President Obama’s Essay on Economic Policy after the Election: “The Way Ahead”

The Economist

“The Way Ahead” – President Barack Obama.


Much of the protectionist mood in the US is driven by anti-immigrant sentiment and a resurgence in nativism

“How has a country that has benefited—perhaps more than any other—from immigration, trade and technological innovation suddenly developed a strain of anti-immigrant, anti-innovation protectionism?… Much of this discontent is driven by fears that are not fundamentally economic. The anti-immigrant, anti-Mexican, anti-Muslim and anti-refugee sentiment expressed by some Americans today echoes nativist lurches of the past”


Rise in inequality and slow growth in income for the low- and middle- class has also contributed

“But some of the discontent is rooted in legitimate concerns about long-term economic forces. Decades of declining productivity growth and rising inequality have resulted in slower income growth for low- and middle-income families. Globalisation and automation have weakened the position of workers and their ability to secure a decent wage”


Also a growing resentment of business and political elites

“And the financial crisis of 2008 only seemed to increase the isolation of corporations and elites, who often seem to live by a different set of rules to ordinary citizens.”


Despite these negatives, trade, globalization and technology have been overwhelmingly beneficial to the US

“Over the past 25 years, the proportion of people living in extreme poverty has fallen from nearly 40% to under 10%. Last year, American households enjoyed the largest income gains on record and the poverty rate fell faster than at any point since the 1960s. Wages have risen faster in real terms during this business cycle than in any since the 1970s. These gains would have been impossible without the globalisation and technological transformation that drives some of the anxiety behind our current political debate.”


To restore people’s trust in the forces of capitalism and globalism, the inequality gap needs to be addressed

“Economists have long recognised that markets, left to their own devices, can fail. This can happen through the tendency towards monopoly and rent-seeking that this newspaper has documented, the failure of businesses to take into account the impact of their decisions on others through pollution, the ways in which disparities of information can leave consumers vulnerable to dangerous products or overly expensive health insurance… A world in which 1% of humanity controls as much wealth as the other 99% will never be stable. Gaps between rich and poor are not new but just as the child in a slum can see the skyscraper nearby, technology allows anyone with a smartphone to see how the most privileged live. Expectations rise faster than governments can deliver and a pervasive sense of injustice undermines peoples’ faith in the system.”


Radical change, however, is not the answer

“As appealing as some more radical reforms can sound in the abstract—breaking up all the biggest banks or erecting prohibitively steep tariffs on imports—the economy is not an abstraction. It cannot simply be redesigned wholesale and put back together again without real consequences for real people.”


President Obama advocates fiscal stimulus to boost productivity growth

“A major source of the recent productivity slowdown has been a shortfall of public and private investment caused, in part, by a hangover from the financial crisis. But it has also been caused by self-imposed constraints: an anti-tax ideology that rejects virtually all sources of new public funding; a fixation on deficits at the expense of the deferred maintenance bills we are passing to our children, particularly for infrastructure; and a political system so partisan that previously bipartisan ideas like bridge and airport upgrades are nonstarters.”


Unions flexible enough to not hinder American trade policy, and tax policy are key to addressing inequality

“In the future, we need to be even more aggressive in enacting measures to reverse the decades-long rise in inequality. Unions should play a critical role. They help workers get a bigger slice of the pie but they need to be flexible enough to adapt to global competition. Raising the Federal minimum wage, expanding the Earned Income Tax Credit for workers without dependent children, limiting tax breaks for high-income households, preventing colleges from pricing out hardworking students, and ensuring men and women get equal pay for equal work would help to move us in the right direction too.”


New trade deals— the Trans-Pacific Partnership and the Transatlatnic Trade and Investment Partnership— will make American firms more productive and lift wages for workers

“Lifting productivity and wages also depends on creating a global race to the top in rules for trade. While some communities have suffered from foreign competition, trade has helped our economy much more than it has hurt. Exports helped lead us out of the recession. American firms that export pay their workers up to 18% more on average than companies that do not, according to a report by my Council of Economic Advisers. So, I will keep pushing for Congress to pass the Trans-Pacific Partnership and to conclude a Transatlantic Trade and Investment Partnership with the EU. These agreements, and stepped-up trade enforcement, will level the playing field for workers and businesses alike.”


Unemployment insurance and educational opportunities should be used to address employment

“There are many ways to keep more Americans in the labour market when they fall on hard times. These include providing wage insurance for workers who cannot get a new job that pays as much as their old one. Increasing access to high-quality community colleges, proven job-training models and help finding new jobs would assist. So would making unemployment insurance available to more workers.”


Post-crisis reforms have made the the US financial system more stable

“There should no longer be any doubt that a free market only thrives when there are rules to guard against systemic failure and ensure fair competition. Post-crisis reforms to Wall Street have made our financial system more stable and supportive of long-term growth, including more capital for American banks, less reliance on short-term funding, and better oversight for a range of institutions and markets. Big American financial institutions no longer get the type of easier funding they got before—evidence that the market increasingly understands that they are no longer “too big to fail”. And we created a first-of-its-kind watchdog—the Consumer Financial Protection Bureau—to hold financial institutions accountable”


As evidenced by today’s interest rates, monetary policy alone should not bear the burden for boosting productivity

“With today’s low interest rates, fiscal policy must play a bigger role in combating future downturns; monetary policy should not bear the full burden of stabilising our economy. Unfortunately, good economics can be overridden by bad politics.”


Fiscal policy has been blocked these last four years by Congress

“My administration secured much more fiscal expansion than many appreciated in recovering from our crisis—more than a dozen bills provided $1.4 trillion in economic support from 2009 to 2012—but fighting Congress for each commonsense measure expended substantial energy. I did not get some of the expansions I sought and Congress forced austerity on the economy prematurely by threatening a historic debt default. My successors should not have to fight for emergency measures in a time of need. Instead, support for the hardest-hit families and the economy, like unemployment insurance, should rise automatically.”

European Central Bank (ECB) Monetary policy decision July 2016


Rates left unchanged

“…the Governing Council of the ECB decided that the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 0.00%, 0.25% and -0.40% respectively.”

Interest rates expected to be lower for longer

“The Governing Council continues to expect the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases.”

Monthly asset purchases to continue

“Regarding non-standard monetary policy measures, the Governing Council confirms that the monthly asset purchases of €80 billion are intended to run until the end of March 2017, or beyond, if necessary, and in any case until it sees a sustained adjustment in the path of inflation consistent with its inflation aim.”


2013 is beginning the year with a strong dichotomy in asset class returns.  While the S&P 500 is on pace to have its best January since 1997, the 10 year yield has moved higher by 20 bps.  Expressed in more intuitive terms, SPY is up 5.3% year to date, while TLT is down 3%.  The divergence between the two could represent some psychological pain for any investors substantially invested in bonds.

How Long Can Real Interest Rates Remain Negative?

Ray Dalio made some news this week when he acknowledged that interest rates had probably gone about as low as they could possibly go and that the next big opportunity will be shorting the bond market.  I’m inclined to agree, but there is some historical precedent for rates to go lower and stay there for even longer.

Dalio argued that real rates are currently negative (nominal rate minus inflation)–which they are–but they were also negative for 10 years between 1936 and 1946 as shown by the chart below, which compares Moody’s average Aaa bond yield to the realized 10 year forward inflation rate.  Inflation was high during this period, reaching above 10% in some years thanks to WWII.  The fact that rates stayed low is a testament to the fact that it’s not a good decision to try to fight the Fed.

Real Interest Rates Negative World War II
Used Aaa bonds as proxy for risk free rate.  Source: Federal Reserve Data

Long Term Historical Correlation of S&P 500 with Interest Rates

In the previous post I highlighted how the correlation of rates and the S&P 500 has turned slightly negative, which is an infrequent occurrence judged over the last 10 years.  The risk on/risk off trade has thrived on the idea that rates and stocks are positively correlated (i.e. when stocks go down bonds rally (rates fall) and when stocks go up bonds sell off).  This is likely a function of the fact that the risk premium (as opposed to inflation expectations) is the primary driver of price fluctuation in the current environment.

For most of the 20th century, risk premium was less important than inflation premium though, which led to an inverse correlation of rates and equities.  Because inflation was a greater component of a company’s cost of equity, as inflation expectations fell, interest rates fell (as did the cost of equity) and stocks rallied along with bonds.  If inflation ever becomes a dominant theme again, then one might expect the correlation that has been the heart of the risk on/risk off trade to get turned on its head.  What happens to the algo guys if that happens?

5 Year Correlation S&P 500 and Rates Historical

Correlation of Rates and S&P 500

Operation twist has had the opposite effect on rates that outright QE has had, but equities have rallied during twist just like they did during QE1/2.  This has lead to a divergence between equities and interest rates over the past year.  Previously equities and rates had been relatively correlated: when equities moved higher so did interest rates.  Recently though, the daily correlation has broken down and over the past year has actually turned slightly negative.

Rates S&P 1 year correlation

QE Effect on Interest Rates

Consensus seems to be growing that the Fed is definitely going to announce some sort of new QE today.  From an academic standpoint QE is supposed to lower interest rates in order to spur lending and economic activity, but as a reminder the last two times that there have been unsterilized printing programs rates have actually risen because QE has created the appearance of inflation.  Only operation twist, a sterilized maturity swap program has been effective at flattening the yield curve.  Below is a chart of the 10 year yield with QE dates highlighted.

Interest Rate Chart with QE dates

TLT Nearing S&P 500 Drawdown

Are bonds always less risky than equities?  If TLT’s recent move teaches investors anything the answer should be an emphatic no.  Earlier this year the S&P 500 saw a drawdown (top to bottom loss) of ~10%.  Over the last month TLT, an ETF matching the return of long term US treasuries, has lost nearly the same amount as interest rates have risen.  The moral of the story:  holding duration on the long end of the curve can create equity like returns and equity like volatility.

How Much Have Companies Benefited From Lower Interest Expense?

In an attempt to quantify the extent to which lower interest rates have helped corporate America, below is a chart of the total interest expense of S&P 500 companies for the last 10 years.  On an aggregate level, interest expense is below where it was in 2005, and as a percent of EBIT it is the lowest it has been in 10 years.  The lower interest costs are a result of both lower rates and deleveraging.  Total debt of S&P 500 companies is down from $7.4T to $6.7T since 2010.

Lower interest expense has added $157B in earnings before tax to S&P 500 companies.  If you assume a 35% tax rate and a market multiple of 14x earnings, the lower interest expense has added approximately $1.4T in market cap to the S&P 500–about 10% of the total market cap of $13.2T.

TLT Down by 5.5% Since July 25

For those who still like to think of US Treasury bonds as risk free, below is a reminder that duration on the long end of the curve can lead to equity like returns both on the up-side and the down-side.  TLT, the long bond ETF is down 5.5% since 15 days ago.  It’s still up 2.5% ytd (excluding dividends), but the 30 year bond has only moved from a ~2.5% to  ~2.8% yield.