After the Boom, A Bill Awaits

A reversal of fortune is in the cards. After a year-long hibernation, the world salivates at the arrival of the vaccines. The summer season may be one for the record books as demand overwhelms supply in the leisure industries. These short-term forces shield from thought the prodigious debt expansion and monetary largesse that saved the economy. While the US was not alone with expansive economic policies, it was unique with the poorly targeted policies. Most assuredly, growing debt service will conspire with higher tax rates to crimp future demand. These lurking threats may impede the economy’s return to full employment as the polemic on debt washes over Washington.

A boom year will follow the devastating prior year with the leisure sector the primary driver.

As the year ended, the economy was slowing after its most volatile year on record. While the next year promises less volatility, it also offers continued uncertainty. The fiscal response and, vitally, the vaccine's distribution are essential to a return to normal. The former is necessary (and humane) to help avoid a permanent change in consumer behavior by workers in the leisure sector who are hardest hit by the Pandemic. This policy will create a bridge to herd immunity from the vaccine and the return to some form of normalcy during the summer season.

The disguising feature of the forecast is that the growth centers on the second and third quarters. The vaccine program's progression will enable a fuller return of the leisure sector and the workers waylaid by the Pandemic. After a hibernation of more than a year, the summer season may well set records in the leisure sectors as people break free of their internment. The summer pastime may see record crowds as sports return full throttle. All the forces that conspired to doom 2020 should reverse and cause a mini-boom in 2021. Alas, the party will not endure. As fiscal constraint will most certainly take hold and constrain future demand.

Exhibit 1. GDP Contribution by Component

Source: Federal Reserve Economic Database, CRM Calculations.

Borrowing from the future. The fiscal policy response to the Pandemic was the most significant US budgetary expansion since the mobilization during World War II. Indeed, the times required the action, despite poor targeting of some of the policy responses. In the presence of a demand collapse, waste is more acceptable than an insufficient policy response. The size of the program in absolute and relative terms was unmatched. While all Keynesian economists will regale in the response, trouble lies in the details.

The fiscal policy response is evident in the savings rates for the US. The government sector, principally the Federal level, ran a deficit exceeding four trillion dollars on an annualized rate, which the household sector's saving rate mirrored (exhibit 2). In the national accounts, money merely moved from one hand to another. The intent, of course, is to spur spending during a period of deficient demand. Unfortunately, good intentions do not necessarily lead to the desired outcome, as the policy design matters. In effect, it was borrowing consumption from the future. The debt will require higher future taxes, which will impair future consumption. Thus, the necessity for precision in the programs.

Exhibit 2. US Savings by Sector

Source: Federal Reserve Economic Database. CRM calculations.

The savings rate was the result of two parallel forces. First, consumer behavior changed in response to a likely recession, if not depression. Conspicuous consumption turned into frugality. This reaction came as no surprise. The second reaction did come as a surprise to the cognoscenti of the ivory tower and designers of the policy response, who argued that rebate checks to the masses would spur consumption during a time of depressed demand. They overlooked the obvious: consumer behavior had changed in response to the pending recession, and lockdowns impaired the ability to consume. While the policy response lacked coherence, it made up for it in size.

With rebate checks hitting the pockets of four out of five people who were still employed, it is not a surprise that the excess capital needed a home. The trouble was that business investment plummeted during the first half of the year. At the same time, government and households made little investment (exhibit 3). The dearth of demand for capital for investment led to excess money entering the stock market. On its face, this is a fair trade, as low-cost capital (e.g., Treasury bonds) finances the acquisition of the higher expected return on equities. The challenge is business does not need capital.

Exhibit 3. US Investment by Sector

Source: Federal Reserve Economic Database. CRM calculations.

During periods of slowing or declining demand, business pares back investing. This action is readily apparent when viewing net capital investment for the business sector (exhibit 4). During expansions, companies seek capital to finance their investments. In contrast, during retractions, they slow investment and hoard their cash lows as a defensive maneuver. These actions are coherent for a business when faced with uncertain demand in the future, even when the cost of capital is low. Thus, in the absence of new equity issuance, the money must find a home. Enter the equity market.

Exhibit 4. US Business Net Capital Investment

Source: Federal Reserve Economic Database. Positive values are lending; negative values are borrowing.

While not all rebate checks entered the equity markets, some amount did speculate on their free money. Hence, the equity market rises. Risk-averse investors with excess capital may have found solace in the Treasury markets' trivial returns, which by all measures needed capital (exhibit 2). This situation is where the trouble arises. Despite the unprecedented accumulation of household and business savings, it was not sufficient to cover the US's aggregate capital needs.

The US is running a net capital investment deficit of over $700 billion (exhibit 5). In more explicit terms, it requires roughly two billion of external capital to balance its daily needs. The durability of these inflows into US capital markets requires compelling investment opportunities versus the rest of the world. In the current environment, this requirement seems logical. While US Treasury bonds yields are low, they are positive while offering a premium to most developed-world counterparts. Thus, the fixed income markets argument is that they are the best of a bad bunch.

Exhibit 5. US Aggregate Net Capital Investment

Source: Federal Reserve Economic Database. Positive values are lending; negative values are borrowing.

The US equity markets also offer compelling relative prospects versus their developed market peers. The technology behemoths dominate global markets in their respective fields and few rivals to erode their monopolies. Thus, it appears that there are few immediate threats to the durability of the capital inflows to finance the US capital needs. Alas, this simple framing excludes one mechanism that can adjust: the exchange rate. This measure is where the trouble may arise for both growth and inflation.

The US’s exorbitant privilege as the world’s reserve currency has endured since the Bretton Woods accord in the 1940s. The demise of this benefit has been called many times by the cognoscenti with an imminent devaluation of the Dollar the outcome. While the rise of Japan, the Euro, and China, contested the Dollar's reign, it has endured as the preeminent means of exchange.

The Dollar's recent pull-back from its Pandemic peak in March brings new claims of its pending downfall (exhibit 6). Indeed, the US's impact would be material as a lower dollar increases the cost of exports and imports goods inflation into the US. The increasingly smaller composition of goods in the consumer basket suggests the inflationary impact is most likely modest. The uncertainty is the extent of the effect on growth.

Exhibit 6. US Trade Weighted Dollar, Broad Goods & Services

Source: Federal Reserve Economic Database.

The higher debt service will most certainly reduce future consumption at the Federal level. Higher taxes will eventually lower consumption. In contrast, higher import prices would suggest less demand for imports and improve the trade balance that is accretive to growth. This outcome may stoke further expansion of the domestic industry as companies bring back foreign production. The conclusion is that the net impact on growth is not certain.

The challenge is that no company or country acts in a vacuum. There are competitors. For example, decreased demand for imports may compel the Chinese to weaken their currency to make their products more favorable. Even the Euro region’s recent fiscal compact on the currency may not be sufficient to attract capital, given the negative yields on their bonds. These observations suggest that while a further decline of the US dollar probable, it is not foreordained.

Exhibit 7. Forecast for US GDP Growth

Source: CRM estimates. Amounts are annualized rates.

The US economy's outcome is gradually accelerating growth that peaks in the third quarter as the leisure sector returns. For the full year, growth may approach 4.7% and achieve a rate not seen in twenty years (exhibit 7). Exports should begin to climb from the currency’s decline and the return of international travel. This action should marginally offset the pullback from the boom in the second and third quarters. As is always the case for the US, consumption will lead the way out of the abyss. The lingering threat for the US is the impact on the currency and the higher debt burdens. Borrowing during times of need is a necessity. Unfortunately, it always has a price, which future consumption will bear.

This Macro View is part of Capital Risk's economic outlook for 2021. Read the full report here.

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