A Volatile Season

It is the best of times for equities. It is the worst of times for employment and interest rates. Cooling temperatures augur the imminent arrival of a resurgent virus that threatens further closures. The earnings season arrives with its insight into the durability of business during the Pandemic. Into this mercurial maelstrom steps a duplicitous debate on justice with a cost measured with integrity. To further heighten this noxious brew, a polarized election arrives with widely divergent outcomes for capital markets. The contest is the continued primacy of the return on capital at the expense of growth in the laboring economy. Even the probity of the election is impugned. These hallmarks assert that anarchy will usurp indifference with volatility reigning across markets. For the prepared, risk will offer opportunity.

The market risk is high with stretched valuations and uncertain earnings from the Pandemic-induced economic carnage.

Prepare before the storm. As long as people have sailed the seas, this adage has echoed in their ears. It is sound advice for this season. The world is awash in economic and political uncertainty. Yet, the equity and credit markets dance to their merry tune. Indeed, the rebound in the equity market is unequaled in its speed, and the pricing of credit risk is near cyclical lows. The brief justification for the disconnect between the real economy and the financial markets is insufficient fiscal policy and unprecedented monetary policy. A full economic recovery requires a role reversal. The risk is a collapse of the US dollar that may rattle financial markets.

The fiscal stimulus's hallmark was the unrivaled surge in household savings from the constructive combination of stimulus checks and no place to spend the budgetary largesse. As students of double-entry accounting know, a debit exists for every credit. The surge of $800 billion in private savings mirrored a collapse of $1 trillion in the federal government saving rate (exhibit 1). As the economist long proclaimed, there is no free lunch. The present borrowed money from the future. Therein lies the problem.

Exhibit 1. US Saving by Sector as a Percent of Gross National Income

Source: Federal Reserve Economic Database

As the world’s reserve currency, the US enjoys an exorbitant privilege. After World War II, this beneficial legacy emanated from the Bretton Woods system that established the US currency as the de facto currency for global trade. In possession of the world's mightiest industrial production and most of the world’s gold reserves, the choice was self-evident. The former meant that the US possessed the goods everyone wanted to import, while the latter ensured the faith in the US dollar with their trading partners. That era is a distant memory. Yet, its legacy endures.

An indication of a robust domestic economy is a healthy savings rate. The measure is vital because savings and investment are a reciprocal identity. One is the mirror of the other as high savings means high investment. Low savings implies low investment. The US’s total savings was at the lowest level in 50 years (excluding the Financial Crisis) before the Pandemic (exhibit 2). Investment increases productivity, which raises wages, which leads to higher growth. Thus, the virulent combination of a generational low savings rates and a jump in debt that is the largest outside of a world war suggests growth may slow as debt service expands. The debt service is not necessarily the problem; instead, it is who holds the debt.

Exhibit 2. US Total Saving as a Percent of Gross National Income

Source: Federal Reserve Economic Database

All voids are filled. A low savings rate alone is not a problem. The supplier of capital also matters. If the US generates insufficient capital, it must turn to its trading partners to fill the void. They can do so in two ways: investing in business or lending to the Federal government through the purchase of Treasury Bonds. As the rest of the world supplies capital to the US, the capital account and US dollar increase. The result is cheap capital for the US and lower prices of imported goods for consumers.

The reciprocal of a positive capital account is a negative current account, as the two must balance. The US current account, which measures net trade, is profoundly negative (exhibit 3). This situation places the US at risk of changes to the perception of US fiscal stability. If investors decided that they no longer wanted to provide capital to the US, then the currency would fall, and interest rates would rise.

Exhibit 3. US Current Account Deficit as a Percent of Gross Domestic Product

Source: Federal Reserve Economic Database

This risk is material because the US would need to fill its savings gap. Issuing more debt while interest rates rise would imperil fiscal stability. Asking households to save more would sacrifice growth. That leaves business as the lever to increase savings. What would be the cost? Higher savings leads to increased investment, which should lead to higher productivity and increased profits. This result occurs if the cost of capital level is not insurmountable.

Low growth of consumer spending from higher taxes and higher prices would impede growth. A smaller contribution from the government would occur as higher debt service detracts from growth. Critically, it is the composition of the workforce that will detract from growth. Most of the job losses during the Pandemic were in service industries (exhibit 4). These jobs are less amenable to productivity advances from capital investment as they require people, not capital. The implication is a higher cost of capital as slow growth permeates the economy.

Exhibit 4. Change of US Employment by Sector

Source: Federal Reserve Economic Database

While the rebound from the lows is material and singular in its speed, employment remains 10 million below its peak in February. This rate of job losses only has one comparable in the last century, the Great Depression. Growing out of this malaise requires a strong fiscal stimulus that is tempered by the debt growth before the Pandemic and an unfocused fiscal response during it. Constrained growth limits the ability to rebalance the current account expediently and manage declines of the US dollar.

The type of employment indicates that growth may not return promptly. The recovery in jobs saw a reduction in part-time workers, who initially saw their hours reduced, returning to full-time employment (exhibit 5). Further, those that were working part-time by choice and those furloughed have returned to work. Yet, full-time employment remains at a depression level. The implication is that constrained spending will endure, and household savings will fall. The result could be calamitous for the US dollar.

Exhibit 5. Change of US Employment by Type

Source: Federal Reserve Economic Database

Currencies are a relative game. If other economies are in worse shape, then the US dollar may not fall. After all, capital needs a home and will reside in the best relative abode. The disastrous US response to the Pandemic may strengthen its strategic rival, China. Against the rest of the world, the outcome is uncertain. The US remains the home of the most favorable demographics in the developed world and a technology leader. Public policy can swamp these advantages with poor choices. Investment is the way forward.