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Third Quarter 2023 Client Newsletter

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History is a gallery of pictures in which there are few originals and many copies.

- Alexis de Tocqueville

Current Events – The One-Paragraph Recap

Generationally high interest rates and inflation are stressing consumers. Housing activity is crashing in the face of an affordability crisis, yet prices aren't falling. An Eastern power with a demographics problem threatens to supplant US global supremacy. Proxy wars pit communist and democratic countries against each other, raising the risk of entanglement between nuclear powers. A deeply unpopular incumbent Democratic president faces off against a former television actor. Labor unions are flexing their muscles to secure richer contracts. And a promising new technology has firms on the cutting edge brimming with excitement. Does any of this sound familiar?

Is this 2023? Or the late 1970s and early 1980s? While disco might be dead, the themes above seem alive and well in 2023. In this newsletter, we're going back in time to see if any clues from the last go-round are useful to us today. We have to keep it brief, so don't confuse our succinctness for simplicity.

As always, we're here to keep the conversation going. So, if you'd like to go down the wormhole with us, let us know, and we'll schedule a review. 

Inflation and Interest Rates (Powell v. Volcker)

Boy, oh boy, people love talking about Paul Volcker these days. The 6'7" Volcker was a literal giant of a central banker. He had a no-nonsense style and doled some seriously harsh medicine in his late 1970s tightening cycle.

From 1976 to 1981, The Honorable Mr. Volcker raised short-term interest rates from generationally high levels (about 4.7%) to levels that would make a loan shark blush (20%!). Of course, he did that out of perceived necessity due to the unsustainably high inflation that ruled the day.

Despite his recession-inducing monetary policy, he's always been fondly remembered in finance circles that lean towards hard money and self-sustaining business cycles. When inflation exploded higher in 2022, many policy makers shifted their mindset toward Volcker’s style. And the current chair of the Federal Reserve, Jerome Powell, is one of them.

In his August 26th address at the Jackson Hole Symposium, Mr. Powell asserted that under his stewardship, the Federal Reserve would "keep at it until the job is done." It didn't take long for the financial media to notice that the phrasing was eerily similar to that of Paul Volcker's memoir Keeping At It.

Since then, Powell has used 'keep at it,' or a synonymous phrase, 13 times in his prepared public remarks. Clearly, he is channeling his inner Volcker and wants us all to know it.

So, how have his actions matched his tone? Surprisingly to some, the preliminary salvo against inflation in 2022 has exceeded that of Paul Volcker's.

Here's how each leader's tightening cycle played out. Remember that this chart shows only the incremental rise in the tightening cycle; as with all things, the starting point does matter – Powell began his 2022 hiking cycle with a policy rate of 0.25%, while Volcker started in 1976 with a policy rate of 4.7. The solid lines represent the actual path of the Fed's policy rate, the white dashes represent FOMC members' expected policy rate.

After 20 months of tightening, the distance traveled has been roughly the same. However, the expected flight path from here, as projected by the members of the FOMC, is decidedly different from the Volcker endgame. Policy-setting members have dubbed this a 'higher for longer' monetary policy regime. Interestingly, the Volcker Fed had an almost 8-month pause in their hikes before aggressively resuming tightening. The pause and reacceleration scenario likely gives current officials indigestion about prematurely ceasing their efforts.

Since our last newsletter, the rate of inflation has continued to slow. From a high growth rate of 8.9% in 2022, it has now settled in at about 3.7% per year. In the '70s, inflation annualized at 9% per year, every year, for a decade.

As discussed in our 2nd quarter newsletter, we're keeping a close eye on year-over-year and shorter-term measures of inflation momentum. Thankfully, the uniform trend lower in headline inflation is confirmed by the many alternative inflation measures available. That's a good thing.

Should inflation surge again, as it did in the late '70s, the Fed will be in a position to put its money where its mouth has been – namely, to take interest rates so high that it plunges the US, and likely the world into a recession. And that proposition leads us to one of the main constraints to further hikes – the US national debt.

We generally try not to talk externally much about the US national debt. It's a topic that can consume attention spans and distract from opportunities in the here and now. For decades, anxiety about the national debt could be deftly alleviated by saying, "It'll be a problem when markets start treating it as a problem, but you better believe we're going to keep paying attention." Unfortunately, the markets are starting to reflect some minor stress, and if interest rates continue to rise, the numbers can get nasty in a hurry. Let's review.

Since the US runs a budget deficit, debt is issued constantly to fund the government's annual expenses, about $1 trillion annually. And while that sounds like a lot, it only represents about 3.8% of the $26 trillion public debt. The real needle mover in the short term comes from maturing bonds that will need to be refinanced at substantially higher interest rates. Here's how that maturity wall looks:

The weighted average maturity of US debt is about six years, but it's a very front-loaded distribution. Approximately 47% of the public debt, or about $12 trillion, will mature in the next 27 months. That maturing debt was issued back when interest rates were effectively 0%. Applying higher interest rates to a growing base of debt leads to what we'd call a non-linear relationship – not good.

The chart below illustrates how that non-linear relationship can get out of hand quickly. The blue lines show the interest expense if 100% of the US debt was repriced overnight at a given rate. The red line represents the actual interest expense incurred annually. Note that the red line is between the 2.0% and 3.0% blue band, indicating that the current interest rate paid by the US is about 2.5% (nearly half of the prevailing rate).

Before panicking and becoming a subsistence farmer, remember that the US debt will take almost six years to turn over entirely. If rates fell back to 2%, where they were for most of the last decade, the situation would still be uncomfortable but far from catastrophic.

Side note/silver lining – the government's interest expense is someone else's interest income. And since about 40% of the outstanding debt is held by American citizens, a big part of that interest expense is going straight into the pockets of the public. Is that inflationary? Yeah, maybe. But that's a different newsletter topic.

It's time to reintroduce Mr. Powell into the story again. The Federal Reserve is designed to be independent. Their decisions are solely driven to achieve price stability and full employment. History is littered with failed efforts by global central banks to accommodate their fiscal authorities' ability to issue debt. But if rates remain high by Mr. Powell's restrictive policy and the US Treasury is shelling out >$1 trillion in annual interest expense, the political heat will be immense.

Paul Volcker was notoriously steadfast when President Reagan's officials pushed for monetary mercy in the face of an imminent recession. Will Mr. Powell have the same fortitude?

Housing – Does Activity Drive Pricing?

The housing market in the US is quite simple. Higher interest rates translate to higher mortgage rates. Higher mortgage rates make debt more expensive to service. More expensive debt makes homes less affordable. Less affordable homes lead to less activity in the real estate market. Less activity leads to lower prices, and the cycle begins again.

Well, up until that last point, sure. Many of our clients and readers experienced the housing market in the '80s. And I'll bet that even if you didn't experience it firsthand, somebody in your life has pridefully told you a tale about the abhorrent rate they secured on their first home. Check out this clip from the NYT in 1981 – 10% with 2.5 points. Great deal!!

As you'd expect, by the time a conforming 30-year mortgage peaked at 18.5% in 1981, new housing construction had fallen by more than two-thirds nationally. Yet, the index price for a home in the United States had merely flatlined. No price collapse, no bargains to be had.

Mortgage rates fell year-after-year for the next 40 years. And home prices marched ever higher. During the great financial crisis of '08, an overbuilt and over-leverage housing market spelled doom for the economy. Paradoxically, that crisis sowed the seeds for a housing shortage that still haunts us. It's a multi-decade problem that will take just as many to solve.

To add insult to injury, over 90% of homeowners with a mortgage have locked in a sub-4% rate. In a world of 7.5% mortgages, only those who must move are willing to. The structural supply shortage now has a cyclical component exacerbating the situation. Unsurprisingly, activity in the real estate market has cratered. Yet, there is no relief on prices.

But we can be sure of one thing. In finance, there is always a number that breaks things. Always. It can be challenging to say what that number is, but it does exist. It must. An affordability metric helps put the pieces together. The chart below balances the cost of a mortgage on a median-priced house with an average income level.

The housing market is extremely unaffordable, though things can get more extreme if the '80s are our guide. For fun, we ran the numbers on what it would take to get affordability back to the 50-year average. House prices would need to fall by more than -24%. Or Incomes would need to rise 32%. Or mortgage rates would need to fall back to about 4.8%, a level last available in April of 2022. One of those solutions is a lot easier to fathom.

China 2020-30s v. Japan 1970-80s

In the '70s and '80s, the US watched in awe as the Japanese economy took flight. Their education system and industrial policies meshed to produce a highly technical workforce primed to compete on the world stage. At first, they were an export-driven economy, with leading positions in textiles, automobiles, and semiconductors. Once US industries started to feel the heat, a multi-decade trade war began. In 1982, Presidential Candidate Walter Mondale encapsulated the angst: "What do we want our kids to do? Sweep up around Japanese computers?" At one point in the '90s, the US had leveled 100% tariffs on Japanese cars and auto parts.

By the late '80s and into the '90s, spurred by the 1985 Plaza Accord, the Japanese economy morphed into a domestic consumption-driven financial powerhouse. Many dubbed the 30-year transformation as the 'Japanese Miracle.' On a per-person basis, the Japanese economy actually exceeded that of the United States.

Then, a curious thing happened – the growth suddenly ended. Why? Theories abound, and there are far more dynamics than we can cover in this brief section. But demographics and cultural dynamics are typically used to explain the stagnation.

Population growth in Japan slowed dramatically in the '90s and entered an outright decline in the 2010s. Calculating economic growth (GDP) is pretty straightforward – either grow your population or grow the productive output of your existing people. It's much easier to grow your population, but if it isn't growing and your workforce is already fantastically productive, you will have difficulty growing.

Coincidentally, the US is yet again confronting an up-and-coming export-driven eastern economy. The Chinese economic ascent has been breathtaking since its induction to the World Trade Organization in 2001. Developing into the world's factory lifted hundreds of millions of Chinese into the urban middle class. But don't look now, the demographic bug looks to be creeping up on the People's Republic. Population growth is slowing dramatically and, by many estimates, will begin to decline in the next decade.

However, when Japan reached their demographic decline, it was already a wealthy country with a productive workforce and a balanced economy. China is not. Chinese GDP per capita is less than 20% of the United States'. They're still heavily dependent on exports. Oh, and they have 1.4 BILLION people!

Becoming a more domestically driven economy has the potential to boost productivity and help stem the economic drag exerted by demographics. Transitioning to a consumer-led economy has long been the aspiration of foreign companies seeking access to China's markets. Is China different enough to buck the law of demographics, or are they running out of time?

The glaring contradiction in comparing these two situations lies in military policy and geopolitical vulnerabilities. Post World War II, Japan had severely restricted military capabilities that made them vulnerable geographically to the rise of the Soviet bloc. That meant they had to settle disputes when the US got tough on trade and coerced the Japanese to play ball. On the other hand, the Chinese don't need our protection on the world stage, and they certainly aren't afraid of their post-Soviet neighbors to the north.

Additional China-focused newsletter sections will be coming. If you want to build up your foundational knowledge about U.S.-China relations in the meantime, I'd recommend checking out The Beautiful Country and The Middle Kingdom by John Pomfret.

Biden 2024 v. Carter 1980

I rarely enjoy talking about politics. But in our dive into the 70s/80s parallels, it'd be newsletter malpractice to avoid the Biden and Carter similarities. Both were first-term democrats who succeeded a scandalous prior administration. They shared an agenda for social progress. Dealt with the threat of direct entanglement with a nuclear-armed Soviet Union/Russia. Had contentious relations with OPEC that led to surging energy costs and inflation. And each of their approval ratings are amongst the worst in history leading up to their reelection campaigns.

Carter saw a brief boost in approval ratings when the hostages were taken in Iran. But it was the price of energy and, by extension, the inflation rate that weighed on both administrations’ ratings.

Here's how the price of oil traded during each President's term. Remember that the first oil shock in 1973/74 took prices up 301%, so the populous was already quite upset before Carter took office – the subsequent 180% increase was the icing on the cake.

One of the truest truisms in presidential politics is that if there's a recession in the year preceding your reelection, you should pray. If energy prices spike and there is a recession? It would be best to put some feelers out for a book deal, because you're done.

Many econometric models have been developed to try and predict consumption behaviors. But in the end, we humans are a simple bunch. Raise the price on something I need to continue living as I've grown accustomed to living? I get mad and yell at whoever I can. That's it.

We've flipped the price of gasoline (black) on this chart upside down, so it is directionally consistent with consumer sentiment (blue). Grey shading represents recessionary periods.

Focus on 2000, 2008, and 2020. Is it a coincidence that each time we had a recession/energy price shock/depressed consumer, the political party in power flipped? I don't know, but I'm sure glad I don't have to run for office in 2024.

AI v. PC

The late 1990s get all the love regarding the rise of computing. But it was the pre-internet days in the late '70s and early '80s when the foundation was laid. In 1982, MIT's Sloan School of Business projected a nearly 200% compound annual growth rate for personal computer sales throughout the '80s.

And they ended up being too conservative. But despite the monumental growth of access and the more than 100x increase in computing power, US workforce productivity fell throughout the decade. Economists struggled to explain what should have been a catapult higher. Explanations ranged from an undertrained workforce, mismeasurement of government data, and finally, that saturation hadn't yet occurred. Whatever it was, excitement was certainly in the air and companies fell over themselves to adopt the expensive new tech.

By most accounts, we're on the verge of another technological revolution. You can't turn on the TV or read a newspaper without hearing about AI. Is this a redux of the massive PC investment cycle in the '80s, or will we go straight to the productivity boom portion of the revolution in the late 1990s?

Goldman Sachs sees a future in which AI spurs over $7 trillion of global GDP growth over the next decade, $1.5 trillion of that from productivity enhancements. That is to say, they expect AI to create new avenues of economic expansion, not just a positive enhancement to existing business. That outcome would be consistent with the experience of the computing/automation revolution that has taken place in the last 80 years.

Wherever we're headed, it could be exciting. However, the potentially troubling outcomes get plenty of press, too. Throughout the decades, warnings are easy to find about the potential for things to go wrong with computing and Artificial Intelligence – let's hope the 1983 movie War Games wasn't prophetic.