Notes on the Week Ahead

Every three months, the 19 members of the Federal Reserve’s Federal Open Market Committee, of FOMC for short, aided, no doubt, by an army of econometric minions, work up new forecasts for key economic variables and their assessment of appropriate monetary policy.  In recent days, as they have huddled in their offices engaged on this task, they’ve had much to be thankful for.  The economic roller coaster triggered by the pandemic and the policy response, which manifested itself in wild swings in output, unemployment and inflation, has subsided.  Moreover, the very narrow road by which they thought inflation could be subdued without triggering a recession, turned out to be not so narrow after all.  The U.S. economy has maintained solid economic growth and a very tight labor market even as inflation has fallen towards their 2% objective.

For centuries, economists have extolled the almost magical properties of competitive markets.  In the 1770s, Adam Smith wrote about an “invisible hand” by which individuals end up promoting the common good even though they only ever intended to do themselves a bit of good.  In the 1970s, Milton Friedman spoke passionately of the virtues of a free-enterprise system in boosting innovation and productive activity.  Such voices are quieter now and much of modern economic commentary is devoted to how to fix an economy when markets fail or how governments and central banks should seek to manipulate it.  However, the U.S. economy in the wake of the pandemic should serve as a reminder of the power of simple economics.  No matter how abnormal the starting point, an economy will, if sufficiently neglected by the government, tend towards balanced growth.

One of the most common plotlines in all of literature is when a protagonist, overestimating the gravity of a situation, responds with a series of unfortunate decisions. Perhaps the classic example of this is Romeo, not appreciating the difference between a sleeping Juliet and a dead Juliet, but the pattern has played out in innumerable stories.

When it comes to the state of the economy, it seems clear that Americans are harboring too negative a view. In the short run, this misapprehension may not lead to disaster. However, it could still imperil investment returns if it leads to political decisions that make a relatively healthy economy sick.

The importance of any piece of economic information depends on your time horizon.  For traders, the issue is how it will move markets today.  For politicians, its relevance lies in how it could shape public opinion between now and the next election.  However, for long-term investors, what really matters is how it will impact the economic and financial environment for decades to come.  From this last viewpoint, there is no more important topic than the continued deterioration in the federal finances. 

Information released in the last few days provides an updated perspective on this issue.  However, before delving into this, let’s take a quick look at upcoming economic data.

The most common scavenger bird in the western United States is the turkey vulture, more commonly called the turkey buzzard.  It is a marvel of evolution, with keen eyesight and an extraordinary sense of smell, allowing it to locate the recently deceased from miles away.  Ungainly as it takes off with furious flapping, once in the air it is a majestic creature, soaring thousands of feet upwards on air thermals, with an out-spread V-shaped wing span of up to six feet.  As it circles from a height, it surveys the landscape below and then plunges to feast on the remains of less fortunate creatures.

I don’t believe in reincarnation but, if I did, I would have to say the best real estate investors were probably turkey buzzards in a previous life.  And never more so than today, when the real estate landscape is littered with the victims of the seismic changes wrought by the pandemic and a sudden return to normal interest rates, following 15 years of super-easy money.

I have never been blessed with any skill in golf.  However, I do have some imagination and so I can imagine a situation in which I am lining up a long and difficult putt.  With well-justified humility, I wince as I strike the ball, knowing it will miss.  However, even two or three seconds after sending it on its way, I realize that, surprisingly, I’m still not sure how it will miss – I can’t quite tell if it’s going to miss to the right or to the left.  And so, of course, the ball trundles its zig-zaggy way up to the lip of the hole, pauses, and then topples in.

Last week’s GDP report ignited angst on both sides.  Some worried that the economy was slowing too much, with recession in the offing.  Others saw too much inflation, requiring an even more aggressive Fed campaign to squash it before it begins to reaccelerate in a serious way.

Since the advent of modern financial markets, bonds have always had the reputation of being conservative – rather like an elderly family lawyer in a leather-bound chair frowning at more jumpy and excitable stocks.  Bonds would never make you rich.  However, they would provide you with a moderate, steady and dependable income. 

This reputation was challenged in the 1970s and 1980s by Treasuries yielding more than 10%, in the wake of high inflation, and the explosive growth of the high-yield market.  In the decades that followed, yields drifted down in parallel with inflation but investor excitement was maintained by a steady stream of capital gains as well as income.  However, once monetary easing hit its peak in the days following the Great Financial Crisis, high-quality bond yields fell to levels that promised very little income and, at best, modest capital losses, assuming yields eventually recovered. 

Growing up in New England, our sons had a privileged childhood as sports fans and particularly as football fans. Between 2001 and 2020, the New England Patriots, coached by Bill Belichick and with Tom Brady at quarterback, competed in nine super bowls and won six of them -  a truly extraordinary performance in a league of 32 teams.  It is all the more impressive because of the NFL’s efforts to make the league competitive.  These include the salary cap, which forces all teams to spend roughly the same on their rosters, and the draft, which awards the top picks to the worst teams from the year before.

And yet the dynasty continued for almost two decades, with the Patriots winning many games that they should have lost due to their own confidence and their opponents doubts.  And the supposedly eroding effects of low draft picks seemed to have little impact on the team, as relatively unknown players found a way to win.

Next Monday, I once again get to lace up my shoes and join my friends from the Dana-Farber team in running the Boston Marathon.  This year will be particularly special, as both of our sons are also running the race.

One of the advantages of being an older member of the team, (and I can testify to plenty of disadvantages), is that you accumulate advice that you can share with younger members, particularly those who are running their first marathon.  One such piece of advice is to drink before you are thirsty and to eat before you are hungry.

By the time you are thirsty, when running a marathon, you are likely severely dehydrated and low on electrolytes, causing, at best, a sharp deterioration of your performance.  By the time you are hungry, your blood sugar will probably be too low, making the rest of the race slow and painful.  In short, in long-distance running, one key is to make decisions before it feels like you need too.

When I was nine, my father was elected to the Irish parliament and joined the new government.  Not long after that, my history teacher, a man of the opposite political persuasion, was expounding on the Norman conquest of Ireland and the attempts of the local Irish clans to wage war against them….”not like the “wage war” we have with the current government” he said, finding humor in a rather dull subject.  I, being an overly sensitive child, took this as a terrible insult to my father and promptly burst into tears, whereupon he sent me out into the hall for disturbing the peace.