Fixed Income Insights: The Great MMT Experiment

Rich Consul: Thank you for joining the INCORE Capital Management, Fixed Income Insights for the Fourth Quarter of 2020. My name is Richard Consul. I'm a senior portfolio manager with the INCORE team. Out of our presentation today is the great MMT experiment. From an overview perspective, our thoughts can really be broken down into four, I think, critical areas. The first is our macro viewpoint. Generally speaking, we think the economy continues to grow and rebound in 2020, really driven by a couple of different key points. The first is the large rebound is based on 2.6 trillion of fiscal stimulus. And we're going to talk about this more detailed in this presentation in the later sections, but this fiscal stimulus combined with the monetary stimulus is really one of the key drivers of what's going on in this rebound.

Rich Consul: We've already replaced about 55% of the laid off workers have returned back to work, but what we're seeing now as progress here is slowing, and we'll get into exactly what's happening in the pages ahead. The continued recovery is going to really depend both on the pace and the efficacy of the vaccine distribution. But again, it's going to be up to a lot of this additional stimulus until we return back to "normality." The next part is Fed, and treasury is really embarking on this experiment of MMT, which is an unproven theory, but generally, we think in the short term, it's going to be successful, as the fiscal stimulus offsets the increased regulation, and the economy reopens from COVID. But what is a real concern is that the long-term consequences of MMT remain to be proven or justified because what we're really looking at is unsustainable levels of debt, currency devaluation, and at some point, in the future, possibly inflation.

Rich Consul: So, from a monetary and fiscal policy perspective, we're looking at it and basically think continued record levels of fiscal and monetary stimulus are really driving financial assets as MMT is implemented. A better way to think of it is, because of the amount of money that the federal government and the Federal Reserve are putting together and shooting at the market, it is really sculpting the investment landscape. And we'll get into exactly what that means in the pages ahead. But a great example is when you shut down some of the pipelines and disfavor U.S. energy, obviously the U.S. energy market goes down, but then if you try to replace that with solar energy, what you're really doing is picking losers in the segmentation of industries. And it changes the investment landscape from a policy procedure perspective.

Rich Consul: And then what you do from a policy perspective is that not only do you change the regulations, but you also direct more federal stimulus dollars towards your chosen sector of interest. And what that does is it changes the investment landscape. It sculpts the investment landscape. And that's why MMT really is kind of a controlling mechanism on the economy. And while it can definitely work in the short term, we have definitely seen some concerns or should have some concerns around this. Congress passed an additional 900 billion on top of the 2.6 trillion that they passed in March, with that 900 billion additional passed in December, and it's just continued money being shot at the market. The FOMC has expanded their balance sheet by 3.1 trillion this year, and the current balance sheet is now up to $7.3 trillion.

Rich Consul: Over 30% of US GDP or outstanding debt is now being monetized by the Federal Reserve. Unprecedented. Truly unprecedented. And the Fed's actions are likely to trend higher in 2021 as the Fed continues QE at a pace of around $120 billion per month, or 1.4 trillion dollars-ish per year. I mean, it's a very extraordinary level of quantitative easing and accommodation. From a corporate credit perspective, corporate fundamentals are stretched following the economic slowdown, but spreads have really returned to pre-COVID levels. And a lot of this has to do with how much money the Federal Reserve is putting into the marketplace and just the fiscal stimulus.

Rich Consul: Record U.S. debt issuance in 2020 as companies really focused on building liquidity. 2021 pressures are really going to be focused on the credit side a little bit differently. Now that we've started to rebound in the economy and things are improving, and with a lot of this money on the corporate balance sheets, the focus for corporations in '21 is going to focus more on what do they want to prioritize? Are we going to prioritize the levering and getting the balance sheet improvement after the deterioration of 2020? Or are they going to focus on M&A and other shareholder rewards like we typically see corporations do? We don't know that at this stage and companies really are being very opaque with what their intended plans are for the year ahead.

Rich Consul: So, that's one of the risks. But fiscal and monetary policy combined with the reopening of the economy may drive credit spreads to record tight levels. And we're already seeing that earlier in this year, and we expect that to drive itself tighter over the coming year. From a positioning commentary perspective, we can maintain an overweight to high-quality issuers in both investment grade corporates, investment grade convertibles, and high yield corporates. And then we are technically trading interest rates with a bias toward leaning short duration. From a macro perspective, when we really break down GDP into its five core components, one of the things that we can really see is all this economy really is down to consumption. It's all about personal consumption and personal consumption is in that red highlighted area.

Rich Consul: And what we have seen is a dramatic rebound in personal consumption activity in the third quarter, and likely to see in the fourth quarter as the Atlanta Fed's forecast for quarter GDP growth is around 8.6%, is likely to come in lower than that, but that's where the forecast are likely to be. In third quarter, we saw the economy grow by the single largest GDP jump ever, by 33.4%. Pretty much all of that growth was fiscal stimulus based. And the economic resurgence since May has really been dramatic and just based on that fiscal stimulus. So, one of the things that we can always point to as a good kind of leading indicator of where the economy is going to is ISM services in manufacturing surveys.

Rich Consul: Now, these surveys really are forward-looking. They survey the purchasing managers' expectations for the quarters ahead as far as growth, hiring, orders, so on and so forth. And what we're seeing is that both ISM readings are indicative of robust short-term GDP growth. Specifically, manufacturing PMI is at 60.7, which is the fourth highest reading in the past 20 years. Manufacturing in the United States right now, for a lot of different reasons, is just off to the races and has rebounded very, very strongly off of the pre-COVID lows. Additionally, the services PMI reading of 57.2 is solid. It's not at the kind of lofty highs that we've seen on the manufacturing side of things, but anything really above 53 is a fairly solid reading.

Rich Consul: So, when you get at that 57 level like we are right now, you're solidly in expansion territory. Let's point it to the employment side, because when we think about what really drives the economy, it's personal consumption. And when we think about what drives personal consumption, it really gets down to three things. Do I have a job? If I have a job, do I expect to make more tomorrow than I do today? And then if I don't have a job, what is my expectation of being able to find a job that's suitable to my employment needs in the short term? Well, what we saw is that during the COVID crisis we lost around 21.8 million jobs. We've recovered about 12.3 millions of those jobs. A very, very significant portion.

Rich Consul: The problem is, is if you look down at the leisure and hospitality area, one of the areas that was most directly impacted, leisure and hospitality is restaurants and bars and hotels and things of that nature, which we all acknowledge have been hit the hardest during this entire pandemic, lost the most jobs in this crisis. It lost about seven million jobs. And while we've gained back around 4.4 millions of those jobs, we still are lagging in the recovery of those jobs by about 2.8 million. That's a big number. And we're likely to see just with all the different restaurants that we've seen go out of business in our local communities, as well as our national chain perspective, and some of the struggles that hotels have been having of late, is that a lot of these jobs are likely to be structurally lost.

Rich Consul: And what that means is that they're just not going to return. Not all of those jobs are going to return even when we fully recover. And some of those jobs are going to be lost forever. And that is a real concern because how do you then retrain those workers? How do you replace those workers? How do you re-mobilize them into other productive members, segments of our society, as far as economic growth is concerned? And that's an area that really, we are focused on. The other area is education in health services. Education in health services, it's teachers, doctors, nurses, tends to be very high paid portions of our economy. And one of the things that we've seen is they were hurt very, very significantly and still have not fully recovered to the pre-COVID levels.

Rich Consul: And that is going to be a key component for one of the things that we have to look forward to as far as drivers of consumption going forward, because those people are highly trained people and are easily repurposed into other industries. So, while the big employment gains have occurred, we've brought back 55% of the unemployed workforce, what we have seen is that improvements are slowing. The COVID crisis peaked back in April, as we can see on this chart, and continuing claims have been improved despite recent weakness in initial claims, but really that improvement in initial claims has really stalled since August. We haven't really seen the significant redeployment of laid off workers since late August. And we continue to see that today.

Rich Consul: And that's one of our real concerns is, is until we can get to either an effective vaccination program or a listing of some of the kind of life restrictions that we have across this country due to the pandemic, you're just not going to see meaningful recovery from here in jobs. And I think the employment picture is very, very indicative of that. One of the things that is helping is what we see here. And what this chart shows is U.S. savings rates. And we can see that U.S. savings rates prior to the crisis were around 8%, and during the crisis spike up all the way into the 33% level. All of this, that big increase, was driven by two things. The first thing that it was driven by was the fiscal stimulus. Do you remember the $1,200 checks that Congress passed and passed out to everyone making below $90,000 a year?

Rich Consul: We've got to remember, the average household has less than 1,000 dollars in savings. So, when you give every individual $1,200, essentially, a household of four is basically going to bring in $3,600 in stimulus funds, right? $1,200 for each parent and $600 for each kid, at $3,600, you basically almost in that one event tripled what they have in savings. And that's what we see on this chart is that with those stimulus checks, what you did is really increased the savings rates to all-time highs for the average American. And what we've seen since then is that a lot of Americans use that money to get them through the COVID crisis.

Rich Consul: A lot of people were laid off as we showed in the previous chart, and what they did is use those stimulus checks to backfill for some of the lost wages. And as we've seen, some of the savings rate dip down as people have had to use those funds. What is clear is that that stimulus is starting to run out. It's one of the reasons that Congress had to pass that additional $600 per person stimulus check in December, and that some additional stimulus is probably likely to be required in the first quarter of this year, if Congress or the states don't start helping the economy to open up from this COVID crisis.

Rich Consul: Let's get into the heart of what we've been talking about. Everything that we've talked about from a macro perspective, a lot of the rebound has been driven by stimulus. We've seen it in the savings rate chart, we've seen it in the personal consumption chart, we've seen it in all the different kinds of charts that we talked to prior to now. And what it's all about is this fiscal stimulus. And when we talk about the combination of fiscal stimulus, which is payments from the U.S. Treasury passed by Congress, in coordination with the Federal Reserve, basically, this coordinated fiscal and monetary policy thought process is a concept that can be redefined as modern monetary theory.

Rich Consul: And what modern monetary theory is, or MMT for sure, is really nothing more than a new monetary theory which has been largely untested. It basically says that if you control your own currency, and you control the ability to print that currency, and you have an accommodative central bank who's willing to buy your printed debt, that basically deficits theoretically don't matter. And default isn't an issue because you could just inflate your currency's value away or depreciate your currency's value away. And that any type of demand-driven inflation can really be controlled through tax policy or regular regulatory policy.

Rich Consul: The fourth thought process is, and this is where the control policy of picking industries that you favor over industries that you don't favor like typical natural gas and oil over solar power, is, the government is then basically picking and choosing sector winners, and basically is helping to provide a transition of jobs into their preferred sectors of interest. And that's what MMT is really all about. The problem is it comes with a number of potential hazards. Obviously, when you print this much money and you monetize this much debt, short-term success is very likely. If you give someone $1,000 to go and spend, the fact is they're probably going to generally go and spend it. And this large amount of fiscal stimulus that's being injected is really encouraging immediate economic growth.

Rich Consul: The problem is, and what we've seen with a lot of controlled economies, whether it be the Russians in the past or the Chinese, or some of the other socialist countries around the world, is that governments are ineffective allocators of capital. And governments' spending typically failed to support increased long-term economic productivity. If a government spends money, and that money does not go to increasing the economic productivity of the average worker, then the short-term growth stimulative effects of those dollars aren't sustainable. And that's the problem, is that a lot of what's being tossed around with all this MMT is short-term sugar high with no long-term lasting effect. And what we're likely to see is debt to GDP levels becoming unsustainable, or look in the case of Europe or Japan, just basically get to levels that limit the ability of the economy to grow.

Rich Consul: And that's what we're really focused on and what we're really concerned about. And when you talk about controlled or uncontrolled currency devaluation being important to avoid default, is the erosion in value of the U.S. dollars' unit measure of transaction value. And that's one of the critical components, as we've seen the dollar really sell off since a lot of the stimulus has come out, and nothing seems to be ebbing that flow outward. And really, a lot of this has to do with the concerns around MMT. So, the currency devaluation imports inflation, but it really doesn't always import a demand function. And that is one of the main concerns, is basically just inflating prices for consumers without actually increasing economic growth. And that is the real concern.

Rich Consul: And what the other problem is, is will Congress have the fortitude to raise taxes when constituents are already going to be upset at some stage with higher prices on goods? So, when we look at this kind of ballooning government debt, this chart right here is provided by the CBO, Congressional Budget Office, and it looks at debt to GDP percentages. And what I've shown is going all the way back to 1900 to where we are today and shows every kind of critical important event. World War II, Great Depression, World War II, the Great Recession of 2008, and the most recent pandemic. And then from that line on, a projection of where the Congressional Budget Office expects debt to GDP levels to get to. And as we can see, by 2040, they expect that GDP level to get to 150% of GDP. A level that really is unsustainable and unproductive.

Rich Consul: A lot of the economic research that we know is available out there is once debt to GDP gets over 90%, and right now, we're over that number, you start to impact the long-term growth trajectory of an economy. And I think that's one of the real concerns that we have is this ballooning government debt issue, as Congress has already passed 3.5 trillion of fiscal stimulus for last year, the new administration is eyeing another 1.9 trillion in fiscal stimulus for 2021, is how long can we really support MMT, where it doesn't become long-term negatively impactful to growth rates of GDP? And when we look at where the CBO estimates of what actually ends up blowing up our budget? What ends up creating some of the clear issues that need to be resolved?

Rich Consul: And what we can clearly see is that the scope and size of the 2021 stimulus spending in the graph in that green bar, but really, long-term, it's healthcare and social security and net interest that really are going to blow the budget up. Healthcare and social security obviously is the baby boomer issue that we've been dealing with or have failed to deal with adequately over the last 20, 30 years. We've talked about it, we've heard our politicians talk about it, but yet, no one has had the political will to actually get it done. Well, that issue hasn't gone away. It's now ever more present right in front of us herein now. And then the other part is, as you just do all this stimulus, is that all you're doing is really adding to the deficit.

Rich Consul: That deficit means you have to issue more debt. When you issue more debt, what do you have to do? You have to pay interest. And one of the things that we can see clearly on this chart is that blue line showing and indicating that net interest cost to the economy as a percentage of our budget is going to balloon in the years ahead. It's going to become one of the biggest components of our budget, surpassing even social security as a budgetary line item. So, that's one of the things that really drives that slowing down of U.S. GDP growth, it's really that the GDP has to slow because you have more costs or more of your budget not going to stimulative programs but paying for the programmed stimulus in the years past.

Rich Consul: The other part to MMT is you can't do the fiscal stimulus unless you can have the ability to monetize your debt. Which brings in the Federal Reserve. The Federal Reserve basically through their different quantitative easing programs has to monetize the debt. Thus far since February of 2020, we've seen the Federal Reserve increase its balance sheet by $31 trillion. And what this has really done is they basically almost dollar for dollar monetize everything that the U.S. Treasury has issued since COVID. And what that basically has done is it's crowded out the investors from the treasury market. It brought down U.S. Treasury yields to these very low levels. And it's forced all the investors looking for yield into anything with incremental yields available to it, such as corporate credit, high yield credit, securitized credit, all the different areas where typically you get additional spread or a yield for the additional risk.

Rich Consul: Well, because the Treasury or the Federal Reserve is buying all the U.S. treasuries, all those investors are now searching for yield in all these different credit products, kind of what we like to call a keener environment A, there is no alternative but to buy credit because the treasuries are so low in yields. And when we look at what the Federal Reserve has done over the four quantitative easing programs, we can see that this latest QE4 is not only the largest quantitative easing segment that they've done, but it's likely to increase actually in the year ahead as the Federal Reserve or as the U.S. Treasury needs to have the Federal Reserve buy an additional 1.9 trillion to service the new fiscal stimulus program that the incoming administration wants to get passed.

Rich Consul: On this slide, we show corporate credit, OAS. OAS being the incremental spread above treasuries available to corporate bonds. And what we can see is going back to 1992, that spreads typically widen or increase during periods of stress. So, going back to the 2000 to 2002 area where it was the tech correction and the accounting scandals, or the 2008 banking crisis, we can clearly see the March COVID pandemic and that initial spike up, but we can also see that while it was dramatic, it was very short lived because of the quick response of the Federal Reserve. And one of the things that really helped was the Fed outright purchase of corporate bonds and ETFs, which helped bring spread levels back-end very, very quickly. Spreads have really returned back to pre-crisis levels, as excess liquidity is basically searching for yield anywhere available.

Rich Consul: So, really, when you think about it, a lot of this, the spread widening is obviously on the risk, forcing spread to compensate investors for the increased default risk of whatever is going on, but it's now become very, very apparent that the Federal Reserve will step in very quickly as they did in the most recent pandemic and making these events very muted, much more short-lived. And when the Federal Reserve is stepping in to actually buy the credit sectors or the incremental yield sectors that investors are typically searching for, this rebound happens even quicker. And that's what we're seeing in this chart. There are certain sectors that have weathered the storm a little bit better, and what this shows is kind of relative spread, sector spreads, pre- and post-COVID.

Rich Consul: And one of the things that we can see is that like kind of the sectors of what we defined as COVID utilities of technology and banking tended to fair the best during the crisis, whereas REITS, capital goods and transportation have really relatively underperformed their peers. But there are certain sectors like energies, basics and communications that were wide before and remain wide now, and they've got their own kind of sector concerns that lead to the sectors being wide, and nothing that happened during the pandemic or since the pandemic has helped to bring those sector spreads in. So, they were wide before and they remain wide now. And it's kind of an area where you've got to really do some deep level credit analysis to figure out what are the companies that you believe are going to survive? What are the companies that are going to be successful long-term, especially in a sector like energy, where the regulations are likely to change significantly with a new incoming administration?

Rich Consul: We're going to shift here to corporate credit, and a couple of things that we want to really take away is where credit fundamentals are. What both of these show, these charts here on the left-hand side is leverage. We can see that corporate leverage is at an all-time high. We saw corporations issue just the highest amount of corporate debt in the history of issuance in 2020. And what a lot of corporations did was basically, they increased their borrowing just to increase short-term liquidity to get them through this crisis. So, liquidity for these corporations remains really strong, but leverage is definitely elevated. The good part is that chart on the right-hand side. While leverage is elevated, interest coverage or debt servicing capabilities, because yields have come down so much, corporations were able to refinance their high interest debt into low interest debt.

Rich Consul: So, while they did increase their leverage ratios, their net interest coverage ratio was still stable and still service full level, because they were able to refinance at lower yields. And they have a ton of cash on the balance sheet right now, and liquidity remains strong. This chart looks kind of like fallen angels, which is how many companies have been downgraded. What we've seen is about $2 trillion in debt was downgraded this year from investment grade into high yield, which is one of the worst downgrades that we've seen since the 2008 crisis. And we have another 500 billion in B that remains on a downgrade kind of watch. The question is, as we mentioned before is, the pressure to deliver is very, very high.

Rich Consul: Bond holders right now, corporations have huge leverage, and we're demanding that they use the excess cash that they have on their balance sheet to deliver. The problem is, now that they've already borrowed from us, what are they, they being the CEOs and the corporate boards, going to actually do with it? While there's pressure to deliver, there is also pressure from the equity holders to give special one-time dividends, do share buyback programs, or to do mergers and acquisitions. At this point in time, we just don't know how this kind of cookie is going to crumble at this stage, but it is something that bears watching as we go into 2021.

Rich Consul: In summary, the economy continues to rebound in '21. We don't see anything in the immediacy that's likely to throw a monkey wrench into that. A lot of that rebound is going to be based on fiscal and monetary stimulus, which is going to continue to drive asset prices higher as MMT is implemented and the economy reopens. 2021 pressures for deleveraging versus shareholder rewards and M&A will rise as revenue improves. And we fully expect that spreads may move to record tight. And we're already seeing some of that early on this year, and it's likely to be a motivating force for spreads in the quarters ahead. We continue to be overweight high-quality issuers in both investment grade credit, investment grade convertibles, and high yield debt. And then we are technically trading interest rates with a bias towards leaning short duration in the long end of the yield curve.

Rich Consul: Again, thank you for joining our fixed income insights for the fourth quarter of 2020. My name is Richard Consul. If we can help, or if you have any questions, please feel free to reach out to your sales associate, who can put you into contact with us. Thank you and have a great day.