When we started 2021, investors were holding onto hope—for a sustained economic bounce back, for assets to prove worthy of their valuations, for vaccines to enable a return to normalcy, and for policymakers to keep a steady hand. As we head into the second half of the year, those hopes have largely become realities.
Below, we take a look at how those developments shaped the investment landscape in the first half of the year. Let’s dive in.
- Markets: Reflation, realized.The market mood has been decidedly risk-on in 2021 so far. Broad commodities, boosted by reflationary dynamics and global demand for goods, are leading the way. Global equities are up double digits.
- This is the strongest 1st Half rally we’ve seen for broad commodities since 2008.
- Earnings have been the overwhelming driver of stock market returns in all regions (except China) as valuations have contracted.
- Since 1928, in years when the S&P 500 has risen 10%+ in the first half of the year, full-year returns finished positive 28 out of 30 times.
- Jobs: Plenty of progress to be had. By the time the United States had entered its most stringent lockdown period in April 2020, over 22 million American workers had been laid off. Midway through 2021, we’re still more than seven million jobs below peak pre-pandemic employment, with total non-farm payrolls having recovered only about two-thirds of lost jobs.
- If anything is holding back the labor market recovery, it may be workers’ willingness to get back to it. The Job Openings and Labor Turnover Survey (JOLTS) from April showed that U.S. job openings and the quits rate had reached series highs of 9.3 million and 2.7%, respectively.
- The leisure & hospitality sector represents ~33% of unrecovered jobs.
- COVID-19: The effective end of the pandemic for some, but an ongoing global tragedy. For most in the United States, the pandemic is effectively over thanks to quicker-than-expected vaccine rollout and the broad-based removal of restrictions. The situation continues to improve in many parts of the developed world, but both the global year-to-date case count and death toll already exceed 2020’s full-year totals (cases: 98.0 million YTD in 2021 versus 83.5 million in 2020; deaths: 2.1 million YTD in 2021 versus 1.9 million in 2020).
- Policy: Peak support has passed. Monetary and fiscal policy support “bazookas” yielded financial conditions (which measure how policy is transmitted to the economy) that are about as easy as they’ve ever been, which has helped sustain the recovery in 2021 so far. It seems that the only direction in which we can go from here is toward more restrictive policy, but we expect that to be a gradual process.
“Twin Deficits” Won’t Tank the Dollar
Many analysts have been thinking and writing about the “twin deficits” and whether the record-breaking size of those two deficits, combined, mean the US dollar is about to plummet versus other currencies.
Before we get into the weeds, a little background is necessary. When people talk about the twin deficits they are talking about the budget deficit plus the trade deficit. Combined, these two deficits were 22.8% of GDP in the year ending in the first quarter, easily the highest on record. Before the pandemic, the record high was 12.8% of GDP back in 2009. Before the Financial Crisis, previous peaks included 8.7% in 2004-05 and 8.0% back in 1985-86.
The reason they are called the “twin” deficits is that superficial Keynesian theory suggest they should go together. The idea is that if the United States runs a larger budget deficit, it should have higher interest rates, which should drive up the value of the dollar. In turn, a higher dollar means more imports (we can buy more stuff!) and lower exports (foreigners buy less because it costs them more to get dollars).
This theory seemed to work in the 1980s. Budget deficits grew under President Reagan, mostly because of more defense spending, and so did the trade deficit.
However, the theory fell apart in the 1990s, when the budget deficit fell (and even turned into surpluses). If the theory held, you’d expect the trade deficit to shrink, too. But that didn’t happen. In fact, the current account deficit, which is the most comprehensive measure of the trade deficit, hit a new peak at 3.9% of GDP in 2000, even higher than the peak of 3.3% in the late 1980s.
What this showed was that the old Keynesian theory behind the twin deficits was too superficial and the two deficits don’t have to move in tandem. What really matters isn’t whether the government runs a larger or smaller budget deficit; what matters is the set of policies the government is implementing. In the 1980s, the Reagan Administration cut tax rates, deregulated, and got inflation under control. All of these policies made the US a better place to invest. Those policies attracted capital from the rest of the world, which pushed up the dollar and also increased the trade deficit.
In the 1990s, a large combination of factors helped the economy and also reduced the budget deficit. These include lower inflation (which reduced the effective capital gains tax rate), the “peace dividend” (which allowed for less military spending), President Clinton holding to the federal spending caps inherited from President Bush, the failure of Clinton-care, enacting welfare reform and Medicare reform, free trade pacts, and the natural aging of Baby Boomers into their peak earning years.
All of these helped reduce the budget deficit, but they also made the US a better place to invest. And being a better place to invest meant a higher dollar and an increase in the trade deficit. So, in the 1990s, the twin deficits were not twins at all: the budget deficit went down and the trade deficit went up
Right now, the combined twin deficit is at a record high. But notice that almost all the increase is due to the budget deficit. The trade deficit is larger than it was a year ago, but is roughly the average it’s been for the past twenty years.
Now, ask yourself, since the onset of COVID, since when the budget deficit has soared, has the US adopted policies to improve its long-term growth potential? Have we cut tax rates? Have we deregulated? Have we reigned-in or reformed government spending programs or made them more actuarially sound? No, we have not, unfortunately. What we have done is spent future taxpayers’ money like there is no tomorrow to generate some extra economic growth in the short-term.
The pandemic-related policy set in the US is not as dollar friendly or investment-friendly as what we did in the 1980s or 1990s. However, because every other country has done similar things, the US is a relative safe-haven for economic activity versus others.
Considering all this, we do not expect a massive increase in the trade deficit to match the surge in the budget deficit. The lack of a massive trade deficit to match the budget deficit is important for forecasting the dollar because a massive trade deficit could put political pressure on the Federal Reserve to reduce the exchange value of the dollar by postponing rate hikes. Again, we don’t see that happening.
But at least it brings us back to what really matters for predicting future changes in the value of the dollar: monetary policy. Forecasting changes in the dollar is probably the toughest part of managing assets. And, right now, we are not forecasting the dollar to either plunge or soar in the next year.
The one thing we do know is that if the dollar does make a big move in either direction, it won’t be because of what we already know about the twin deficits.
Did You Know?
– 33% of the $7.25 trillion that the US government is forecasted to spend in the 2021 fiscal year are outlays for Social Security, Medicare and Medicaid (source: Budget of the U.S. Government released 5/28/21).
THEY MUST NOT BE TOO WORRIED
– 3.99 million Americans quit their jobs in April 2021, the largest monthly “quit level” recorded in US history (source: Department of Labor).
Success is walking from failure to failure with no loss of enthusiasm.” – Winston Churchill
“Much of the difference you make tomorrow will start with what you do today.” – Ernie J Zelinski