong performers in fixed income, with positive returns year to date versus negative returns in most other fixed income sectors. For most economic and fiscal issues, economic growth is the salve that makes things better.
Random thought: “I have not failed. I’ve just found 10,000 ways that won’t work.” -Thomas Edison