Fair warning…this is a long one. 2020 was quite the year, and there’s a lot to talk about. If it makes you feel any better, I left out more than I put in (I don’t even touch the election…you’re welcome).
We hope everyone is doing well and adjusting in this ever-changing environment. To say there was a lot of change in 2020 would be the understatement of all understatements. This was a challenging year for everyone, for some more than others, but we all experienced some level of challenge or, at the least, inconvenience.
I’m not one to put much stock into the New Year. Very rarely do things in life tie up as neatly as they do in movies or books, and the sense of finality we get from seeing the closing scene of a movie or the turning of the next chapter of the book rarely happens in life, especially once you pass the educational milestones of our youth. For me, the New Year doesn’t really represent any closure…life will be much the same as the calendar rolls from December 31st to January 1st. I admit, I am probably in the minority in this way thinking, especially this year. As December rolled around, the excitement surrounding the close of 2020 and looking hopefully towards 2021 was palpable. As the COVID vaccine circulates, people are looking forward with great anticipation for the return of some level of normalcy. This social zeitgeist is important as we look ahead economically. If and as normality materializes, people will likely let loose: travel, eating out, spending time with friends, going to the movies, all of those activities we all had to abstain from in 2020. As the year presses on, and the pandemic hopefully abates, activity will pick up, and we are likely to see some big economic numbers.
Any economic gains in the next year will occur with the backdrop of massive economic damage. Service sector jobs lost in the shutdowns won’t all be coming back in the next year. Corporations that had spent the last 10 years bingeing on debt just had to double down and borrow more to make it through a pandemic. For many companies, the increased debt will strain their cash flows going forward and remove growth capacity. Business closures and permanent work from home arrangements are changing the commercial real estate market. Though we expect things to improve, we also don’t know what will happen with COVID. New mutations of the virus appear to spread faster, and the vaccine rollout is proceeding at a much slower pace than the country had hoped. This reality may require more severe lockdowns before herd-immunity is achieved. This has already happened in the UK, and they are looking at another loss in GDP. Financial markets and the economy will have to move forward on shaky and uncertain ground.
If you read the annual predictions of what the “pros” think is coming for markets in 2020, you will find people in opposite corners. In one corner, we have the doomsday predictions: the market got too far ahead of itself in 2020, is not recognizing the massive damage done to the economy, and is bound to come back to reality in a scene reminiscent of the 1999 tech bubble pop. In the other corner, market euphoria: we are about to reach the other side of the pandemic, the world is about to party like it’s 1920, and trillions more in stimulus will be passed this year, which will drive economic activity and the stock market to all-time highs. The reality is, it’s anyone’s guess what the market will do this year. As we’ve said many times before, where the market moves from one year to the next isn’t about math or predicting events, it’s the response of the unpredictable masses to the unknowable future.[i]
Consider 2020. What if I told you in November 2019 that in 2020, governments around the world would shut down their economies for months in response to a pandemic, and the US stock market would still post double digit gains? You might have sent me to see Nurse Ratched. I would have probably gone voluntarily. That’s what happened though. True, you didn’t have all the information. I didn’t tell you that central banks and governments responded with never-before-seen levels of stimulus. Nor did I mention the concentration of market gains in tech stocks benefiting from demand shifts caused by stay-at-home orders. But you never have all the information, and it’s anyone’s guess how the masses will respond. History can be a guide, but as I read the various opinions floating around, I’m reminded of what Will and Ariel Durant, authors of the 10-volume The Story of Civilization, said: “History is so indifferently rich that a case for any conclusion from it can be made by a reflection of instances.”[ii]Is it 1999 or 1920? Is it the end of a stock market party or the beginning of one? I can make a case for either. I could also make a case for neither.
With uncertainty ahead, we continue to be disciplined in our selection of investments. In global markets, we see pockets of euphoria and pockets of reasonable value. To an extent, we have tried to position the portfolio with investments of reasonable value. Emerging Markets, Asia, renewable energy (particularly solar), and biotech are all positions we held at the beginning of the pandemic and will likely continue to hold for the foreseeable future. Going into the pandemic, we believed they represented good long-term value. We held to that belief, and they performed very well over the course of the year. During the year, we also made a lot of changes. We usually don’t go into specifics in our commentary, choosing rather to discuss this in client meetings, but given the events over the last year, we think it’s fitting to provide some additional information. Here are some of the adjustments we made to portfolios over the last year:
- Allocation to precious metals was increased, adding silver to the portfolio back in April. We plan to maintain this higher allocation as debt loads balloon, risks remain elevated, and direct economic stimulus adds to money supply.
- There were a couple corporate positions added that we had been watching for a long time. Market turmoil priced these very attractively, and we were able to purchase them with a good yield. A few of these companies should benefit very well if there is more turmoil in the corporate bond market, as we expect there will be.
- We shifted some assets from a very conservative income fund (FPA New Income) to a more opportunistic multisector bond fund (Guggenheim Total Return). We saw the pandemic as a catalyst to an increase in corporate defaults resulting in volatility in the debt market. We wanted a fund that would be opportunistic in the chaos. Defaults did go up, the fund was able take advantage of some volatility, but the Federal Reserve actions stabilized corporate bond markets, at least for now.
- In early November, we added a small cap fund (invests in smaller companies). As we highlighted in the Q3, small caps have seen three years of flat performance while large caps have had stellar performance. The performance disparity increased in the first part of 2020 as the market – rightfully so, in our opinion – saw an increased risk in small companies. By the third quarter, these companies had been largely left behind in the market rally and looked to be priced at good long-term value, on a selective basis (there’s a lot of bad out there too).
- We added a precious metal miners fund (technically, we implemented this the first week of 2021). With suppressed precious metals prices over the last several years, these companies have had to tighten their belts, increase their operational efficiency, and reduce their debt in order to be profitable. Generally speaking, they are now sitting on clean balance sheets and high operating margins. If metal prices stay at their current levels, future earnings will be good and will only get better if precious metals prices go up, which we suspect they will.
- As prices went down, we added to several of our existing positions. This is especially true in the energy sector. Prior to pandemic, we believed the energy sector was very cheaply priced. The pandemic made them even more so, and we added to several positions as prices went down.
- There were a few positions we did not want to carry through the pandemic that we eliminated. A few were sold early in the year at losses. One in particular, a pipeline fund, had extensive losses. That one hurt. But we were able to reallocate the capital from those investments and put it to work in other places that we’ve mentioned above.
Our long-term clients will likely recognize this as many more changes relative to activity in the past. It is true, we don’t have a lot of turnover in our portfolios. We tend to buy positions that we believe are well priced and have potential ahead of them, and we often hold those positions for several years. But market chaos tends to create opportunities. In the chaos of the last year, we were able to add—or add to—several quality investments at very reasonable prices. They should serve the portfolio well in the long-term.
What is going to happen with all this debt?
This commentary has already reached its normal length. If you’ve had enough, this is a good place to stop. This next section is a bit of bonus dealing with a subject that we think will have huge long-term implications but doesn’t have much immediate impact on our investment thinking (though it does have some). We also hope it will provide a little understanding as to why many in the Federal Government believe they can continue creating money out of thin air without considering the cost to the future.
In response to the pandemic, the Federal Government passed two stimulus packages. These measures blunted the losses in the economy, given our elected leaders’ decisions – right or wrong – to shut down large swaths of the economy. But at what cost? The US Federal Debt at the start of 2020 was $23.2 trillion. It ended the year at over $27 trillion. That’s almost a 20% increase in one year. This trend is unlikely to change. President Biden said the recent stimulus package passed in December was just a “down payment.” With Democratic control of Congress, some expect to see $2 trillion more in stimulus packages. Federal Tax revenue per year is “only” $3.4 trillion. Almost half of that is payroll tax, which goes straight to Social Security and Medicare programs. There is no room for any stimulus in the budget. Any additional stimulus dollars will go straight to the Federal Government’s debt.
This has left many wondering, how does all this debt get paid for? Many politicians and a few economists are now concluding that it doesn’t need be paid for, arguing that the amount of Federal Debt doesn’t matter. Enter Modern Monetary Theory (MMT), an economic theory that is starting to influence more policy decisions and will have very real impacts on our lives and your investment portfolios.
The basic premise of MMT is that a currency issuer (like the U.S., which issues dollars and whose debts are all in dollars) cannot run out of money. Since all our debt is in dollars, which the US Government creates, it cannot possibly default on its debt. If a debt comes due, the government can pay it by simply creating more money. Under this premise, the fact that we have a $27 trillion debt load means virtually nothing and taking on more debt has no impact on the government’s ability to further spend. Want to introduce a social program, like a jobs guarantee, or cover all healthcare cost or provide free college to all? You first need to find money in the budget to cover it, right? Nope…in MMT, the budget does not matter. You can spend without consideration of whether the government can afford and what it does to the Federal Government Balance Sheet.
This can be difficult to wrap your mind around at first, because we are so used to looking at finances through the lens of our personal budgeting. You have income and if you spend more than you make, you must borrow to pay for the shortfall. If the borrowings get too high, you can’t pay your debt, and you go broke. We tend to look at the Federal Government the same way. They have income in the form of taxes. If they spend more than they bring in then they have to take on debt to cover the shortfall and if the government debt gets too high, they go broke. MMT would tell you that’s not an apples-to-apples comparison, because you are a currency user, whereas the Federal Government is a currency issuer. You can’t create money to cover your shortfall. The Federal Government can.
The next natural question to ask is, if debt doesn’t matter, why doesn’t the government print as much money as it wants? To be clear, MMT does not propose that the Federal Government can print money with no limit. It’s not a governmental blank check. It shifts the limiting factor from debt to inflation. Inflation is the constant increase in prices of the goods and services in the economy over time. We are familiar with this concept. It’s why a burger costs more today than it did 20 years ago. Most economists argue that a little inflation is good, but there is a point where there is too much inflation. There are a lot of historical examples of inflation going off the rails. The classic example is Weimar Republic in 1923, where the cost of a loaf of bread went 250 marks in January to 200,000 million marks in November. That’s not good. People were literally taking wheelbarrows full of cash to the market to buy a loaf of bread. This inflation was, in part, a result of too much money being printed. So, in the world of MMT, keeping inflation at a reasonable and manageable level is the limiting factor to how much money the government prints.
MMT was a fringe theory just 10 years ago. We remember looking into it then as we saw it as a natural outcome to the massive money printing that happened in the wake of the financial crisis. Over the last 10 years, we have seen it rise to more prominence. Progressive liberals have adopted it as a means to fund many of the social programs they would like to see implemented. We expected it be a prominent component of the 2020 election. COVID-19 moved the focus elsewhere, and it never became a primary topic. But, it was functionally implemented when the government provided unprecedented monetary support to the economy with barely a nod by either party to what it would do to the debt level of the US Government. There was more pushback on the second stimulus. After it passed the Senate, Senator Rand Paul gave a speech about how its passing represented the adoption of MMT. We believe he’s right. With more stimulus measures coming in the future and a Democrat-controlled government that would like to see trillions spent in infrastructure, renewable energy development, health care, and many other social programs, MMT will be the counterargument to many congressional leaders’ opposition based on incurred debt.
Should this be concerning? Maybe. There is much about MMT that makes sense. For one, the US Government can’t run out of money. The government can’t default on debt that’s repaid on money the government creates. In that sense, debt isn’t a limiting factor. So, what is the concern?
We see a couple problems with MMT. First, it assumes economists have some predictive accuracy on inflation. Before a new program is implemented, the idea is to evaluate whether that would cross the tipping point of creating too much inflation. Sounds nice but the last 10 years have been rather condemning on the idea that economists understand inflation. Relying on our limited understanding of inflation, and what causes it, to red-light/greenlight projects seems a little foolhardy.
The second, and more worrisome, problem we see with MMT is once you cross into unwanted inflation, how do you get back? Dr. Stephanie Kelton is the one of the leading proponents of the theory. Interestingly, Dr. Kelton once worked at the University of Missouri Kansas City (UMKC) and the founder of our firm, Jack Kynion II, called her up one day to hear about this out-there philosophy. From those humble beginnings, she’s risen to be a thought leader on MMT. She recently released a book called The Deficit Myth, where she discusses the basic premises of MMT and outlines many challenges in the US that could be addressed by shifting our thinking to MMT. Dr. Kelton’s suggestion in the book is that government could use their money creation powers to provide for a host of social and infrastructure programs, like jobs guarantee, fully fund healthcare, renewable energy infrastructure, infrastructure at large, and college education, among others. Once inflation starts to pick up, you throttle back. That’s where we fear it breaks down. Let’s say we start going down this road of funding all these programs and somewhere along the way inflation starts to go nuts. What’s next? MMT proponents suggest that congress would act to adjust taxes and government spending. Here is Dr. Kelton as she suggests adjustments to current monetary and fiscal policy:
Or maybe congress could help fine-tune the economy with better real-time adjustments to government spending and taxation?[iii]
You want Congress to do what?!? Fine-tune? Real-time? Those terms don’t compute with Congress. All these decisions will be politicized. If the inflation threshold is crossed, which social programs do you take away? Which congressional representatives will sign up for hosing their constituents? Increase taxes? To who, how much, and how? These are questions that don’t get answered quickly, and they’ll be answered largely in the self-interest of our representatives. If we are counting on them to make quick decisions to reel in inflation, we will likely be left with a lot of inflation.
Regardless of our beliefs toward MMT, we believe we will see a greater shift to this mode of thinking. In the next few months, there will likely be $1.9 trillion in stimulus. Then, there could be additional funding proposed for other social programs. The support in Congress for the programs will likely be there, but as dissent is raised, the rallying call will be MMT. In fact, Dr. Kelton – who once worked for Senator Bernie Sanders, who will be chairing the Senate Budget Committee—has been placed on President Biden’s economic team. We will likely hear more and more often that the deficit doesn’t matter. We will be watching this closely as it will directly impact our day-to-day financial lives and investment portfolios. We will continue to look for opportunities to invest capital at an acceptable level of risk.
Blake
[i] For more pontifications on the limited usefulness of investment professional prognostications, see our 2016 Q4 commentary. Don’t have one? Request a copy here: bstanley@finadvs.com
[ii] Lessons from History by Will & Ariel Durant, Page 97.
[iii] The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy by Stephanie Kelton, page 55.