When it comes to writing, I’m a master procrastinator and negotiator! Oddly, buying myself more time on deadlines makes me happy — like I’m getting something valuable for free. I feel like I’m living on the edge, carefully toeing the line while trying to avoid falling off the cliff. What a rush!
Like me, the market is operating on borrowed time thanks to a decade of accommodative monetary policy, the Trump administration’s massive fiscal package and trade negotiations between the US and China. To be fair, I have a few clients to thank for my borrowed time theme. When both the Dow Jones Industrial Average and the S&P 500 Index reached all-time highs during the third week of September, I was meeting with financial advisor clients in the great state of Colorado who had questions about the strength of today’s market. Hadn’t a decade of emergency global monetary policies artificially inflated asset prices? Sure, the massive US fiscal package has accelerated domestic economic growth, but aren’t the effects only temporary? And, while it may appear that the US is winning all of these trade skirmishes, over the long term, doesn’t rising protectionism lower overall global trade and thwart global growth? Reflecting on their questions, I finally understood the aching uncertainty that something just doesn’t feel right about this bull market. Thank you, Colorado!
Let’s explore how monetary and fiscal policy and trade talks have the bull market running on borrowed time:
Slowly but surely moving off easy street?
The US Federal Reserve (Fed) raised interest rates for the eighth time in the last three years on September 26. Despite these persistent rate increases, monetary conditions in the US remain wildly accommodative. In fact, today’s targeted fed funds rate roughly equals the Fed’s preferred measure of inflation. As a result, real interest rates in the US are essentially zero. The Fed’s balance sheet may have peaked in early April 2016 at $4.5 trillion, but it weighs in at a still hefty $4.2 trillion as of September 19, 2018. That’s a great deal more than the $870 billion in Fed balance sheet assets in early August 2007 just prior to the global financial crisis.1 In his Jackson Hole speech in late August, Fed chair Jerome Powell underscored his gradualist approach to monetary policy. The Fed may be simultaneously raising rates and reducing its balance sheet, but it cannot yet be described as tightening monetary conditions.
Meanwhile, the Bank of Japan (BOJ) concluded a two-day meeting on September 19 by keeping its aggressive monetary policy unchanged, opting instead to monitor the effectiveness of recent tweaks amid chronically weak inflation.2 Also, the European Central Bank (ECB) left benchmark interest rates unchanged on September 13. In a subtle change to the bank’s guidance, the ECB announced plans to end bond purchases at year-end and keep interest rates at record low levels at least through next summer.3
If the global economy is on such firm footing, why is it necessary for the world’s central banks to keep interest rates at historically low levels and balance sheets fat? Ten years on from the worst of the financial crisis, central banks are using what was supposed to be a temporary solution as a permanent crutch. Obviously central banks remain fearful about removing easy monetary policies too quickly from the fragile economy and markets. It may be the prudent course of action, but it sure feels like living dangerously on borrowed time to me.
The money pit?
Monetary policy helped restore confidence in the financial markets and repair a challenging credit environment. However, it did not return economic growth to the good old days. With the rise of populist candidates and in the aftermath of a wild 2016 presidential election, fiscal policy quickly became the silver bullet solution to boost our long but shallow economic malaise. With Republicans firmly in control, a massive fiscal stimulus package was passed with the expectation that it would permanently alter the trend growth rate to a much higher level. Classic supply side economics.
All told, more than a trillion dollars in fiscal policy will run through the US economy in the coming quarters. And, its positive effects are easily observed. The US economy will likely have back-to-back quarters of 4+ percent GDP growth. But, this good cheer comes with some painful long-term consequences. The US federal deficit is fast approaching a trillion dollars. The US federal government debt burden has surpassed $21.5 trillion.4 And, the problem is getting worse as the American population ages. As a result, the US Treasury is on track to issue over $1 trillion in marketable debt this fiscal year.5 It is unusual for the government to be borrowing so much when the economy is doing so well.
Longer-term massive deficits brought on by profligate government spending will likely result in slower growth, higher interest rates or both. Until then elected officials will continue to borrow time to enhance their chances of being re-elected. Let someone else deal with the long-term consequences of their actions. Politicians happily living off the borrowed time of our children.
Clash of the trade titans?
I may be pressing my borrowed time theme a tad too far here, but give me a minute to address the trade dispute between the US and China. Secretary of the Treasury Steven Mnuchin provided China one more chance to avoid tariffs on Chinese imports to the US when he extended an invitation to Beijing for more trade negotiations on September 12. On September 17, the Trump administration announced tariffs on $200 billion of Chinese goods. But a funny thing happened. The proposed tariffs were just 10 percent, not the 25 percent many had anticipated, plus they excluded more than 300 products. It seems as though the administration wanted to avoid going nuclear in the trade dispute. The markets applauded their effort.
China is also buying time. Their response to the $200 billion in tariffs showed restraint. And Chinese officials committed not to purposefully devalue the yuan as a weapon in the trade conflict, signaling some willingness to negotiate. However, China refused to accept the administration’s most recent invitation for more trade talks, saying it would not be bullied by tough trade tactics.
Both the US and China are delicately trying to avoid the more serious consequences of a trade war by buying time. The Trump administration wants a trade win in the worst way before the midterm elections. And, the Chinese want to wait until after the elections to determine if Trump trade policy has been strengthened by the electorate or weakened. It’s a game of cat and mouse. Markets have responded positively when it appears the trade dispute may be thawing and they have suffered when it flares up. Buying time may be a thoughtful negotiating tactic, but the markets crave resolution.
Time is on our side?
Investors’ relationship with time is complicated. They rightfully interpret a long time horizon positively, and the market’s long-term performance has rewarded them for their patience and discipline. But borrowed time presents risks. Even as investors gobble up US stocks and continue to be rewarded for their investments, there’s an eerie feeling that time may be running out.
If we have borrowed time from the future, have we borrowed returns, too? What if this time around the temporary positive effects of easy monetary policy and massive fiscal stimulus stole investors’ future returns? What if delaying the pain from more normal monetary policy conditions results in an increase in market risks? What future challenges will we have to deal with in the aftermath of the current generous fiscal policy package? As the impact of monetary and fiscal policy wane, investors should make the time to prepare their portfolios now for more normal bouts of market volatility in the future.
For more detail, read this month’s Uncommon Sense.
1Board of Governors of the Federal Reserve System, September 19, 2018.
2“BOJ stands pat on stimulus policy, says it will monitor impact of recent tweaks,” The Japan Times, September 19, 2018.
3European Central Bank holds interest rates steady as economy ticks over,” CNBC, September 13, 2018.
4Congressional Budget Office, September 2018.
5Treasury sets $78 billion auction as it’s on track for topping $1 trillion in issuance” Marketwatch, August 1, 2018.
Gross Domestic Product (GDP)
The monetary value of all the finished goods and services produced within a country’s borders in a specific time period.
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