Slow Growth, Low Inflation: Positive Financial Market Trends

First we will try to summarize the politics.

The political damage the Republicans inflicted upon themselves during the shutdown, debt-limit, sequester debate has now morphed into political damage the Democrats have inflicted upon themselves. There have been two catalysts for the latter. First is the continuing Obamacare website rollout fiasco. Second are the revelations regarding America's snooping, including tapping the cell phones of foreign leaders. There will be more and more negative news flow on each of these. Imagine the media when Snowden speaks to the Bundestag. Meanwhile, the Obama White House is developing what the Financial Times calls “siege mentality.” (See Weekend FT, November 2, 2013, “Rescuing Obama’s second term”.) As a note from history, some of us may recall the siege mentality at the end of the Jimmy Carter term or in the second Richard Nixon term.

Republicans looked like they were in deep trouble, as if they were surely going to lose some House seats and would not improve their Senate position in the 2014 election. Now, thanks to the Democratic administration’s missteps, the 2014 political frenzy and accompanying media frenzy will continue and intensify. Meanwhile, Democrats in both the House and the Senate are distancing themselves from an unpopular, lame-duck president. In the US Senate, staunch supporters of Obama’s healthcare initiative are now backing away. Some are calling for extensions, delays, or reconstructions. Their Republican political enemies bare their teeth and saliva rolls down their chins as they now smell victories in 2014.

Add to the political madness this monstrous committee that will (more or less) deal with the sequester, debt-limit, and budget issues. The committee will resolve nothing. The reason is clear: neither side can take any risk. The large contingent of American middle-class, undecided, independent, and/or disgusted voters do not like the behavior they see on the part of either major political party's extreme wing. The middle would like to have some choice other than radical and oppositional extremes. It is not often given one, because of the nature of our primary electoral contests and because of the gerrymandering of congressional districts. So when such an opportunity does arise, Americans tend to seize it. They seize it and create political outcomes that reject the polarized, dysfunctional politics of Washington, DC. They seize it by electing the moderate middle if they can do so. The rise of New Jersey Governor Chris Christie as a non-Washington, more centrist Republican is an example of this tendency.

What do these political trends mean for the economics of the country?

They mean that, as long as the political stalemate continues, there will be no tax increases, because the Republicans will not permit them and the Democrats will lose support if they try to push them. Nor will there be tax cuts, because the Democrats will not permit them, and the Republicans will lose support if they try to push them. There are going to be no new spending initiatives of any consequence. There will be only minimal sequester-related spending cuts.

The political situation also means that further bailouts of financial institutions and state and local governments are highly unlikely. Federal money does not bail out Detroit or Harrisburg. Federal money is unlikely to bail out Puerto Rico. Federal regulators are more harshly oriented toward banks and financial institutions now. There has been a regime change from bailout to “bail-in."

Bail-in means that risk has transferred from the government intervention level to the shareholder, bondholder, uninsured depositor, or business agent level. These subordinate and private agents are now more at risk than since the end of World War II, and they have certainly been more at risk since the financial collapse five years ago. In the old days, you could think about the government’s stepping in to bail out firms and agents during a crisis. In the new days, do not think about it. It is not likely to happen.

In short, political deadlock in Washington is contributing to an economic climate of slow, steady, but suppressed economic growth, much less robust than it might have been.

Shutdowns and other government actions have set the growth curve back by three to six months according to whatever baseline trajectory one wishes to examine. We see that outcome in the worsening employment statistics for which we can hold both the Congress and White House accountable, as a result of their respective behaviors during the shutdown. Nobody wanted to blink, so people were put out of work. Uncertainty rose and markets suffered.

We may also see falling energy prices as the marginal price of oil production drives the price level lower. Think about what it would mean if West Texas Intermediate crude (WTI) were to trade at $80 or $85 a barrel or even less in the US. We see that as a downward pressure on inflation. We see that oil flowing through the US on a sustainable basis as the country moves toward energy independence. The result is that inflation will remain below the Federal Reserve’s 2% target and may actually trend lower. If we get another economic shock or slowdown, it may trend below 1% and even approach zero.

Think about a US economy where the economic growth rate is 2% and the inflation rate is 1%. Think about that as a possible new normal trend. The nominal economic growth rate is then 3%. That rate justifies a 10-year Treasury yield somewhere in the vicinity of 2.5% to 3%. It keeps the Federal Reserve on its long, stretched-out trend of policy gradualism, with very low short-term interest rates. It also means a sequential, gradualist tapering as the Federal Reserve tries to bring its assets and balance sheet into a new-normal alignment. It means the Fed's balance sheet will easily exceed $4 trillion by the time it is stabilized. It also means that the US current account deficit will continue to fall; hence the need for the US to draw in capital from abroad to finance itself will also continue to fall.

This mix can make for an ongoing and very positive financial market trend.

Very low inflation, very low interest rates, and slow growth mean higher asset prices and a gradual, stretched-out recovery. Sequester-type budget determinations mean the federal government is borrowing less and less relative to GDP. The deficit could trend to under 3% of US GDP. The Federal Reserve could taper easily and stabilize its balance sheet.

Market pundits are ignoring these trends that are so strong. Dramatic predictions of bubbles and collapses gain attention. Slow growth and low inflation are boring forecasts: they lack drama. The bubble gang is ignoring these possible positive outcomes that may lead to stabilized bond prices, higher stock prices, more real estate recovery, and a general improvement in asset prices. By the way, rising asset prices translate into improving economic growth, but they do so only slowly and with a time lag.

The municipal bond sector is being largely ignored during this entire period.

It does not get help from the Federal Reserve. There are no municipal bonds in the Federal Reserve's assets holdings. Munis do not get help from the banking system, with minor exceptions, because of the adverse structure of taxes on banks that hold tax-free municipal bonds. Munis do not get help from upper levels of government to subordinate jurisdictions because of politically-related budgetary pressures. Thus the municipal bond sector, which is $3.8 trillion in size, just languishes. Meanwhile the headline risks, like Puerto Rico and Detroit, continue to frighten investors into liquidation.

When the tax-free municipal bond of the highest credit quality yields more than the comparable taxable Treasury security of the US, one must either assume that the entire income-tax code is going to be repealed or that there is an ongoing and substantial pricing anomaly. We do not expect repeal of the income-tax code, so we must examine the latter possibility.

If the tax-free municipal bond of an issuer is yielding above the comparable Treasury, then the taxable municipal bond of the same issuer will yield even more. Taxable and tax-free bargains exist in the municipal bond sector. At this point in our economic evolution, they are still available, and they are cheap.

At Cumberland Advisors we are buyers of taxable and tax-free municipal bonds in selected high-grade credits. We do not want to own credits that are dependent upon support from a parent governmental unit to a subordinated unit. Credits have to be able to support themselves. Credits must be able to withstand the prospect of a bail-in, not a bailout. Proposals for a massive federal bailout of Puerto Rico or for the Fed to launch a muni bond-buying program through the discount window are only proposals. In our view they will go nowhere. Any investor betting on their success is playing with fire.

On the stock market side, we remain fully invested in our US and international accounts using selected ETFs. We think the stock market is still in a bullish phase and will go higher.

BY David R. Kotok