The U.S. is on the cusp of switching from a decade of plenty to a 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 inflection point that can only temporarily be averted by such probably ephemeral phenomena as the AI craze and the favorable November 14 CPI report that got shares jumping. The exhaustion of the COVID money, the end of student loan forbearance, and the stubbornly rising prices bound to spook consumers will “pave the way for an eventual recession,” and usher in years of austerity.
At hand is what novelist John O’Hara called the time of “sermons and soda water” that follow a binge.
First factor forcing austerity: The huge cost of government borrowing
The decisive difference between the ages of abundance and austerity, says Masturzo, is the level of interest rates. Since March of 2022, the Central Bank has hiked its benchmark gauge from near zero to the current 5.25% to 5.5%. The Treasury is now financing the deficits running at $1.57 trillion or a projected one dollar in four of all spending in fiscal 2024, at costs that are a multiple of three years ago. As a result, the CBO expects net interest expense to hit $745 billion in 2024, double the number in 2019, and around three times what the agency forecast that year for the mid-2020s, on the assumption the Treasury could keep borrowing, on average, at under 2%. By 2028, the CBO expects the interest line to reach over $1 trillion, equal to one-third of all individual income tax receipts, and 63% more than outlays for Medicare.
Higher rates, Masturzo asserts, will severely limit stock and home price increases, reducing the take from capital gains. That hit will cause a federal revenue squeeze, creating the need for new borrowing, and forcing the “deficit and debt to spiral higher in a vicious cycle.” The worsening budget picture, says Masturzo, will deprive the U.S. of the financial flexibility to initiate new stimulus programs that support GDP when the economy suffers turbulence. In addition, says Masturzo, gigantic shortfalls tend to feed inflation. As a result, the pressure on prices from all the borrowing will inhibit the Fed from, as he puts it, “coming to the rescue” in a downturn, as it did repeatedly the past ten years. The reason: A newly-expansive monetary policy would turbocharge prices at a time of huge budget shortfalls. “The Fed won’t be able to stave off recessions as in the past,” says Masturzo.
Second factor tightening the grip: persistently high inflation
RA predicts that the Fed will be unable to consistently hold inflation at its target rate of 2%, and that the CPI will wax well above the Central Bank’s ideal at an average at 2.6% over the next decade. The two main drivers will keep prices chugging at that disappointingly rapid clip are the already yawning deficits destined to grow from here, and a big push from commodities. Masturzo notes that capital spending for oil and gas production has declined sharply as producers fret over competition from green energy sources. But now, renewables are gaining traction far more slowly than posited a few years ago, and the outlook for fossil fuels looks increasingly strong. The International Energy Agency predicts that oil consumption will rise from 100 to 106 million bbd by from 2022 to 2027. The shortages caused by under-investment and the inevitably rising thirst for crude, natural gas, and their derivatives will collide to keep their costs to consumers and businesses on a fast-rising trajectory.
Masturzo observes that renewables are also highly commodity-dependent as big users of metals, notably copper, rare earth, and uranium that powers nuclear plants. The revival in nuclear has sent uranium prices soaring 100% since 2021.
When inflation’s chronically high, it’s also volatile. That’s bad for companies, especially those relying on commodities, whose costs are likely to careen widely in the future. Quicksilver prices also spawn fear among investors, who want a higher return to compensate for the risk of backing companies that constantly struggle to raise prices sufficiently to offset erratic but generally rising input costs. A fall in PE multiples, giving shareholders more dollars in earnings for each dollar they’re paying per share, is what provides the extra cushion. Delivering more margin for safety means that today’s multiples probably need to fall from mid-20s level, an expensive tag by historical standards.
A huge structural change moving forward: The return of pretty normal “real” interest rates. That’s the margin provided by risk-free government securities over and above projected inflation. For a decade, the U.S. was hooked on minuscule real rates; on the ten-year Treasury bond, they averaged about 0.5% from 2012 to early 2022, and went negative from mid-2020 to mid-2021. As of November 14, the real 10-year rate stood at 2.15%, nearly its highest reading since 2007. A once bounteous trade wind is now a gale blowing in investors’ faces.
RA forecasts that higher real rates are here to stay, and will remain above the 2% for years to come. Keep in mind that car and credit card loans, mortgages, corporate debt and all other credit charges a more or less fixed premium over the “real” rate on treasuries of comparable duration. So the 1.5% rise in that benchmark over the tiny numbers pertaining in the abundance decade means that all borrowing will be a lot more expensive than in that golden era. As Masturzo points out, the extra carrying costs will deplete consumers’ wallets, leaving less to spend on everything from groceries to travel.
Austerity’s onset mandates new investment choices
In the new paradigm, the best investment categories of the last decade should prove the worst performers going forward, while the beaten-down, unloved sectors of recent years are likely to thrive. For example, RA forecasts that U.S. large cap stocks will generate total returns of just 4.9% over the next ten years, far below the 11.6% they delivered in the past decade. The outlook’s even worse for “growth” stocks, a grouping epitomized by the high-flying Magnificent Seven encompassing Apple, Microsoft, Amazon, Alphabet, Meta, Nvidia and Tesla. S&P “growth” is expected to hand investors just 3.7% annually through 2033, beating the CPI by a tiny 1.1%. The big reason: A decline in their extremely high multiples, once again, driven by the new regime in rates.
By contrast, value stocks that are below average in PEs and book value, and hence the cheap choices, should provide returns twice as high at 7.3%, since their dividend yields are much richer and their multiples more modest. Masturzo also recommends those scarce commodities whose prices are likely to outstrip inflation, as well as other hard assets such as gold, art, watches and even a limited slug of cryptocurrency. The past decade’s been something of a fantasyland where asset prices flew unmoored to fundamentals and the government could seemingly spread largesse without inflicting significant pain. Now the basics are back in charge, and the bill’s come due. Welcome to grinding new world of austerity.
