When economic shutdowns were instituted in March, some experts predicted a repeat of the Great Depression. That’s a quaint forecast in hindsight. As 2020 ended, Americans were on a home-buying spree including bidding wars, holiday retail sales were poised to set records, stock prices were at all-time highs, IPO sales were blazing hot and, amazingly, the Fed and Congress were nowhere near finished with injecting money into markets and the economy to make sure there was no chance the recession returned. What happened to go from glum to giddy in the span of a handful of months?!? Trillions of dollars happened, making 2020 look nothing like the last crisis in 2008 with its classic rounding bottom and recovery (see chart above).
Pop quiz. What day in 2020 did the Federal Reserve first cut rates in response to the growing pandemic and by how much did it lower rates? The date is probably earlier than you remember: March 3, cutting by a half point to 1%. But on March 15, the Fed decided to hold nothing in reserve. In one fell swoop it slashed rates by 100 basis points to 0%-0.25%. And in a show of force that’s never been seen before, the Fed launched a barrage of financial market support facilities to stanch the bleeding in both the equity and fixed-income markets. Congress, meanwhile, was gearing up to pass the $2 trillion CARES Act — signed by the president on March 27 — and to support businesses with the paycheck protection program.
The contrasting speed with 2008 is telling.
In that fateful year, the Fed started cutting interest rates in January, but it would take another 11 months – until December – to finally reach 0%. The central bank’s alphabet soup of facilities were rolled out over several months to combat new crises as they arose. As for Congress, it passed an economic stimulus program in February 2008, but it would be another eight months until the Troubled Asset Relief Program (TARP) was approved in October to help banks. Lawmakers would eventually ratify another dose of economic stimulus in February 2009, a year after the first one.
How we got to this point, with the death of the business cycle, has been a long road that never envisioned killing off the economic ups and downs. The journey begins under Alan Greenspan, when the Federal Reserve achieved the holy grail of central banking: the soft landing. By setting interest rates that are neither too high nor too low, Greenspan was trying to carve out a middle ground to produce long periods of prosperity punctuated by shallow downturns. Soft landings would protect as many jobs as possible and avoid the widespread financial pain that comes from deep contractions. The consensus is that Greenspan’s fine-tuning was successful in the early 1990s, and ever since then it’s been refined towards perfecting it.
The end result of the fine-tuning is that strong, quarterly GDP growth of 3% or more recorded from 1950 to 1985 is not seen as often in the last 35 years. Gone, too, are long-lasting and deep contractions.
Soft landings are an important achievement, but something fundamental changed in 2020, where the authorities wanted to achieve something far different than cushioning the downside. One could argue that the ferocity of the Fed and the federal government’s fiscal response last year was due to the simple fact that a lot of Americans were going to be in financial pain with the shutdowns. But that would ignore five important announcements from the Fed after cutting rates to 0% on March 15; all of them aimed at controlling the economic risks that could emanate from global financial markets.
Federal Reserve’s Very Busy Week in March
The Fed’s monetary bazooka has all the hallmarks of the lessons it learned in 2008. During the earlier crisis, the central bank discovered the economic dangers that lurk, unseen, in credit markets, insurance contracts and derivatives.
Those so-called “financial linkages” are a black box, and the effects of breaking those linkages are impossible to predict. The tsunami of lending and liquidity facilities in 2020 is a clear signal that the central bank’s aim is to control hidden risks during an economic downturn. And the only way to control them is to compress the contraction by throwing a massive amount of money at the problem as quickly as possible.
The other lesson from the Great Financial Crisis is that economic risks can come from anywhere on the planet and feed back into the U.S. China may pose the greatest risk given its opaque banking system and state control of financial institutions. But China plays another key role in the demise of the business cycle: dampening inflation or dis-inflation.
If inflation is going to remain lower for long stretches of time, then the Federal Reserve has a very good reason to keep interest rates lower for longer. Why is inflation so weak? One critical part of the answer is that China, like the U.S., is no longer dominated by manufacturing. Factory inventory gluts and shortages, a primary inflation driver in the past, are a shrinking part of GDP worldwide. It’s well known that the majority of American economic activity is in services. What isn’t widely appreciated is that China’s services sector easily dwarfs its manufacturing sector.
Services don’t have inventory cycles. And it covers a wide variety of intangible things from financial transactions and office cleaning, from concerts and education to health care services and surgery. If one part of services is weak, there’s a reasonable chance that another is strong, buoying the economy. That’s far different from manufacturing where weakness in automobile production, for example, would ripple along the supply chain to affect chemicals, metals and railroads. Additionally, the empirical evidence is that economies dominated by services have lower rates of inflation. The dominance of services, therefore, short-circuits the Fed’s need to either raise or lower rates, both by eliminating inventory cycles and by muting inflation.
No discussion of inflation is complete without addressing technology’s role in driving a dis-inflationary environment. Every company now pitches itself as being a technological leader in some way. The reason is that technology is a highly flexible, business-building material. It may start out selling books, but it can morph into taking on shipping giants such as FedEx. And a key result of that business evolution is the obliteration of old cost structures.
Technology’s other big effect is making all of us more productive, meaning we can do much more with less. Measuring something as amorphous as productivity, however, is difficult if not impossible given the hyper-fast changes driven by technological breakthroughs. Measuring productivity in manufacturing is a complex task, and measuring it in services is even more daunting. Suffice it to say that the soft landings central bankers get credit for is arguably a result of something that they have no control over: technological advancement which drives down costs which can keep more people employed while also lowering the cost of goods or services.
A third key factor that appears to be limiting the economy’s growth: anxiety. Americans are saving more money than ever, rather than spending it. 2020’s experiment in seeing what people would do with trillions of dollars in direct stimulus checks may have surprised Congress and the Federal Reserve which were banking on a spending spree. Many Americans used the money to pay down debts or to bulk up their savings account.
The scars of 2008 seem to be all too fresh in the minds of many consumers who are seizing the opportunity to have a fortress balance sheet instead of allowing their lifestyle to be determined by the bankers who lent them money. The end result is that consumer demand is reined in, tepid enough to act as a brake on economic growth. That offsets those who are taking advantage of 2020’s low mortgage rates to buy a home or to refinance their loans. Meantime, businesses competing on price for those scarce consumer dollars ensure that competition keeps inflation in check. The strange behavioral economics outcome of 2020’s helicopter money drop is the Fed now sees that Americans are willing to save for a rainy day rather than splurge.
It’s a new world that’s taking shape. The euphoria will be kept in check at the highs, and the low points will likely be fleeting with long stretches of unspectacular growth in between. We believe that’s a world where professional financial planning will be essential for the average American, who likely finds this new world an unsettling and confusing place.
The first task for investors, then, would be to root out investment narratives that rely on riding cyclical highs and lows. Those investment approaches probably won’t be as rewarding as they once were. Growth companies, on the other hand, are likely to remain highly valued in the global stock market for the simple reason that growth will be hard to find in a slow-growing world. Plus, low interest rates mean higher price/earnings multiples. Additionally, investors are unlikely to view mining, manufacturing and other economically-sensitive businesses as long-term investments.
Prepare for interest rates to remain mired near zero percent. A technology-heavy, global economy dominated by services is unlikely to generate the inflation pressures of a boom-bust manufacturing cycle. There is, of course, the risk for an industry — such as housing or a sector such as online retailing — to become a bubble. But that would be because of too much money chasing an investment narrative. Central bankers and investors alike have shown no expertise in identifying bubbles before they burst. So the only recourse is to react when they pop by limiting the downside and keeping financial linkages intact.
Welcome to the new world order where a dead business cycle is the outcome of a global, dis-inflationary economy coupled to central banks and politicians who are reluctant to let their citizens experience the full force of a recession. We believe it is important for Investors to reassess the rationale for their investments to take account of this macro-economic change. Investing styles and techniques that worked in the past may not work very well – if at all – as this evolution takes hold.
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