Macro Themes for 2021 & Beyond

Echoes of '60s policy mistakes, Schumpeter's Gale, Capital for Labor, Deglobalization and the End of the 39-Year Bond Bull Market

This is the second for our three-part 2021 outlook series. This is our favorite; it is our attempt to identify macroeconomic themes that will persist through the business cycle. Because we are at the beginning of a new business cycle we are going to start with our expectations for the duration and characteristics of the ‘20s expansion. Last year’s themes were deglobalization, China’s economic model flaws, accelerated technology innovation adoption, a recovery for energy despite ESG mandates and an end to interest rate suppression. The pandemic made the first theme more compelling, exposed and increased the risks of the second, turbo charged the third and delayed, but increased the investment opportunity of the final two.

The ‘20s Expansion, Echoes of the ‘60s Policy Errors

“The years 1961–71 were a part of the Keynesian interlude dominated by a strong belief that government was responsible for stabilizing an unruly private sector. The distinguishing characteristics were two related beliefs: (1) that policymakers could adjust their actions in a timely way to smooth fluctuations, and achieve full employment with high growth and low inflation, and (2) that policymakers could choose and achieve the right, possibly optimal, combination of inflation and full employment. Keynesian economists called their program “the new economics” to signify the departure from prevailing orthodoxies.”

“A History of the Federal Reserve, Volume 2, Book 1, 1951-1969”, Allan H. Meltzer

The 1960 presidential election took place amidst a recession that began in April and ended in February 1961. The Kennedy Administration brought the new-Keynesians into the Federal Reserve and throughout the administrative state. While their earliest actions were to accelerate depreciation schedules and later cut tax rates, which contributed to strong investment. The Kennedy and later LBJ administrations tipped the scales of Chairman Martin’s Federal Reserve he described as independent within (not from) the administration, heavily towards the unemployment mandate of the Employment Act of 1946 while they doubled outlays to pay for the Great Society and Vietnam War. The Chairman of the Council of Economic Advisors Walter Heller “went to Washington thinking we ought to end the independence of the Federal Reserve”. Inflation came into the ‘60s as a lamb averaging 1.3% for the first half of the decade but went out like a lion at 4.2% for the second half. Earnings growth boomed at 12.4% average annualized for the first half of the business cycle before slowing sharply to 1.7% in the second half of the cycle underscoring the different impact of reflation and inflation on profit margins. The S&P 500 multiple increased throughout the ‘50s to nearly 20 by JFK’s inauguration where it remained throughout what at the time, was the longest business cycle in US history. In short, what began as an optimal investment environment, due to low and stable inflation, accommodative monetary policy and supply-side tax reform, led to the Great Inflation and economically devastating decade of the ‘70s in large part due to policy errors and policymaker hubris.

Figure 1: After increasingly steadily through the ‘50s, equities stayed historically expensive through the ‘60s despite increasing rates and inflation late in the decade. It was a strong period for real investment as well and earnings growth was robust until the earnings but not economic recession of ‘66.

We do not believe that Janet Yellen or any of President-elect Biden’s economic advisors believe the independence of the Fed should be ended, however, with federal debt at levels last reached during World War II and entitlements created in the ‘60s on the verge of reacceleration, the best the Fed can hope for is to be independent within the administration. Consider the economic school of thought likely to dominate public policy this cycle. The country elected a Democrat in a recession like in 2008, though it did not give his party control over the federal or state and local governments to the same extent. The perception that China, a command-and-control economic system, handled the crisis better than the US market economy is reasonably pervasive. China is tightening control despite clear evidence that their response to the global financial crisis was the greatest fiscal misallocation of resources of all-time. US markets rally on weak data due to the expectation that the probability of stimulus will increase. This naïve market reaction inevitably has a nasty second order effect as it becomes clear that spending multipliers on government outlays are lower than forecast by the IMF and Keynesian consensus and tax hike negative multipliers are greater. Non-pharmaceutical interventions (NPIs) will result in scaring, the policy response in the US and the rest of the developed world is likely to be similar to the ‘60s. The case for inflation grows.

Figure 2: Price stability, the standard deviation of headline CPI, was lowest in the early ‘60s and mid to late ‘90s. By the end of the ‘60s the combination of overly accommodative monetary policy and expansive fiscal policy triggered the Great Inflation of the ‘70s.

There is one final issue to address before we move on, the duration of the expansion. Since the ‘80s, the average duration of an expansion has roughly doubled to 9 years. There are no debt or real investment related imbalances in the private sector that are likely to led to a contraction in the near term. Asset prices are a different story, by all historic measures real interest rates, stock prices and credit spreads are elevated and with monetary policy heavily skewed towards the employment portion of their mandate, financial instability is a near and present danger. Within this context it is worth considering the difference between the tech bubble bursting in 2000 with little associated debt, and debt financed housing bubble. Given that the federal government is the only sector with debt above threshold levels relative to GDP of 90%+, a policy response to that debt, tax hikes or monetary policy tightening were inflation to push interest service costs to levels that crowded out government spending, are possible catalysts for an end to the business cycle. Still, we suspect that like the ‘60s, these pressures will build over time and will not be sufficiently acute to led to a policy mistake that causes the next recession until the second halve of the decade at the earliest. Alas for classic economic liberals and others that believe like Meltzer the private sector is inherently stable, it is policy that creates instability, the Keynesians are in control, for now. Consequently, we expect a favorable environment for real and asset investment in the early years of the ‘20s, later in we expect the effects of Keynesian monetary and fiscal policy to prove costly.

Implementation of this theme: Long inflation beneficiaries; Treasury breakevens or inflation swaps, commodities and related equities

Schumpeter’s Gale: The Pandemic Positive Productivity Shock

For much of the ‘10s, economists debated slower global productivity growth. We spent considerable time researching the topic in the middle of last decade during our investment management sabbatical at BlackRock. Like Robert Solow’s quip in 1987, ‘you can see computers everywhere, except in the productivity numbers’, the power and disruption of mobile computing and weak productivity growth was a paradox. We offer two broad explanations; first the global labor supply shock, a 120% increase from 1990-2010, left most of the world dependent on cheap labor for goods production. As the rate of change of labor supply slowed, a lack of capital investment resulted in slower output. The second factor was detailed in an excellent book on the topic, “A Great Leap Forward, 1930s Depression and US Economic Growth”, Alexander Field. The theme of the book is productivity improvements from ‘20s innovation were obscured by the financial crisis in the ‘30s. After WWII, productivity boomed in part because the Depression accelerated creative destruction. The war put the boom on hold for 5 years.

Figure 3: Labor productivity typically rebounds in the cycle as output recovers faster than hiring. Sustainable trends through the cycle are driven by capital deepening and technology. We expect both in the ‘20s.

Prior to the pandemic evidence was building that as the labor market tightened, service sector businesses were increasingly substituting capital for labor and adopting technology innovation. Productivity growth increased in 2018 and 2019, despite a negative contribution from the manufacturing sector as the trade war sent global goods production and trade into recession. Easy to conceptualize examples include Starbucks investment in their mobile app and preordering that solved their assembly line bottleneck and Newark Airport’s Terminal C where iPads replaced humans for food and beverage service. The pandemic was a positive productivity shock that accelerated adoption of technology to deliver goods and services.

Figure 4: These three sectors have been a drag on US productivity since the ‘80s. Prices have increased above trend apart from the housing crash and a few brief periods for healthcare. Few would argue healthcare outcomes, educational attainment or housing utility justifies the price increases.

We doubt there will be much resistance to this thesis, there are however two important related questions. The first is whether the three deadweight sectors detailed in a 2016 Gallup analysis of productivity, housing, education and healthcare received a shock sufficiently large from the pandemic so that inflation in these sectors falls relative to the general price level and outcomes begin to improve. We have confidence this will occur in housing and healthcare. Healthcare deliverers face an existential threat from the progressive wing of the Democratic Party and have been forced to integrate technology in basic wellness as well as advanced treatment by the pandemic. The work-from-home necessity appears to have increase the mobility of the workforce and crowding into cities or regions thereby reducing the productivity drag we suffered during 30 years of NYC commuting. Education has been a major disappointment during the pandemic, teachers’ unions resisted compelling scientific evidence and held politicians hostage. However, while the Democrats are taking over the federal bureaucracy, they lost ground at the state and local level to the Republicans who were already in the majority. Student loan forgiveness and associated moral hazard threatens to exacerbate the borrowing and cost spiral at the university level. However, competition for public schools from charters seems likely to increase further and the integration of technology as a supplement to traditional in-person learning seems likely to return power to professors and teachers from administrators and unions and slow the cost spiral. Our approach to capitalizing on a turnaround in these deadweight sectors is our healthcare overweight. After three decades of margin contraction, we expect technology integration to reverse that trend. Healthcare is the largest contributor to S&P 500 revenues, however peak margins in 2Q19 were 6.5%, far below the 20.8% peak for the technology sector.

Implementation of this theme: Reduce Technology and Communication Services exposure, increase healthcare, industrials, financials and consumer exposure as the benefits of digitization migrate from the producers to users.

Figure 5: The pandemic also created a positive shock for household formations. The Millennial age cohort is larger than Boomers, they are moving into peak consumption years and in combination with improved mobility formations are likely to be a tailwind for residential investment for a decade.

Rebuilding the US Capital Stock

The two strongest decades for nonresidential fixed investment (NFRI) were the ‘60s and the ‘90s. In both cases real investment grew at twice the post-WWII average of 4.5% following significant supply-side tax reform. In the first case, tax reform began early in the cycle, in the second tax reform was enacted late in the previous cycle as is currently the case. Both cycles began with relatively low and stable inflation expectations. The Georgia Senate runoff elections could degrade the outlook somewhat, though the economic case for stronger capex was in place prior to the passage of the Tax Cuts & Jobs Act. The balance of this section is a reprint with some minor modifications from last week’s 2021 Outlook. Please skip ahead if you read last week’s note.

A 2017, pre-Tax Cuts & Jobs Act (TCJA), Congressional Budget Office International Comparison of Corporate Tax Income Tax Rates and analysis from Robert Barro and Jason Furman from Harvard titled Macroeconomic Effects of the 2017 Tax Reform, reach the conclusion that keeping TCJA’s 21% rate will significantly reduce the after-tax cost of structures investment integral to the evolution to ‘just-in-case’ supply chain management. The factor not explored in these reports that will have a larger immediate effect, is a rebound in business confidence from the trade war, pandemic and presidential election year uncertainty.

Figure 6: The Biden tax plan would significantly denigrate US corporate tax competitiveness.

Capital investment was weak through much of the ‘10s, like the ‘50s prior to the Kennedy Administration supply-side tax reform that led to the first post-WWII capex boom. Additionally, the economics of manufacturing in China to import to the US were largely gone by the mid-’10s ( U.S. Manufacturing Nears the Tipping Point) and supply chain risks, after a series of shocks beginning with the Great East Japan Earthquake and Tsunami in 2011, including the trade war, can no longer be ignored following the pandemic. One final point, demographics are destiny and the developed world has fully exploited the 120% increase in the global supply of labor from 1990-2010 (Demographics Will Reverse Three Multi-Decade Global Trends), consequently, substitution of capital for labor is likely to be a major theme in the ‘20s. This implies margin expansion broadening from the technology and communication services to consumer, healthcare, industrials and financial sectors. It also implies the trend change in productivity growth from 1% to 1.7% in 2019 attributable to the service sector, was not an aberration and will likely strengthen further as the benefits of digitization diffuse across sectors.

The pandemic was a positive productivity shock.

Figure 7: This is nominal capital investment, consequently the ‘70s appear to be a strong period for capex but in real terms not so much. The ‘60s and ‘90s followed corporate tax reform, inflation volatility was low and productivity growth was high.

Implementation of this theme: Long industrials particularly those that are at the forefront of the industrial internet.

Deglobalization, Collectivism and Mercantilism

Calling for the end of history for Mercantilism is analogous to predicting the end of collectivism, these ideas never really die, they are on a pendulum though not the same one. The collectivism pendulum is swinging towards command and control systems in most of the world including the US, though not as quickly as political strategists expected given the strong performance of the GOP everywhere except the top of the ticket. On the other hand, Mercantilism peaked in the ‘00s and the pendulum began swinging towards deglobalization in the ‘10s. In the world’s number two economy, a hard shift towards increased command-and-control combined with deglobalization seems likely to make this a difficult decade. The ‘20s expansion is beginning with an exceptionally robust recovery of global trade as a consequence of the twin shocks of the trade war and pandemic, the last cycle began similarly only to see Asian trade growth slow to a third of the 2000’s rate. By the early ‘10s, the most efficient manufacturing companies in China, US multi-line industrials, concluded that the increased labor, transportation and energy costs no longer covered the implicit costs from intellectual property theft, exchange rate and supply chain risks. Most adopted what Honeywell calls a ‘locally sourced’ model, manufacture where final demand resides. Only the high margin technology sector is holding out, we expect that sector to adopt the industrials model this cycle.

Figure 8: Why would China need to increase crude steel production in a world where structures investment collapsed? So much for reform and cutting excess heavy industry capacity.

There is plenty of good analysis of Chinese economic activity that offers better information content than the flawed official data. Nonetheless, even the mix of the official data leads to the unequivocal conclusion that like the heavy industry hard landing of 2014-2016, the response to the pandemic from the central committee and General Secretary Xi was to deepen state control over the means of resources. Fixed asset investment recovered more quickly for state-owned-enterprises than private entities, the rebound in industrial production was led by heavy industry, retail sales lagged production and the recovery in exports is well ahead of ordinary imports (domestic demand). Admirers in the west marvel in China’s handling of the pandemic, students of economic history are increasingly confident China’s fatal conceit is increasingly likely to doom them to the middle-income trap. This theme runs deeper than China. European fiscal integration and the BOJ’s position as the largest stockholder in Japan are moving these countries towards greater state control over the means of production, a form of corporatism. We see few signs that these export dependent economies are well positioned for another decade of deglobalization.

Figure 9: Asian export growth slowed from 14% during the peak of globalization to below 6% in the ‘10s, we expect it to slow further in the ‘20s after a sharp recovery from the twin shocks in ‘21.

Implementation of this theme: Underweight Chinese equities particularly State-Owned-Enterprises (banks and heavy industry), and developed world export-dependent markets (Germany, Japan, South Korea).

The End of the 39-Year Bond Bull Market

There are three major variables in our forecast for higher bond yields in the coming cycle. The first is our inflation forecast we discussed in last week’s note. The second can be characterized as demographics are destiny. Goodhart and Pradhan’s capital for labor thesis is likely to begin in the US, and in fact already has, though in part due the negative shock to business confidence from the trade war and pandemic, increased demand for capital has been concentrated in intellectual property products that are financed by equity rather than debt capital. In the ‘20s as supply chains are restructured demand for capital to build physical plant financed by debt is likely to increase significantly. The additional demographic shift in demand for capital is the largest age cohort, Millennials, moving into the peak life-style consumption stage. A key variable in research explaining the 39-year bond bull market is the aging of the developed world population and in the US, it was Boomers leaving peak consumption years and the associated demand for savings and fixed income. That process is now shifting as the Boomer influence is overwhelmed by Millennials.

Figure 10: This is not intended to attribute the spike in rates in the early ‘80s to policy, though it played a role. Explicit rate caps in the ‘40s made Treasury investment risk-free. Today Fed intervention is more direct but is likely peaking.

The final factor in our bearish bond forecast is deglobalization. During the peak following China’s entry into the WTO and reduced tariffs in the mid ‘00s, one of our first calls every morning was to Lehman’s Treasury desk to see how large the overnight demand from China was. Japan spent ~$350 billion attempting to weaken the yen from October 2003 through March 2004, 5 & 10-year yields rallied over 1% in the ensuing 2 months beginning the day after the last BOJ dollar purchases. Until 2005, China’s currency regime was a hard peg, it is still controlled. Petrodollar recycling was another source of demand for US fixed income assets due to currency pegs, that demand collapsed in 2015 as oil exporter revenues dropped $600bn+ as the shale revolution triggered a 75% drop in the price of crude. We did extensive analysis of energy’s contribution to the current account deficit beginning in the ‘60s and ran statistical causality analysis that supported our view that periods of high oil prices and large US energy trade deficits led to secular weakness in the dollar (‘70s and ‘00s), and the strong dollar decades (‘80s until the Plaza Accord, ‘90s and ‘10s) were partially a consequence of a falling energy trade deficit. Despite the current struggles in the shale sector, we do not believe large energy trade deficits are likely to return in the ‘20s. Consequently, Petrodollar and Asian goods export related demand for US fixed income is likely to be far smaller in the ‘20s than the ‘10s and the peak in the ‘00s.

Figure 11: Oil was a major contributor to the end of the Bretton Woods fixed exchange rate regime in 1971. After the ‘79 oil embargo the dollar rallied sharply as the Reagan administration regulated the energy sector and production recovered. In the ‘00s the oil deficit peaked at $440 billion.

This leaves the goods trade deficit as the primary source of the US current account deficit. There is no doubt that the Mercantilists will not go quietly into the night, they will make every attempt to weaken their currency to support their export dependent economies and the US remains an attractive destination for capital (the opposite side of the current account ledger). Nonetheless, monetary policy is even more inefficacious and even counterproductive in the rest of the large economies relative to the US. The economic and risk management forces of deglobalization imply a shrinking of the US goods deficit through the cycle. Additionally, the US services surplus is likely to widen further, particularly in financial services with tighter regulatory policy under the Biden Administration due to financial sector innovation. On balance, with a 3-decade disinflationary trend ending, higher domestic demand for capital and lower foreign demand for dollar denominated assets, only the Federal Reserve and Treasury stand in the way of higher rates. Financial repression will slow but is unlikely to stop a secular trend toward higher rates. One final point, markets generally have sneak previews of major inflection points. In the case of higher rates, the 10-day shock to risk parity in March when Treasuries failed as a risk mitigation tool for equities and collapsed concurrently was a warning sign that policy cannot completely mitigate risk.

Implementation of this theme: The death of the 60/40 optimal portfolio and risk parity goes the way of portfolio insurance.

Barry C. Knapp

Managing Partner

Director of Research

Ironsides Macroeconomics LLC

908-821-7584

bcknapp@ironsidesmacro.com

https://ironsidesmacro.substack.com

https://www.linkedin.com/in/barry-c-knapp/

@barryknapp

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