The U.S. is on the cusp of switching from a decade of plenty to an long and painful period of austerity.
That’s the view from Jim Masturzo, chief investment officer at Research Affiliates, a firm that oversees strategies for over $130 billion in mutual funds and ETFs for the likes of Pimco and Charles Schwab. Founded by capital markets legend Rob Arnott, RA created the first funds deploying “fundamental indexing,” an approach that weights equities by such features as sales, book value and dividends reflecting their importance in the economy. Hence, the RAFI fundamental funds avoid the pitfalls of cap weighted vehicles that chase the most expensive stocks and over-concentrate their holdings in the priciest names. For this writer, RA provides superb, academically-based insights into both where the economy is headed, and how investors should best position themselves to profit from the looming trends.
In the last decade, super-low rates and big government spending brought abundance. It’s over.
Masturzo points out that two extraordinary practices made Americans a lot richer in the years following the Great Financial Crisis. The first: A regime of super-slender interest rates engineered by the Fed. The easy money started as stimulus to shield the economy from the 2008-2009 hurricane. Then, after a brief period of normalization, the Fed cut again to counter drag from the Trump tariffs, and went into full-on overdrive during the Pandemic. From the start of 2010 to early 2022, the Fed Funds rate hovered above 1% for just two-and-half years, and spent ten years at near zero.
Second, federal spending—already far exceeding inflation in the 2012-19 period—exploded during the COVID outbreak and its aftermath, rising from $4.45 trillion in fiscal 2019 to $6.82 trillion in 2021, a jump of 53% or nearly $2.4 trillion in two years. And though outlays have retreated a bit, they’re still on a plateau dwarfing the pre-pandemic levels. The $6.35 trillion budget for 2023 is down just 7% from the apex reached two years ago.
Despite the gigantic borrowings, the U.S. managed to hold deficits at less than disastrous numbers through fiscal 2021, thanks largely to the Fed-fashioned near-zero rates. To minimize carrying costs, the Treasury borrowed “short”—for most of 2020 and 2021, the U.S. was funding a big part of the shortfalls by issuing 5 year treasuries yielding under 1%.
Risk-free rates so low that they frequently lagged inflation ignited asset prices. From the close of 2019 to Q2 of 2022, average home prices across America jumped by 45% according to the American Enterprise Institute’s Housing Center, an annual clip of 16%, capping a total 130% increase since 2012. Americans rushed to tap the burgeoning equity in their houses by taking cash-out mortgages. Stocks fared even better than dwellings. The S&P 500 leapt 54% from early December of 2019 to the end of 2021, led by the mega-tech names and such speculative stars as Tesla that benefit greatly from low rates, since such a high proportion of their market caps rely on fast-rising earnings far into the future.
Consumers spent freely, says Masturzo, buoyed by “the wealth effect of steadily rising stock and bond prices,” and of course the swelling equity in their colonials and ranches in the ‘burbs. “Generous outlays in the pandemic padded their bank accounts, and companies gorged on cheap borrowings,” he adds. The rush to finance new plants and fabs, as well as inventories, often at low-single digit rates lifted corporate profits. And more than half of those business loans don’t come due before 2030. Indeed, the benefits of the policies that brought all that abundance linger on. Home prices are still sitting just above their 2022 summit, though they’ve declined versus inflation, and the S&P is only 6% off the late ’21 highs. Still-strong hiring is holding the jobless rate at a tight 3.9%, and though families are cutting back, they’re still pretty flush thanks to their ample war chests and rising paychecks. Their amazing durability helped send GDP upwards an astounding 4.9% in Q3.
The reckoning is finally at hand
Masturzo concedes that in the short term, “The economy could remain buoyant and investors resilient.” But he believes that the big federal spending and “free money” Fed policy that funded the bash will soon leave a stiff hangover. “The macro game of musical chairs cannot go on forever,” he writes. It was the regional banking crisis starting in March, he says, that exposed the first cracks. But after a steep selloff, frenzied excitement over the future of AI sent Big Tech soaring once again. Now, Masturzo believes the economy and the markets stand near an historic…
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