Fifteen years ago, in April 2006, Outlook & Trends recalled Bob Dylan’s lyrics, “The times they are a-changin’ “, as we spoke about the demographic shift that would be occurring as the baby-boom generation was about to enter retirement and the effect it would likely have on your financial planning. That change is still occurring ever-so-slowly, with deflationary forces resulting in almost imperceptible, but real, slower economic growth. Clearly the times are still a-changin’, and economic effects are becoming increasingly volatile as the government pulls out all the stops to recover from the pandemic and limit the impact of a more lackluster performance.

The Economy

Despite the renewed uptick in Covid activity, the path back to normalcy is in view. While the disease will no doubt be with us at some level for years, the vaccination process promises to have a favorable impact on reopening the economy. Additionally, both the elected branches of government and the Federal Reserve have unleashed an unprecedented amount of financial stimulus, designed to stop the recession in its tracks as well as support people who have been affected financially. 

As a result, economic activity is almost back to where it was pre-pandemic Recently GDP grew at an annualized rate of 4.3%, although the yearly change still measured a 2.4% contraction. Leading economic indicators and the purchasing managers’ index also show that the policies have been effective, and we are back on track for expansion.  However, unemployment is still at 6.2%, and consumer confidence is returning slowly. In the real world, people have remained hunkered down. Consumer credit is slightly lower than a year ago, and household financial debt obligations remain near the low set after lessons were learned by the overextension of credit that peaked in 2008.

The Markets

There is a dichotomy though between the financial and real estate markets, which have enjoyed the benefits of the government’s largesse, and the general population. The markets have responded to the government policies as all pretenses of fiscal and monetary restraint have been dropped. The US national debt  has ballooned  to over $28 trillion, and a new $2 trillion infrastructure spending plan was announced yesterday.  Additionally, the Fed’s balance sheet simultaneously doubled to almost $8 trillion in the last year. It is now 10 times the level it was 2008. The stimulus bills and the Fed’s money printing have been rather blunt tools, however, and are creating side effects in the markets. Returns on peoples’ safe savings accounts are virtually nil, while rising longer rates have reduced the value of longer-term bond investments. The value of long-term bonds has dropped by 20% since last August, as measured by a representative bond exchange-traded fund. Conversely, the average price of a single family home increased by 13% across the country during the last year. It has risen more steeply than any at any time since March 2006. Interestingly though, house affordability is still attractive, because mortgage rates and payments dropped significantly and have only started to rise again during last quarter.

Blowing Bubbles

The adoption of Modern Monetary Theory provides cover for current support policies by explaining that the government can spend as much as it likes by borrowing until a time when inflation becomes a problem. In a short-term sense, this is true. If you are a government, it makes complete sense to drive interest rates to zero and refinance your accumulated debt. As long as rates stay low, borrowing costs also remain low. With close to zero interest, in essence the borrowed money is free. Who can argue with that?

There are no arguments from the administration or Congress, as they have recently distributed $1,400 per person in a manner that former Fed chairman Ben Bernanke likened to throwing money out of a helicopter. The current Fed chairman, Jerome Powell, has promised to continue to remain “patiently accommodative” by continuing to expand  the bank’s balance sheet (print money) and keep short-term rates low for the foreseeable future, until “maximum” employment returns (3.5% unemployment rate last year) and inflation exceeds 2%.

As it turns out, however, there are many arguments. In addition to free money promoting moral hazard, and risky or useless investment projects that are eventually prone to fail, what will happen at the end of the free period when inflation and interest rates are no longer zero and the extensive debt needs to be repaid? It won’t be possible to rollover, let alone reduce the debt burden without incurring big interest expenses. What might the solution be? 1) Jack up inflation to repay the debt with money that has less value, 2) Raise taxes. As the old saying goes, there is no free lunch. Today’s spending and money printing is borrowing (or perhaps more accurately, stealing) from the future. The policies to avoid the political pain of an economic slowdown today are likely to be paid by future generations.

The current path seems to resemble the lead up to Japan’s “Lost Decade” (or lost 30 years), which was caused by easy money from the central bank and resulted in a big asset price bubble. When the bubble burst, it caused a market crash that started in 1990 and ended in 2009, 80% lower. During this period GDP growth was about 1%. Meanwhile, Japan’s debt/GDP ratio is still 225%. In comparison, the US’s is still “only” 133%.

There are no rules dictating how big a bubble can get or how long it might last. A seemingly unrelated event, like an unexpected virus could pop it. Given the “patiently accommodative” and spending policies that are seen to be necessary to spur growth now, but also continue to inflate stock, bond and real estate values, the final outcome may depend on how long the policy lasts, how big the bubble becomes, how gracefully the policy makers can unwind it, and whether the financial markets lose confidence in their ability.

In the interim, it is reasonable to expect that asset prices may continue to increase, inflation will increase, and taxes will increase and to plan accordingly. It is also reasonable to prepare for the bubble to burst eventually. We have seen how rapidly markets can fall these days due to the currently high valuation level and computer based trading.  The challenge is to balance a very valid need for risk control versus the emotional fear of missing out (FOMO) of a continued run-up. We caught a glimpse of how a burst bubble might unfold last March, when the market price from stocks dropped rapidly, in one month quickly erasing all the gains from the prior three years. In this case, the gains were recovered, in Japan’s case they were not.

When preparing your financial plans and your investment strategy, following average historical data to project future wealth expectations is likely to be a misleading exercise. Again, in Bob Dylan’s words, “the times they are a-changin’ “.

These are not issues for tomorrow or next week, but they are issues to consider and plan for. What has worked in the past will likely change in the future. We suggest considering the possibilities for you and your children. If you create and maintain a financial plan, you will be ready. LFM&P is ready to help when you are.