On Populism & Economic Consequences

For this week’s Market Commentary, I thought I would send out an excerpt from the fourth quarter edition of our quarterly newsletter, The Farr View.

The Oxford English Dictionary describes “populism” as “a political approach that strives to appeal to ordinary people who feel that their concerns are disregarded by established elite groups.” There is no doubt that populism has been on the rise in the US, and it is becoming more prevalent on both sides of the aisle. The genesis of populism’s rise is the ever-expanding problem of economic inequality. We are not being political when we report that a majority of Americans have not participated in what President Trump calls “the greatest economy in the history of the U.S.” Something isn’t adding up. The realities across the country do not match the rhetoric coming out of Washington. Despite modestly better middle-class income growth, the large majority of the income and wealth gains continue to accrue to a small percentage of wealthy people. Clearly those with assets like stocks and real estate have seen significant appreciation in those values. Those without assets have remained financially stagnant.

One implication of the rise of populism is that we can expect populist candidates to continue getting elected and populist policies to continue getting implemented. Candidates are increasingly likely to promise some mix of tax cuts, increased government spending, wealth redistribution, large-scale infrastructure plans, debt forgiveness, loan guarantees, more restrictive immigration policies, and super-low borrowing costs. While the short-term economic implications of these policies can be quite positive, the intermediate- to longer-term side effects can be quite profound. At a time of low inflation and interest rates, we won’t immediately feel the effects. But could that be changing?

 

In the third quarter edition of The Farr View, we noted that interest rates had dropped rather precipitously, and the yield curve had inverted, both of which were suggestive of a dramatic slowing in economic growth. Well, growth has slowed a bit, but the threat of recession appears to have passed. The consensus estimate seems to be that the economy will end up growing a little more than 2% in 2019 and another 2.0% in 2020. The rapid change in the economic outlook from just three months ago reflects a number of factors, most notably stimulus initiatives across the globe and the completion of “phase 1” of a trade agreement with China. Reflecting the improved outlook, interest rates have bounced and the yield curve has normalized (long-term interest rates are higher than short-term interest rates again). And a confluence of factors suggest that interest rates (and inflation) may head even higher, and perhaps meaningfully so. Consider the following:
  • The global economy appears to have found a bottom as foreign governments and central banks have aggressively added fiscal and monetary stimulus. Positive trade developments and less uncertainty regarding Brexit have also helped.
  • The dollar, which has been very strong for the past several years, is now weakening. We would expect this to continue if economies outside the US continue to improve.
  • Commodity prices, which move inversely to the dollar, appear to be bouncing off low levels as well. The strength could reflect a better global growth outlook.
  • The conflict with Iran appears to be escalating following the air strike that killed a key Iranian general. Iraq and Iran together account for 9% of the global oil supply, so further escalation could send the oil price even higher.
  • The Fed has essentially committed to keep interest rates at current levels even in the event inflation rises above their target of 2.0%. The Fed’s reluctance to raise rates in 2020 also reflects its need to avoid the perception of interference in the 2020 presidential election. In other words, there is a high bar for Fed action to prevent undesirable levels of inflation.
  • The Fed is growing its balance sheet again, providing additional liquidity into the system.
  • Unemployment is at 3.5%, and wage growth on the lower end of the pay scale has accelerated to 3.7%. (Incidentally, we disagree with those who believe the Phillips Curve, which says there is an inverse relationship between the unemployment rate and inflation rates, is dead.)
  • Many Americans (mostly the richest ones) are flush with investment gains. Though the marginal propensity to spend is much lower for wealthier folks, some of this wealth will be spent.
  • The long-term trend of globalization appears to be reversing, which is inherently inflationary.
The recent trend toward populist policies will, at best, support the rise in inflation and interest rates in the future. At worst, populism could cause dangerous levels of debt and a spike in interest rates that contribute to the next recession and/or financial crisis. Think about it. What do all the populist policies (tax cuts, deficit spending, redistribution from rich to poor, debt forgiveness, loan guarantees, stricter immigration policies, interest-rate suppression, etc.) have in common? They are all inflationary. We may be seeing the initial effects of the policies that have already been enacted. More could be on the way. Therefore, the major intermediate-term risk for the economy and markets, in our opinion, has gone from recession to overheating. And regardless of its past pronouncements or political agnosticism, the Fed may feel compelled to act to rein in inflation within the next couple of years. That moment could represent the aforementioned day of reckoning.
If there is one thing we have said more than anything else during the course of this 10-year recovery, it is that the economy simply cannot withstand meaningfully higher interest rates. This has been proven correct from the first “Taper Tantrum” in 2013 to the Fed’s most recent policy reversals in 2019. And it will likely be proven again before long. As previously discussed above, though, our capacity to respond to the next economic downturn is now much more limited. The dramatic and ongoing buildup of debt will simply make it that much harder to avoid the consequences of long-term interest-rate suppression.