When Fiscal and Monetary Policy Collide | Guggenheim Investments
At FocusPoint, we work with a number of credit and income-related strategies such as film/television and other media content, music royalties, sale-leaseback, direct lending, specialty finance, and asset-backed lending. In this article, Scott Minerd, Global CIO of Guggenheim, provides a unique and insightful perspective on the credit markets, that you may find useful.
By Scott Minerd, Global CIO at Guggenheim Investments
I have come to realize that the markets are potentially on a collision course for disaster. The collision course is being brought about by strong fiscal stimulus in the late stage of the business cycle, when conventional economic wisdom mandates that it should be heading the other direction to create fiscal drag. The U.S. economy is beyond full employment. The labor market is beginning to reach capacity constraints in a number of areas, which is resulting in a pickup in wage pressures. At this stage of the business cycle monetary and fiscal policy would normally be utilized to cool off the economy, but with the huge fiscal stimulus coming online, the Federal Open Market Committee (FOMC) will feel obliged to play the role of creating economic headwinds.
During the financial crisis and the Great Recession, the FOMC played the opposite role. As budget sequestration took effect and the size of the deficit shrank between 2010 and 2016, the Fed was left as the only source of stimulus for the economy. The fiscal headwinds of the economy made it necessary for the Fed to maintain a very low interest rate policy through the use of quantitative easing to help the economy expand and offset fiscal headwinds.
Now, as newly installed Fed Chairman Jerome Powell has testified, the headwinds of fiscal policy are gone and have turned into tailwinds. We are seeing some market estimates for economic growth upgraded to 3.5 percent. That might be a challenge for the first quarter but it is certainly not impossible this year. To have 3.5 percent growth at this phase of the expansion—when we are essentially running out of labor and other factors of production are being stretched—makes it extremely hard not to see how inflation and wage pressures will pass through to the real economy. As I have been saying for a while, the Federal Reserve (Fed) will raise rates four times this year, and probably four times next year. Currently the overnight rate is between 1.5–1.75 percent. Thus a year from now it will be 2.5–2.75 percent, and a year later it will be between 3.25–3.5 percent. When the overnight rate gets to 3 percent the amount of free cash flow in corporate America will be reduced to a level which is consistent with what we have seen in prior recessions.
There should be some offset to this cash flow squeeze from the reduction in the corporate tax rate, but what are corporations going to do with the money? Since return on equity (ROE) has been declining for the last 10 years, corporations will try to increase ROE with stock buybacks. Some corporations will increase dividend payouts. Others will make strategic acquisitions. Corporate America will not be sitting on the cash.
When you consider where we are today, things look pretty rosy as corporate earnings rise. But what happens in 2019? Corporate debt as a percentage of gross domestic product (GDP) is sitting at a record high. By the time we get to the end of 2019, when the overnight rate is between 3.25–3.5 percent, corporate America will be in worse shape than it is today. It will be in worse shape than it was last year. It will be in worse shape than in 2007.
This is the collision course. The collision will take place when the effects of fiscal stimulus begin to wear off and monetary policy keeps getting more and more restrictive.
We will enter the next recession with the highest debt load on record for corporate balance sheets. In the last recession, consumption by households collapsed because their balance sheets were overburdened by debt, and it was the household sector that led us into the recession. This time around, the household sector is in good shape. The next recession is going to emanate from the corporate sector. There is likely to be a sharp decline in employment and a sharp decline in profitability, followed by widening credit spreads as the market discounts the expectation of higher corporate defaults.