Animal Spirits Podcast - Talk Your Book: But What Happens Tomorrow?

Episode Date: November 13, 2020

On today's show we talk with Michael Arone, Chief Investment Strategist at State Street Global advisors about how elections impact the market, and why we might be on an unsustainable path going forward. Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Riddle 12th Management. All opinions expressed by Michael and Ben, or any podcast guests are solely their own opinions, are subject to change based on market and other conditions and factors, and do not reflect the opinion of Ridholt's wealth management, state tree global advisors, and or state street corporations and its affiliates. This podcast is for informational purposes only and should not be relied upon for investment

decisions. Clients of Ridholt's wealth management may maintain positions in the securities discussed in this podcast. We're joined today by Michael O'Roney, Chief Strategist for State Street Global Advisors. We're recording this on Monday around lunchtime. Michael, thank you for coming on. Oh, my pleasure. Thanks for having me.

So we were going to talk about the election and the stocks, and we certainly will, but what a morning. What a day. What a year. Yeah, yeah. I mean, you can't have enough superlatives to describe 2020. But today was a kind of giant step forward in terms of COVID has always been a health problem that requires a health solution. And today we took a giant step forward and coming up with that health solution. And what's interesting here is that a lot of the stocks, the sectors, the industries that have been lagging as a result of the environment are starting to catch up to where tech has been for a while now. So that's nice to see. Does it surprise you at all that this obviously wasn't priced in? That may be the effectiveness of this or is this just a relief rally?

What is most surprising to you about this? Well, I'm not surprised at the market's rallying. I think what it's doing is it's overcoming something that was uncertain. So now I put it a little more clarity around not only the election, but the potential defeat of COVID-19. So I think there was a lot of pent-up demand. I think one of the things that 2020 has shown us, is that markets rallied throughout the summer,

despite some pretty dreadful economic numbers, some pretty dreadful earnings numbers. To me, the market was setting up for this idea that if we could just get some clarity on the election, if we could just get a solution to COVID-19, the backdrop for stocks, the foundation, is pretty strong. And I think markets are reacting to that. The economic data tells us that.

The earnings tell us that. And I think what you're seeing here is ultimately a re-rable of prices to reflect what's hopefully going to be a good environment in 2021. I think I know what you're going to say, but let me get your opinion on this. What would it have taken for the stock market not to have rallied in spite of all of the lousy economic news and the virus hanging over us? If we could play revisionist history, what would have caused the market to do the opposite of what it did?

I think an overwhelming Biden win with a decidedly kind of progressive. left agenda, might have spooked markets, at least temporarily until they could get greater clarity on what those policy objectives would be. But I do think that would have been a concern for markets in terms of much higher taxes, much tighter regulation for businesses, stacking the Supreme Court, making D.C. and Puerto Rico states, if that were to materialize as something more probable, I think markets would have struggled with it a little bit from that perspective. I should have been more clear. And thank you for that answer. But what I was really getting at is what would have caused a stock market not to rally throughout the summer and the fall. Oh, so I think the biggest thing that would have prevented the rally.

So for me, what happened was expectations for the economy and for earnings were at depression error levels. The fact that we easily surpassed those very low expectations, markets rallied significantly on. So to your question, Michael, I think the biggest thing that would have prevented that rally is if we got the depression error type economy and the depression error type earnings expectations. But we didn't get those. We kind of easily surpassed a much lower expectation. And that allowed folks to look forward to the eventual defeat of COVID-19 and a much better economic and earnings environment in 2021. So I think that was the key. It's hard to believe. But back in March, people were talking like this is going to be a depression. Yeah, you. And it felt like one. And obviously, you talked about this. You wrote a piece recently called Tomorrow and Tomorrow and Tomorrow.

and you talked about all the money that has been thrown at the system and you talk about the growth and the debt and all the things the Fed has done. Is it possible for them to pull back or are they just going to be here forever? I think it's incredibly difficult for both government, regardless of Republican or Democrat, to kind of turn off the spending spigot. And I also think it's nearly impossible for the Fed to begin to either raise rates or curtail its balance sheet in a meaningful way. We have multiple recent examples of this. Just the mere mentioned by Ben Bernanke in 2013 that, hey, someday we might have to peel this back, caused the now famous taper tantrum. And the Fed from 2015 to 2018, while the economy was growing, the labor market was at

multi-decade lows in terms of unemployment, meaning very strong labor market. And inflation was, we didn't have a lot of inflation, but the numbers were around 2%, maybe a little bit more, depending on whose figures you're using, and the Fed was kind of slowly but surely, very telegraphically, raising rates, and markets threw up all over themselves at the end of 2018. So to me, it just continues to signal this idea that we're addicted to massive government spending and funded by bloated bank balance sheets and really easy monetary policy. So it's going to be very difficult to step back from that. So let's dig into this.

And by the way, with a taper tantrum, Ben was caught levered long zero coupon bonds. that can not work out too well for him. If you would have stayed in a trade like that, you've done extremely well, obviously, right? True. So some numbers that you throw out in your post, you wrote the U.S. national debt is now more than $27 trillion, going to pass $30 trillion projected by the end of 2021. At the turn of the century, the debt to GDP was 56%. Today, it's more than 137%. So these are, I mean, these are big numbers.

And you push back against MMT. and I read the book, the deficit myth, which makes me an expert. I think that's how it works, right? But why don't you explain to us why you don't think, why you think deficits matter? Because as a layman, just reading this, it really makes sense to me. Maybe that's recency bias. Tell me why Ben and I are nub whales and why we're wrong in thinking that this MMT stuff is legit.

Well, I think the biggest thing is there's this view that deficits don't matter. And I would argue that they already have mattered. really since the ballooning of the deficits in policy responses in the aftermath of the global financial crisis, the view was is that very low rates, quantitative easing, and massive fiscal spending would help the economy rebound to historical trend growth rates and inflation come back. Those things have not happened. So yeah, the economy kind of rebounded and inflation became more normalized, but nowhere near kind of historical level. So my view is that massive amounts of debt tend to crowd out more productive uses of capital, and you have much lower trend growth rates. And I think the irony in all of this is that the continued solution to this problem is just to throw more money at it.

And I think that essentially these are self-perpetuating kind of circle here, that more debt, bigger deficits leads to lower growth, disinflationary kind of forces. is add-on technology and demographics. And I think it's impossible for us to see rates at more normal levels, economic growth at more normal levels and inflation at more normal levels. Now, for all of us, this is a great environment for holders of financial assets. I think it was Ben that was joking like, hey, if you held on that Ben Bernanke trade, you're making out just great. And you're right.

Hey, low rates, low inflation, without recession or contraction, load me up on growth all day long. it's a winning formula. And I think that's kind of the environment we continue to be in. But for those that are holding out hope that we're going to see a much greater economic environment with pretty decent bouts of inflation and higher rates, I just think that I just don't see it. I actually agree with you that I think it's possible. I don't know, put a time horizon on this, but that rates could stay low for a long, long time. If that happened, I don't know what that level is, if it's below 2% or 3% or whatever that is. What does that do to markets then?

What happens if we're in a world for, call it, two decades, where rates just stay way lower than people think could have been imaginable in the 80s and 90s? So I think it continues to kind of, you see this distortion in markets. So we all know, I put it forward in the paper. We all learn, we all were taken aside in finance 101, and we know that the present value of all the future cash flows discounted at the discount rate is how you come up with a value. That's for a bond. That's for a stock. That's for real estate. That's for most investments.

And when that discount rate is held permanently at zero, what it means is much higher than normal valuations and much higher prices. So again, Ben, I think from an asset standpoint, it's great if you're a holder of a financial asset or a borrower or a borrower and it rewards those. If you're a saver and you need that income, it's not so good. And I do think it does distort other behaviors, right? If I'm a corporate executive and interest rates are low and that's kind of distorted in that way, why am I going to take a risk?

I'm just going to pay dividends. I'm going to give the capital back to you. I'm going to buy back stock all day long. It helps by earnings per share element. It's a conservative strategy. So I'm not going to go ahead and make some kind of aggressive decisions when the cost of capital is zero. I'm just going to return the capital to shareholders, to investors, and say, you guys

figure it out. And my shareholder base, creditors, or shareholders are going to reward me for it. they're going to applaud me for it. So again, you don't see what's one of the biggest holding back of economic growth, low business fixed investments. It's been virtually depressed forever. And I think it will continue to be. What if that's just the function of the makeup of the economy, that these are asset like businesses. And I've always said, correct me if I'm wrong, I've always thought that we're growing less quickly than we have in the past just because the economy is just much bigger. It's harder to grow a $20 trillion economy than it is a $3 trillion.

In my office, there's something to that? There's absolutely something to it. So Michael, then why are we spending all this time and money loading up on debt, increasing the deficit to try to get back to 4%. We're just not going to get there. You say in your post that you don't necessarily blame the Fed for their decision making this time around, right? Yeah. So what we describe in the post is the following. During crisis situations like the pandemic, like the global financial crisis, coming through with fiscal spending and easy monetary policy is the absolute right thing to do. Let's not leave people hanging out there. Like, this is important, and these decisions are the right ones. And another stimulus bill probably is needed to help this

recovery to keep going. What I have a problem with is that when times are good, you're supposed to address those debt and deficits, not compound the problem. Same thing with easy monetary policy. So Ben asked me earlier, so what's up with the Fed? So the Fed from 2015 to 2018, in my opinion, was kind of doing the right thing until all of a sudden markets balked and said, oh, you've gone too far too fast. And then they responded to the market rather than the economic environment. That, to me, is the problem. So who gets hurt? In other words, when does the rubber meet the road?

Is this all going to blow up? Are we just going to be dealing with lower growth? Why is all this so damaging? So it penalizes savers. That's a big thing. particularly with your aging demographic. And that's not just a U.S. problem. We have it throughout most of developed Europe.

You have it throughout Japan and even in some instances in China. So low rates penalizes savers from that. Can I push back on that? Yeah, go ahead. I feel like that's maybe a little bit theoretical. You're 100% right that savers that were getting 6% in the 90s or whatever, or even in the 2000s, they were getting 4, 5, 6%. That's gone.

That is off the table. So the question is maybe why do they deserve to get, paid just for leaving money in the bank, A. And B, these savers are, let's be real, wealthy people have all of the assets. Wealthy people that are not getting 5% in their 10 year. They're making it in other places. So their total return is unchanged. I mean, I agree with you. In theory, savers are being punished. But who are these savers? Well, I mean, I do think that you have a wider ownership of stocks than any time in history in terms of 401ks, from a pension percentage, perspective, your manufacturing worker, your average worker through the power of the 401K is

owning stocks from that standpoint. So it's a bit broader than kind of history. I do think that you're kind of forcing people out from a risk standpoint. And then I think if you take that follow on, potentially you're creating those bubbles. Now, I'm not saying we're in a bubble, right? But it is kind of you're starting to see some things that private equity assets, private credit markets, all-time highs, special acquisition companies, BACs, all-time highs, IPO markets hot, M&A's heating up, seeing a day late. Like you said, we're talking, it's November 9th, it's Monday, markets rallying on the vaccine news strongly. We've had a lot of all-time high set in NASDAQ today. So you're starting to see a lot of this euphoria environment. Now, you don't have

it all in, but it's there. And Michael, do the second part of your question, the other thing you're doing is you're penalizing your financial system, your bank. with low rates. So they are that from that and they are an important mechanism for growth in your economy, particularly one that's so much fueled on debt, that type of thing. So the kind of the folks that get hurt by ultra low rates are your financials and your financial system, your banks, and your savers. Poor Goldman Sachs. Yeah. Yeah. Yeah. I've been saying for a while, I think to your point, low rates could lead to volatility in both directions. So I think these air pockets like we're seeing today where you have a huge rally up and then a couple weeks

ago, we had a huge downturn on nothing. I think those air pockets are only maybe a little bigger going forward. Now, I would never stick my neck out for saying something like this, but I want to ask you, because this is what people like to do following an election. They like to ask which sectors are going to benefit. And after Trump was elected, people thought, well, it's going to be energy. And of course, that was the worst performing sector. And we not only have the election, but we have the pandemic. And you can almost try to pick the winners post-pandemic if this vaccine works. Are you willing to stick your neck out and say, these sectors or industries are probably going to do a little better under Biden because of A, B, and C, or post-pandemic?

Are there anything that you are thinking about or is it way to really to even suggest anything like that? I think that from my perspective, the underlying trends for technology to continue to do well or there, from an investor standpoint, tech has become your security blanket. It's reliable growth, compounding cash flow. You both mentioned. this idea that these are not capital-intensive businesses with high organic growth rates, compounding cash flows at a very strong clip. And if you think about where our discretionary money goes, whether I'm a business or a consumer, it almost all goes to technology. Now, the one caveat I would have here is that I do think that the regulatory spotlight is going to shine more brightly

on fang. But that creates a tremendous amount of opportunities downstream for technology companies. that are kind of on the cutting edge of robotics, automation, artificial intelligence, those types of things. And so I do think that that continues to be an area that will benefit even under a Biden administration despite the fact that the regulatory environment could pick up. And the thing that's interesting here is that Silicon Valley is one of the biggest donors to Biden and Harris. So are they really going to turn around and kind of bite the hand that feeds them in that regard as well in terms of this concern around the regulatory environment? I think tech will do well.

It's like tech is the safety trait. Tech is selling off today as the rest of the market rallies. Maybe tech are the new bonds. Well, this is the thing, right? And that, again, you're talking about this environment. Like, who gets penalized? Who gets penalized? Well, in order to get a normal kind of income, you're asking older folks and more

conservative folks to own junk bonds and convertible bonds and preferred things they wouldn't normally own. And I do think there's a risk to some of that. There 100% is. And we speak about this all the time. For example, our high yield savings account at Marcus is now 60 basis points. And Ben and I have discussed how we're doing other things with that money, buying risky things that we never in a million years would if we were getting, I don't know, even 2%.

Right. That's what I mean. So that I think is a concern. Again, as we talk and we talk about where could the risk be? Why does this matter to save it? So, hey, I'll just, instead of putting in my Marcus account at 60 basis points, I'll just buy junk bonds. I mean, what could go wrong, right? Come on. Like, we both know that that's a lot riskier in terms of capital loss, potential for defaults, pick up in interest rates unexpectedly. That account,

a total return basis could be down in the teens, if not even more. That's not what you get when you buy a conservative CD, even though those don't exist anymore. I thought MLPs yielding 11% were safe. Yeah. Hey, they have nothing to do with the underlying commodity price, right? You know, is really being punished more than savers is value investors, of course. Absolutely. But do you buy this idea that low rates pushes people out into more growth-y investments and low inflation? That's one of the reasons that value has done so poorly versus growth. I totally believe it. It's also why I believe that going forward, all these folks now today is going to be another headfake in a long line of head fakes. When the cost of capital is zero and inflation is benign and

rates are low, you want to own growth all day long. So to me, the mechanism in order for that to change is a much greater economic growth with higher real interest rates and building inflationary pressures. That is the mechanism under which value works. So now all these folks that are getting excited about the cyclical value trade, it's kind of interesting, right? Yeah, you're going to talk about 10-year treasuries that went from 66 basis points to 100 basis points. man, that's high trade. It is a crazy world when people get worried when 10 your treasuries hit 90 basis points. It's all so crazy how relative that is now.

That's right. And inflation, I just find it difficult. Yes. Is inflation going to increase? Yeah, to a more normal level. But it's not going to get to the level that has historically caused challenges for markets. Wage inflation and things like that. I mean, look at the labor market.

We still have another 11 million jobs to go. until we get back to where we were to start this year. How can you suggest that all of a sudden we're going to see this breakaway wage inflation unless maybe we get a national minimum wage of $15 an hour? I don't know, maybe, but I'm not sure that's going to happen now with the balance of power that we have. So last week, Ben and I were talking about how UBS did a survey of investors, what they were doing with their portfolios prior to the election.

We're an anti-survey podcast, so we take these numbers with the grain of salt. I think it was like 50% of investors or 60% of investors, is we're doing something, whether they were hedging, raising cash, whatever, whatever. So people were doing something. So do you think that some of the move that we've seen post-election, and by the way, stocks had their best day ever post-election, do we think that some of that move is less driven by fundamentals and expectations and more driven by just macro positioning? What are you seeing?

That's interesting. It could be a little bit of both. So some of the things that we saw, at least in the spider exchange traded funds and the ETF kind of world more broadly prior to the election suggested to me that folks were setting up a little bit for this kind of cyclical value trade and a Biden victory. So for example, we saw global and international ETFs, not just spider ETFs, but in the broader kind of spectrum of all exchange traded funds, outpace U.S. ETFs in the month of October. You saw health care outflows. So preparing for the expansion of the Affordable Care Act, universal health care coverage.

And we saw a rotation into materials, industrials, and clean energy, almost a billion into clean energy ETFs. That suggests to me that folks were kind of setting up for this Biden trade. You saw small cap flows, value flows in, growth flows out, and tons into ESG ETFs. So again, that suggests to me kind of this more cyclical value trade with a Biden throwback to Obama era policy with a liberal progressive twist. While we're on the topic of fund flows, what do we make about the fact that yields are where they are, pinned to the floor, and yet fixed income flows have been absolutely enormous, despite the fact that savors are being punished?

What are they massacists? Why is there so much money going into fixed income ETFs? Well, I do think that you continue to see. One of the things I do think was a big contributor this year was the Fed's programs where they're now buying exchange-traded funds for the first time in their history. So in some ways, that provided a bit of a safety net, a cushion for investors who have these concerns. If it's good enough for the Fed and they don't care about price, they don't care about fundamentals, They don't care about the credit worthiness of the companies. They're just buying these things.

That led to some flows. So the biggest trade of the year, Michael, was the investment-grade corporate bonds was the biggest overwhelming trade in the ETFs all year to pick up incremental yield relative to treasuries where the Fed is buying. And that was kind of a slam dunk winner as it relates to exchange-traded fund ETFs. And a lot of the historical concerns went by the wayside because the view was the Fed wasn't going to let anything bad happen. I'm trying to paint one rosy picture here, and I want you to see if you can see through this.

Is it possible that we get out of this slow growth world for a little bit, vaccine comes and people just celebrate like the war has ended, basically? We see all this pent-up demand from stuff people haven't been able to do. They want to go on trips. They want to travel. They want to see friends. They want to go out to bars and restaurants. In that world, in that scenario, where maybe growth picks up a little bit and we do see like a hint of inflation

and the Fed lets things run a little bit, could we see, better than expected growth if something like that happened? I do think we'll see a rebound. So it's kind of funny when you said, oh, let me see if we can find a silver lining here. I've said all along, this environment of reasonable economic growth with low rates and low inflation, this is wonderful for holders of financial assets.

I'm totally bullish on stocks. Negative real rates, easy monetary policy, more fiscal policy. We're going to defeat COVID eventually, inevitably, whether it's herd immunity or a vaccine, it's going away. Earnings are better. The economy's better. I mean, this is a great environment to hold risk assets from that perspective.

The debate, like you said, is which type of risk assets, right? Is it value? Is it growth? So, Ben, my thing is that, yeah, you might see another glimpse, another glimpse of value, cyclical value rally. I just don't think it'll be permanent. So again, it's all about time horizon. Yeah, the economy's probably going to grow at a higher rate next year than it has in the last few years.

you might see you tick up in inflation and maybe interest rates get a little higher. But the trajectory, the trend is still going to be for below trend growth rates, low interest rates and low inflation, kind of looking a little beyond that. Do you think it's possible that we get the opposite of what we all kind of agree on, that rates are going to stay low, that inflation is not going to be here? Is that possible that, I mean, of course it's possible. What do you think? Do you think that consensus is going to be right?

I think the old adage is that the market tends to cause the most, amount of pain to the most amount of people from that standpoint. So when positions are decidedly one way, I do think that you see often that doesn't come to fruition. But I wouldn't suggest Michael that more research than not that I now see, and you raised your hand earlier, although folks couldn't see it, is folks are lining up for the cyclical value trade, right? And so to me, you have enough dispute here or enough kind of difference of opinions where not everyone's on the low rate, low inflation train forever from that standpoint. So I don't see this is overwhelmingly one side. Absolutely. Could you see higher rates and higher inflation? Yes, you could. I struggle to

see what the catalysts are. I mean, maybe I throw it back to you. What catalyst do you see that's really going to make interest rates move higher combined with inflation? Well, wiping out $10,000 or $50,000 dollars worth of student loan debt is not exactly inflationary. Oh, I guess it could be if that money now floods the system. I was joking, but now that I say it, maybe. I agree with you. I think it could be a massive head fake where let's say we get one year of above average inflation and then it comes back to Earth and people think we're going to have the 1970s again. I agree that the demographics and the economic growth situation just doesn't seem to have that in its course. I think it's a challenge. I mean, I think it's funny too. Just think about it. You guys mentioned it earlier. At the

end of 2016 after the election, I think it was Ben that mentioned it. Trump wins, Republicans. It's going to be a lower tax, lighter regulation environment, cyclical values finally here. Now here we are four years later. Biden wins under a potential progressive agenda with tighter regulations and higher taxes. And people are saying it's going to be a cyclical value trade. You can't have it both way. Someone's got to give. To me, I just don't see the catalyst. Now, I'm a pretty humble guy. Maybe I have my blinders on, but I just don't see the catalyst to get that kind of trade going, particularly on the inflation side and the rate side. All right, Michael.

Last question. How important is the president to the economy, to the stock market? Like, who do you think matters more, the president or the central bank policies? I think the central bank policies are probably the key. If you look at all the historical data, regardless of who's in the White House, who controls Congress, markets are mostly up. There's very kind of rare instances where markets struggle under different kind of combinations of White House Senate and House of Representatives. So ultimately, for me at the end of the day, what's going to matter is earnings,

compounding of cash flow, valuations, interest rate, inflation, those types of things are going to be the key. And the Fed has a much greater influence on those types of things than kind of fiscal policy agenda or regulatory agenda from that perspective. I think what's happened is markets in the aftermath of the election, this kind of works out I don't know about perfectly, but Biden, for some, that means a steady hand on the tiller, kind of more friendly foreign policy, trade policy. That's good. The fact that the Senate is held Republican means you're not going to get the kind of most

aggressive. You're not going to stack the Supreme Court. You're not going to raise taxes across the budget. board, that type of thing, that's great. And you have a conservative Supreme Court. So you have a great balance of power that I think markets have responded to. And ultimately, I think at the end of the day, what's going to matter is how are the earnings shaping up, how is the economy, interest rates, inflation. That's the key. So we'll like to Uncommon Sense in the show notes. How often do you put these out? Monthly. So Uncommon Sense is written monthly. Okay. All right, Michael,

this is excellent. Thank you so much for taking the time today. My pleasure. Ben. Michael, good to be with you guys. I don't know.