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Fourth Quarter 2020 Write-Up

                                                                                                                        January 25, 2021

             The past year was a challenging ordeal, full of vitriol, anguish and tumult.  A global pandemic led to a worldwide public health intervention that led to the greatest economic contraction since the Depression that led to the largest fiscal stimulus package in history. Despite a harrowing year, stocks actually performed very well.  During 2020, the Dow Jones Industrial Average gained 7.3%, the Standard & Poor’s 500 Index added 16.6% and the Nasdaq Composite rallied a remarkable 43.6%.   The stock market is not the economy and the economy is not the stock market.  Although rebounded from the second quarter’s nadir, the economy is uneven and still running about 2% below 2019 levels of activity.  Vaccinations are rolling out nationally, and lockdowns are easing.  We have a new President who will enjoy a narrow House majority and a functional Senate majority, which should facilitate the passage of his ambitious legislative and regulatory agenda.  That agenda, judging from policy proposals and a raft of executive orders and actions, reads very much like Newton’s Third Law of Motion leveled at the former administration.  Currently, the three major equity indices are at or near record highs.  In the coming year, the nation will be affected by the response to the pandemic, the efficacy of fiscal and monetary stimulus and the pace of economic recovery.  

           In a speech, President Biden outlined the broad parameters of his proposed Covid relief plan, “Direct cash payments, extended unemployment insurance, rent relief, keeping frontline workers on the job, aid to small businesses.  These are the keys to an American recovery plan.”  A few days after unveiling his plan, Mr. Biden’s nominee for Treasury Secretary, Janet Yellen, gave confirmation hearing testimony endorsing the proposal.  In her testimony, the former Fed Chief argued that the economic rewards from “acting big” on Covid-19 relief spending would create economic benefits that far out-weighed the risks of incurring a much higher federal debt burden.  In this thinking, Dr. Yellen has the support of current Fed Chair, Jerome Powell and former Fed Chair Ben Bernanke.  

Reuters reported on the testimony:

In more than three hours of confirmation hearing testimony, the former Federal Reserve chair laid out a vision of a more muscular Treasury that would act aggressively to reduce economic inequality, fight climate change and counter China’s unfair trade and subsidy practices.

Taxes on corporations and the wealthy will eventually need to rise to help finance Biden’s ambitious plans for investing in infrastructure, research and development, and for worker training to improve the U.S. economy’s competitiveness, she told members of the Senate Finance Committee.

But that would only come after reining in the coronavirus pandemic, which has killed over 400,000 in the United States, and the economic devastation it brought.

Yellen, who spoke by video link, said her task as Treasury chief will be to help Americans endure the final months of the pandemic as the population is vaccinated, and rebuild the economy to make it more competitive and create more prosperity and more jobs. 

“Without further action we risk a longer, more painful recession now and longer-term scarring of the economy later,” she said.

Yellen said pandemic relief would take priority over tax increases, but corporations and the wealthy, which both benefited from 2017 Republican tax cuts “need to pay their fair share.”

She raised eyebrows of some senators and Wall Street when she said that Treasury would consider the possibility of taxing unrealized capital gains - through a “mark-to-market” mechanism - as well as other approaches to boost revenues.

Wall Street stocks rose on Tuesday in reaction to Yellen’s call for a hefty stimulus package, as well as to positive bank earnings updates. Oil prices also rose, while Treasury yields fell slightly on her comments that parts of the 2017 tax reform should be repealed. 

We compliment Dr. Yellen for her forthrightness.  She really put her cards on the table.  She heartily endorses an enormous fiscal program and does not shy away from the budget implications of paying for it.   She warns of future taxes, and specifically mentions that unrealized capital gains might be taxed.  In more normal times, this would have caused an immediate negative reaction in the stock and bond markets.  

            Let us take a look at President Biden’s outline for the $1.9 trillion coronavirus relief program.  If the package were passed as proposed (it won’t be), it would represent 8.6% of current GDP, which dwarfs the amounts spent during the Financial Crisis, even before considering December’s $900 billion Relief Bill (4% of GDP).  In declining order of estimated program cost:

            $450 billion: Stimulus payments and expanded child tax credit, including a $1,400 individual stimulus check in addition to the $600 check from December’s lame-duck stimulus plan. 

            $370 billion: State and local fiscal aid.   This is a Democratic priority to aid high-tax states such as California, New York and Illinois.  Notably, the amount is considerably lower than House Democrats’ May proposal of $996 billion or their October proposal of $492 billion.   The December lame-duck Relief Bill contained no state fiscal aid.  Allocation formulas were not disclosed. 

            $200 billion: Unemployment insurance.   Increase supplemental unemployment insurance from $300 per week to $400 per week and extend the term until September.    

            $170 billion: Education grants.  Funds to open schools, improve safety and administer frequent testing and tracing efforts. 

            $160 billion: Public health.  Federally supervised testing, tracing and vaccination efforts, including hospital relief. 

            $100 billion: Health insurance. This would cover health insurance premium subsidies. 

            $50 billion: Business assistance, including restaurants. Grants and loans. 

            $40 billion: Child care programs, including daycare.

            $35 billion:  Homeowner and rental assistance.

            $20 billion: Safety net programs.

            $20 billion: Transportation relief funds.   NYC subway, we are looking at you.

            $285 billion: “Other” including nutrition assistance, paid sick and family leave, Disaster Relief Fund, cybersecurity and government information technology upgrades, domestic violence and mental health programs, clean water programs, OSHA safety programs.  The Administration did not break-out the details of many of its proposals, which will be subject to Congressional horse-trading.   

            The scale of the proposal is unprecedented.   The intellectual heft behind this audacious proposal comes courtesy of former Treasury Secretary Lawrence Summers and former Council of Economic Advisors Chairman Jason Furman, both Harvard professors.   In their paper, “A Reconsideration of Fiscal Policy in the Era of Low Interest Rates,” they argue that it is worthwhile, and even prudent, to incur low-cost debt in order achieve full employment.   Although they concede that future interest rates are unknowable, they think they will continue to be low. They write:

Our analysis begins by considering the downward trend in real rates. We note that with massive increases in budget deficits and government debt, expansions in social insurance, and sharp reductions in capital tax rates, one would have expected to see increasing real rates if private sector behavior had remained constant. We suggest that changes in the supply of saving associated with lengthening life expectancy, rising uncertainty and increased inequality along with reductions in the demand for capital associated with demographic changes, demassification of the economy, and perhaps changes in corporate behavior have driven real interest rates down.

One economic aspect the professors do not address is the effect of pervasive accommodative monetary policy by central banks.  The Fed has added more than $3.0 trillion in assets to its balance sheet in the last year.  Currently it is buying over $80 billion a month of Treasury securities in the open market while the federal government is selling about $90 billion in Treasuries just to finance what now looks like a “structural” $1.1 trillion budget deficit.  Does printing money have no effect on interest rates and investment behavior? Is it really different this time?  Below we use Prof. Jason Furman’s own words (a Tweet) to record our reservations about the scope of the proposal:          

            A few thoughts on the recovery plan that President-elect Biden is announcing tonight. 

It is *very* large. Together with the December legislation it would be around $2.8T, which is about $300b per month for the nine months it is in effect. For context in November GDP was about $80b below pre-crisis trend and compensation was about $20b below pre-crisis trend.

The motivation appears to be more "bottom up" (what the health situation, households, states, etc.) need than "top down" (how big is the output gap, what is the multiplier, what is needed to fill it).

From a top down perspective, advocates of stimulus often point to multipliers like 1.5 or higher. In this case the hope has to be that the multiplier is *much* lower otherwise this would bring us way past what the economy can produce this year.

That sounds like it could become pretty inflationary, pretty quickly.   Spending $300 billion a month to deal with a $20-$80 billion per month economic deficit seems like overkill.   Especially in the face of re-openings and ramping vaccinations.  In fact, if President Biden can meet his aspiration of 100 million vaccinations in 100 days (and we think he can), the whole country could be vaccinated (or immune by virtue of having had Covid) by late this summer.  Are we bringing a bazooka to a knife fight?  Finally, if inflationary pressures increase and interest rates move higher, what is the appropriate central bank response?  More Treasury note purchases?  Will there be unintended consequences? There always are. 

            One criticism of the previous Trump relief program, and a reservation concerning the Biden relief program proposal is the untargeted, unfocused nature of both.  The pandemic and subsequent shutdowns hit various strata of the population very differently.  According to the Opportunity Insights Economic Tracker, on April 15th, after a National Emergency was declared and near the nadir of unemployment, high wage workers (earning >$60k) suffered a 12.8% decrease in employment compared to January 2020 levels, but low wage workers (earning <$27k) saw a 37.3% decline in employment.  Today, that disparity remains.   High wage workers effectively regained January 2020 employment levels by the middle of June.   Low wage workers, as of December 20th, were still enduring a 25.1% decline in employment levels.  On the same date, middle wage workers (earning $27k-$60k) were still 6.5% below January 2020 employment levels.  Since October, high wage employment has been generally improving while middle and low wage employment has been declining.   

            Both the Trump package and the Biden proposal throw a lot of money at the economic recession caused by the pandemic and the lockdowns, but not in a targeted or focused method.  Evidence of this can be seen in two areas.  First, economists were surprised by the relatively minor contraction in the national income accounts.  This is reflective of the earnings power disparity between wage-earning quartiles.  Rich people did fine.  Middle class people were hurt.  Poor people were rocked, especially gray market workers and “gig” employees.  Many poor workers can get by with supplemented unemployment insurance payments, but might not have a job to go back to when it runs out. Perhaps the hardest hit were the upper middle-class business owners in service industries that were shutdown: the barbers, restaurant owners, dry cleaner owners, hairdressers and gym owners.  Unemployment insurance, even with a federal supplement, did not come close to replacing their income.  It also destroyed their capital.  In the aggregate, the income numbers look fine.  Disaggregated by occupation, they look much worse.  The other statistic that highlights the disparity in the rate of economic recovery among citizens is the personal savings rate.  During the last few years, the personal savings rate as a percentage of disposable income has run in the 7.2 to 7.8% range.  In the first quarter of 2020, it hit 9.6%, followed by 26.0% in the second quarter and 16.0% in the third.  This is an upper middle-class and wealthy phenomenon, as the poor are under-banked.  Credit card balances are being paid down at record rates (from $854 billion in March to $741 billion today) and demand deposit balances have grown from $1.6 trillion last February to $3.3 trillion in December.  There will be funds to spend upon re-opening.

            The past year was a challenging ordeal, full of vitriol, anguish and tumult.  And, no, despite what you Patriots fans believe, we are not talking about the Tom Brady trade to Tampa Bay.  We have great hopes that in 2021 a receding pandemic and a recovering economy will unlock America’s entrepreneurial strengths and rebuild our middle-class businesses.  An enduring recovery depends on a healthy middle-class economy.  Stimulus, topped-up bank accounts and pent-up demand bode well for a good economy, eventually.  But remember, the economy is not the stock market, and vice versa.  Go Giants.

Sincerely,

Your Team at Baxter Investment Management