Capital Market Outlook (September 9, 2019)

In This Issue:

  • Macro Strategy—The deflationary shock that excessive Federal Reserve (Fed) tightening delivered to the global economy in 2018 continues to spread and deepen, causing the dollar to strengthen, commodity prices to weaken, breakeven inflation rates to plunge well below central-bank targets, and global interest rates to sink to new all-time lows. It's very important, in our view, that the U.S. central bank get more assertive about hitting its inflation target.
  • Global Market View—Cybersecurity remains one of the top infrastructure challenges of today as demonstrated by the proliferation of debilitating ransomware attacks on U.S. cities, posing as both a crisis and an opportunity for investors.
  • Thought of the Week—Last month's primary election in Argentina sent a clear message that confidence in the current administration has wavered after stalled pro-business economic reforms, rising unemployment, soaring inflation and falling incomes.
  • Portfolio Considerations—We believe equities remain more attractive than fixed income despite the long list of concerns from a macro and geopolitical perspective. Therefore, we remain overweight equities with a preference for U.S. large-cap relative to the rest of the world.

One Instrument, One Target

In 1969, the first Nobel Prize in economics was shared by the Dutch economist, Jan Tinbergen, who was a pioneer in the development of econometric forecasting models.

Fifty years later, he is arguably best known in academic circles as the originator of the Tinbergen Rule, which states "policymakers trying to achieve multiple economic targets need to have control over at least one policy tool for each policy target."

Over the years, this principle came to be embodied in the notion that the Fed ultimately can only control inflation with its interest rate policy because "inflation is always and everywhere a monetary phenomenon." That's why every year the Federal Open Market Committee (FOMC) reaffirms its commitment to a "Statement on Longer-Run Goals and Monetary Policy Strategy," which says: "The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate." The statement goes on to explain that other economic objectives, like the unemployment rate, are determined by factors in the real economy and are beyond the domain of monetary-policy control.

Thus, there are two fundamental reasons why inflation is the primary target of monetary policy. First, inflation can be controlled by monetary policy to counteract the other factors people frequently blame for deviations from target levels, for example, demographics, debt levels, tariffs and a host of other forces. These factors may make it harder to raise or lower inflation but ultimately central banks can adjust policy to overcome any forces in the real economy to change the inflation rate. That's why, despite all the reasons for the Fed's failure to hit its 2% target, the example of high-inflation countries, like Venezuela, proves that enough money-supply growth can always overcome all the reasons why inflation is less than the target.

Aside from the fact that monetary policy has the power to achieve an inflation target, the second fundamental reason why inflation is the only long-run target of U.S. monetary policy stems from the Tinbergen Rule. If the Fed tries to use its interest-rate policy to achieve two objectives, or more, it runs the risk of compromising its ability to achieve any objective. The Fed's one instrument—the federal funds rate—can be aimed at hitting an inflation target or, for example, it can be aimed at hitting an unemploymentrate target (at least in the short run). Last year, the Fed worried that unemployment was too low, and it raised rates aggressively only to find inflation and inflation expectations began to collapse well below target. The presumed connection between unemployment and inflation that the Fed was relying on turned out to be missing, as is implicit in the "Statement on Longer-Run Goals and Monetary Policy Strategy."

Often, commentators and even FOMC members connect interest-rate policy considerations to financial stability. This is another source of potential monetary-policy mistakes, as we've seen recently when two dissenters to the Fed's July 31 rate cut claimed they were worried about increased financial instability if the Fed held rates too low. Ironically, holding rates higher is fueling the deflationary shock that is causing inflation and inflation expectations to collapse around the world. If this puts the U.S. into a zero- and negative-rate world, like Japan and Europe, the U.S. financial system would be much weaker and less stable than if the Fed focused on hitting its 2% inflation target.

The proper instrument for achieving financial stability is macro-prudential regulation, not interest-rate policy. The Tinbergen Rule again applies here. Each objective requires the proper instrument, or instruments, to achieve any particular target. One instrument cannot be used to consistently hit two or more targets.

Interest-rate policy is best aimed at the inflation target, while macro-prudential or regulatory policy is best aimed at stability in financial institutions. Trying to do both with the interest-rate-policy instrument has not been successful, as we have seen over the past two decades, when the Fed consistently fell short of its inflation objective and created a mood of deflationary risk aversion, which has deepened since last year's aggressive tightening.

Basically, we believe that in a world with deflationary tendencies, the central bank needs to be more aggressive to overcome those tendencies. As the Venezuelan case illustrates, excessive money-supply growth can cause excessive inflation. Deficient money-supply growth causes inflation to fall short of the target objective.

Exhibit 1: Tight Money Inverts Yield Curve, Causes Recessions and Disinflation.

As can be seen in Exhibit 1, real money-supply growth has collapsed since the Fed raised interest rates over 200 basis points and used quantitative tightening to shrink the monetary base, which is the raw material for the money supply. Notice that weak real money-supply growth tends to be associated with a flattening and, especially, an inverted yield curve. This is why inverted yield curves precede recessions. They are a sign that monetary policy is too tight for the economy to continue to expand. Real growth and inflation fall as tight monetary policy squeezes economic activity. That's what we've been seeing since the Fed passed neutral and went into restrictive territory last summer in its zeal to "normalize" interest rates.

Ironically, the Fed's zeal for higher rates makes normalization less likely. By imparting a deflationary shock to the economy, rates are falling much more, and around the world are at new all-time lows because central-bank credibility is collapsing. The fresh all-time lows in the 30-year Treasury yield is an ominous sign that the market does not believe the Fed is serious about pushing inflation up. The alternative is a continued disinflationary decline that lands the U.S. in the negative-rate trap engulfing Europe.

Jan Tinbergen would not be surprised. The Fed is in a difficult position and is aiming at too many objectives with its interest-rate policy. An interesting September 4 Bloomberg article by Mohamed El-Erian categorized economists and strategists based on their current views about the effectiveness and risk of further monetary-policy easing. The majority adhere to the view that further easing is unlikely to do much for the economy or that economic considerations don't warrant further rate cuts. Some others worried that more rate cuts would encourage irresponsible risk taking. In a speech on September 4, New York Fed President, John Williams, called low inflation the problem of our era. It is a problem easily solved by more aggressive monetary policy, as past experience and currently high-inflation countries around the world prove. The bond markets are saying the same message loudly, in our view.

Like the Fed, the consensus of economists seems to dismiss the lessons from Jan Tinbergen and Milton Friedman. These lessons are simple: (1) monetary policy can best stabilize the economy by anchoring inflation expectations around a low, stable positive rate, and (2) using monetary policy for other purposes precludes successfully achieving (1). The BofA Merrill Lynch (BofAML) Global Research Economics team's forecast is for three more cuts this year. We believe the signals from the bond markets seem to be suggesting more are needed to hit the Fed's inflation target. This is very important for long term portfolio strategy. The lower yields go the more difficult it will likely be to produce enough returns investors need for various objectives.

The Crisis (and Opportunity) No One Is Talking About

"This has been the summer of crippling ransomware attacks."—The New York Times, August 23, 2019

Given the recent volatility of the global capital markets and a daily diet of negative headlines—trade wars, inverted yield curves, some $17 trillion in negative-yielding bonds, and growing fears of recession—who could blame investors for not recognizing one of the most pressing challenges of today: the proliferation of debilitating ransomware attacks on U.S. cities. The latter—large and small—have become the favorite hunting grounds for hackers who have scored large paydays against municipalities that are the equivalent of sitting ducks.

Soft targets

Why attack cities? Because many are using antiquated technology, have scarce resources, and are devoid of cyber talent. They are easy or soft targets, in other words. While the United States is a cyber-superpower, the talent and resources are at the federal level, not at the state and local level, leaving cities like Baltimore but also locales like Newark, Atlanta and San Diego (all cyber victims) at the mercy of cyberattacks.

As the accompanying exhibit underscores, spending on cyber security at the state and local level just isn't a fiscal priority. In years past, budgeting for cyber security was neither necessary nor affordable given mounting public sector pension liabilities and rising education outlays. Times have changed, however. The hackers have come to Main Street, crippling numerous town, city, county and state governments at a considerable expense this year.

Exhibit 2: Easy Targets: The Average State Allocates 1%-3% of Their Total IT Budget to Cybersecurity.

According to cybersecurity firm Recorded Future, some 170 county, city or state government systems have been attacked since 2013, with more than 55 known attacks already this year.2 The latest to be assaulted: nearly two dozen small towns and cities across Texas last month, continuing a wave of cyberattacks that have accelerated in 2019. Not helping matters, not only are municipalities inherently soft targets for hackers, they are also targets willing to pay the ransom to get vital public services up and running. As a recent Washington Post article noted, "hackers have scored big payoffs to unlock email, phones and public records across the country," which has only incentivized hackers to keep hacking. In addition, fearing the worse, some cities have opted to buy cyber insurance, which has only greased the lucrative wheels of ransomware.

Even when cities refuse to pay, the financial consequences are hardly insignificant. In Baltimore, for instance, when hackers technologically disabled the city, home sales were delayed, water bills were not issued, and basic services of the public sector (mass transit, emergency services, etc.) were delayed or shut down. The hackers demanded $76,000 in bitcoin, which the city refused to pay. However, getting the city's systems back on line, and including lost revenue, cost Baltimore an estimated $18 million. Atlanta didn't pay up either, but the cyberattack cost the city an estimated $17 million.

In the end, cyberattacks on America's cities can be paralyzing and come with considerable economic costs (whether the ransom is paid or not). It is worth noting that the output of state and local government contributed $2.2 trillion in annual U.S. gross domestic product in 2018. In other words, when hackers attack cities, they are attacking a vital organ of the U.S. economy. With the wherewithal to digitally cripple major hubs of economic activity, the spike in cyberattacks on U.S. cities puts the entire U.S. economy at risk.

The investment opportunity

That said, one of the top infrastructure challenges of today pivots around bolstering the internet forces/cyber capabilities of America's large and small cities with nearly two-thirds of all publicly known ransomware attacks in the U.S. targeting state or local governments.5 With an outsized number of "government shutdowns" in 2019, boosting the cyber defenses of not only vulnerable cities, but corporations, entails billions of dollars of investment in cyber security to protect sensitive customer data, safeguard intellectual property and avoid the costs of a data breach—and also, is one key reason why we remain constructive on direct and indirect cyber plays.

Traditional players in the cyber security space will continue to benefit from macro trends and the regulatory focus on data governance/protection. Companies will need to adapt to the developing attack landscape and growing hacker sophistication, ranging from ransomware, social engineering and phishing, while expanding coverage of traditional firewalls to focus on NextGen cloud security and endpoint protection. Various capabilities important to the space range from identity access management, Internet of Things (IoT) threat management, detection and prevention. Opportunities to invest in cyber security outside of traditional technology names include defense primes, government IT service providers and multi-industrial companies—all likely to benefit from the pickup in public and private cybersecurity spending.

In the end, the very real reality of a more connected and tech savvy world has arrived— but with it, so have the susceptibilities and opportunities.

A Mess(i) market reaction to Argentina's election?

The primary elections held last month in Argentina sent a message: confidence in the current administration has wavered. President Mauricio Macri lost to opposition leader Alberto Fernández by a surprising 16-point margin in what had been expected to be a close race. Macri had been a symbol of pro-business economic reform for a country with a history of debt defaults, but the turnaround was incomplete. Even though he worked to improve economic data reliability, settled a 15-year debt dispute, and briefly lifted the economy out of recession, Macri was unable to attract foreign investment. A currency crisis in 2018 led Macri to seek the largest bailout ever provided by the International Monetary Fund (IMF) of more than $50 billion. Argentina is now facing rising unemployment, soaring inflation and falling incomes in a country where around a third of the population sits in poverty. Given the magnitude of Fernández' primary victory, it suggests voters lack trust in the current vision, but the markets seem to lack trust in what's to come.

Economic instability is nothing new for Argentina, which has spent over 40% of the past 40 years in recession with numerous bouts of debt restructurings along the way, generally hampering asset values. Recently, Argentinian assets found themselves embroiled in a more acute decline. The day following Fernández' surprise primary victory, the country's Merval index dropped 48%, while the peso lost 17% (Exhibit 3). The cost to insure Argentinian sovereign debt, as measured by five-year credit default swaps, soared nearly 370% in August to 4353 basis points (bps). For perspective, that's more than 2.5x the next riskiest issuer in the world (Zambia).6

The market outcry is traced to investor fears regarding future policy in addition to short-term uncertainty running up until the official election. While promising that there is "no possibility" of default if elected, not many seem to be taking Fernández at his word. In response to the brewing liquidity crisis, the current administration has instituted capital controls to preserve reserves and deposits while "reprofiling" external debt. An additional disbursement of $5.4bn from the IMF in September would help matters, but keen attention will be paid to economic policies of the next administration, in particular their reception by the IMF and fiscal credibility. The situation in Argentina is important to understand, in our view, given the exposure some institutional investors have in the country's bonds. In addition, a more stable Argentina is needed to improve Emerging Market investors' appetites for risk in the coming year.

Exhibit 3: Market Chaos Following Argentina's Primary Elections.