Fiscal Dominance

The world is becoming less capitalist and more socialist.  That's not a political statement.  Its a purely objective statement based on the ratio of total government debt to GDP for the G20 nations.  When government debt increases as a share of total debt, as well as a share of GDP, its a sign of governments taking more control of the economy to shape it to its desires.  And the desire since 2016, when Trump got elected, followed by Biden in 2020, is to pump up the economy to win votes.  The politicians want to spend more, tax less, and put everything on the Treasury debt plan.  It is popular.  And the politicians know it, which is why they continue with the policy, and went overboard in 2020 and 2021.  It looked innocuous at first, but the government's footprint on the economy has gotten so big that it can no longer be ignored.  But oddly, despite growing into being the elephant in the room, its being ignored in the economic analysis of the macro pundits.   

The biggest error that I see among the macro pundits on the Street is they overestimate the effect of monetary policy and underestimate the effect of fiscal policy.  From 2008 to 2012, the Fed maintained ZIRP and did 3 rounds of QE, and it didn't do much for the US or global economy.  Sure, you had some credit contraction from the aftermath of the GFC, but monetary policy was very stimulative in the US and Europe.  And economic growth was anemic.  The reason?  Fiscal policy was not expansive enough, considering how weak the economy was.  Fast forward to 2020 and 2021.  This time around, fiscal policy went full bazooka mode.  $5 trillion of fiscal stimulus.  Most of it just pure handouts to the population in the form of PPP, stimulus checks, child tax credits, clean energy subsidies, and other random pork thrown everywhere.  It was a giant money spew.  Much of it sent to people who were going to spend the money, not buy more stocks and bonds.  And you get a totally different result than 2008 to 2012. 

Despite the huge boom in the US economy in 2021 and 2022, the focus of most economists is still squarely on monetary policy, which has been tight for the past 10 months.  Thus, most made the error that the economy would enter recession in 2023.  Yet, it still hasn't happened.  The economists and macro experts forgot about fiscal policy, which was still expansive, as the student loan payments were still suspended, you also had the delayed implementation of infrastructure spending from various pork bills that passed in 2021, which started kicking in this year, as well as the spending caps that were raised by big chunks last fall, for the FY 2023 budget.  Don't forget about the COLA (CPI adjusted) adjustments that boosted Social Security and disability payments for the elderly and handicapped/disabled.  

The huge budget deficits, now on pace for ~$2 trillion for FY 2023, are a giant stimulus for the US economy.  Basically money for nothing.  Yet, I see most economic bears ignore this huge stimulative effect of big budget deficits in their analysis.  Because it doesn't fit into their neat narrative that's based purely on models that focus on leading indicators, PMIs, and other soft data.  But those models have a heavy skew towards monetary policy effects, which are quite restrictive, while mostly ignoring the government's effect on the economy.  Which is only getting bigger and bigger as the government's share of GDP grows.  

In a perverse way, the big rate increases have massively boosted interest income for the wealthy, which is mostly coming from the government, as government debt as % of GDP has grown astronomically over the past 3 years.  That interest is not a zero sum force.  When private borrowers pay interest to private creditors, there is a net zero effect in income.  But when public borrowers (US government) pay interest to private creditors, that is a net positive income stimulus effect for the economy.  That's because the government runs continuous deficits, so debt is just rolled over, and new debt is issued to pay off interest payments, not paid off and eliminated.  

That being said, monetary policy still has an effect on the real economy, but just not as big an effect as people think, due to the lags involved and the vast majority of fixed rate bonds and mortgages set at very low interest rates.  The residential housing market hasn't felt the full force of higher rates, due to all the re-financing that was done when the 30 year was trading sub 2% in 2020.  The most interest rate sensitive part of the economy are those that are dependent on short term variable rate loans, such as commercial housing loans, small business loans, and private credit.  That doesn't show up in the SPX, or even in the Russell 2000, as exchange listed companies have mostly fixed rate debt, and have hardly felt the pressure of higher rates that the private market has.  

And while higher interest rates put pressure on borrowers, it doesn't have a one shot knockout effect like a big uppercut to the jaw.  Its more like low kicks to the opponent's thigh, which has cumulative effects that take their toll over time.  Expansive fiscal policy has ameliorated a lot of the negative credit effects from tighter credit and higher borrowing costs.  But that effect will be lessened with the restart of student loan payments in October, as well as the lack of additional stimulus bills passed in the past 18 months, which will reduce the fiscal impulse at least until the next election in 2024. 

Add to that the lag effect of tighter bank lending conditions and less credit flowing from the banks and you have an overall situation that should skew the economy from being resilient to being vulnerable as the months pass by.  

Macro is hard.  Being dogmatic in this business is the way you underperform and become irrelevant.  I see many who are pessimistic on the economy who can't admit that they were wrong.  Being early in calling for a recession by a month or two is OK, but being early by over 6 months is not OK.  Those who can't admit their mistakes will never learn from them.  I was completely wrong in calling for an economic slowdown in the US in 2023.  It was a consensus view, so there were definitely some losses associated with my call.  It has made me re-think my view of the current US economy.  I didn't consider fiscal policy enough when forming my view on the US economy.  

Haven't thrown in the towel on my pessimistic view, especially considering how much the consensus has shifted from hard landing to soft landing from January to July.  The bond market pricing is much more conducive to making bets on the economy weakening and Fed having to cut than it is to make bets on higher for longer.  As prices have changed, the odds have changed.  They now favor the bears.  

The global economy is noticeably slowing, especially Europe and Asia, yet the ECB remains focused on inflation and not weakening growth, and they are likely to put Europe into a deep recession.  Asian growth is horrible because Chinese growth is horrible.  The Chinese economy is basically real estate, and that looks to be in a long term downtrend due to oversupply, overvaluations, and lack of natural, non speculative demand.  The only way that's fixed is either through housing deflation or massive money printing.  It looks like the Chinese government is leaning towards housing deflation, based on their policy actions to date.  The negative ramifications of spending just to meet GDP targets is something China is now aware of, which makes it less likely they'll repeat another giant stimulus like they did after 2009. Don't expect the Chinese economy to suddenly roar back until they go full bazooka like the US did in 2020/2021.  I wouldn't bet on it happening. 

Still in watch and wait mode, as the pullback in the SPX on bond market weakness is not a great time to short, as I expect bonds to bounce back due to the irrational view that the economy is so strong that yields need to keep going higher.  Russell 2000 has shown relative strength vs. the SPX, so that gives me a bit of pause about entering shorts.  We've got Eurostoxx underperformance. Just need to see Russell 2000 underperformance for the higher probability short setup in SPX.