In ‘Why elevated inflation will persist’ Pella posited that US inflation is likely to remain elevated through 2023 leading to monetary tightening during that period. This blog explains why Pella believes the Fed will relax monetary policy at the first opportunity it gets due to three drivers:
“Houston, we have a problem” (Apollo 13)
“One minute you’re up half a million in soybeans and the next, boom, your kids don’t go to college and they’ve repossessed your Bentley.” (Trading Places)
“A wise bear always keeps a marmalade sandwich in his hat, in case of emergency.” (Paddington Bear)
“Houston, we have a problem”
One of the foremost issues facing the US economy is its debt load. US total public debt recently breached $30T, for the first time, and nonfinancial corporate debt passed $11T in late 2021, which is another record. Completing the podium is US household debt, which just surpassed $15.6T. These figures equate to $57T in debt versus $48T pre-pandemic and $16T at the turn of the century.
At this quantum of debt, even minor interest rate increases will have a profound impact on interest expense. The good news is that $10T of the total debt is residential mortgages, which is based on fixed 30-year interest rates, meaning increases in interest rates shouldn’t sap the consumer through higher mortgage repayments. However, the pain won’t be fully offset as someone is on the other side of that trade, and we learned during the GFC that someone is the financial markets. Nonetheless, putting that aside still leaves $47T in debt that will experience higher interest costs with tighter monetary policy.
Applying an almost criminally simple calculation, a 2% increase in interest rates implies an almost additional $600Bn in interest costs for the US Treasury alone. In 2021 the US Treasury’s receipts were $4T and the outlays were $6.8T, resulting in a $2.8T deficit. The additional $600Bn in interest costs alone would increase the US Federal deficit by 20%. This would likely force the US to make material budget cuts and/or material tax increases, which would be a headwind to US growth. The tyranny of numbers is inescapable, and we can already hear howls of “Powell, we have a problem” when interest rates rise.
“One minute you’re up half a million in soybeans and the next, boom, your kids don’t go to college, and they’ve repossessed your Bentley”
Currently elevated asset prices are materially predicated on low interest rates, which push up valuation multiples. The corollary is that tighter monetary policy should be a headwind to asset prices by suppressing valuation multiples. The implication of the lower multiples is already being felt among the small and mid-cap ‘disruptors’, which experienced material share price declines over the past handful of months.
In theory, the Fed is not mandated to be concerned about asset prices. In practice, the Fed has repeatedly demonstrated that it is (very) concerned about asset prices. After all, someone needs to save the Bentleys from being repossessed.
“A wise bear always keeps a marmalade sandwich in his hat, in case of emergency.”
The Fed’s monetary policy mandate is to maximize employment and price stability. Its recent behaviour points to the Fed emphasizing employment over price stability. This was made crystal clear in August 2020 when the Fed explained that its new approach to monetary policy involves:
Adopting an average inflation target that allows past shortfalls of inflation to offset subsequent overshoots.
Commitment not to hike interest rates until inflation exceeds the Fed’s target persistently.
Basing policies on “outcomes rather than forecasts” and testing the limits of maximum employment to create a recovery with “broad and inclusive” benefits to the labour market.
The outcome of the approach is that the current Fed is likely to loosen monetary policy at the first opportunity it gets. Pella believes it will get that opportunity in relatively short order after tightening monetary policy due to the three factors discussed above. Luckily, the Fed has many marmalade sandwiches in its hat including slashing interest rates, buying bonds, or opening special lending windows.
Bringing it all together
Combining the ‘Why elevated inflation will persist’ blog with this one implies that the Fed is likely to tighten more aggressively than many might expect in the short-term but will then be forced to loosen monetary policy relatively quickly. Applying the above analysis as a guide, the US economy and markets are likely to experience notable strains with interest rates at 2%, which consensus forecasts point to occurring by the end of this year. This may not result in immediate interest rate cuts, but it will likely be a catalyst for starting the conversation.
To position for the first part of the thesis, the Pella Global Generations Fund holds positions in companies that benefit from interest rate volatility, as well as commodity producers with strong ESG credentials. Positioning for the next stage of the above thesis (loosening monetary policy) is a little trickier because it requires fortitude to invest in companies whose materially positive backdrop lies a few years away.
‘Growth’ companies benefit more than most from loosening monetary policy, but equally suffer the most from tightening monetary policy. Given the above scenario, Pella’s approach is to invest in growth companies that are the least vulnerable to rising interest rates, which is as much a case of avoidance as it is in selection.
Pella is avoiding companies that have no imminent prospect of generating cash, have valuations that imply guaranteed market dominance or are simply backed by attractive narratives, rather than substance. On the other hand, Pella owns several rapidly growing businesses that are positioned to be self-financing and have reasonable valuations. This includes ASML, Coinbase, Novo Nordisk, and RingCentral.
Over the past two blogs, Pella has explained its monetary policy thesis and how we have accordingly positioned the portfolio. In an upcoming blog we will share our views on why the Fed’s focus on inclusion, while well intentioned, is having the opposite impact on societal equality, and how Pella is positioning its portfolio in light of that policy error.