In a Time of Fiscal Dominance, the Market Cares About Spending More Than Who Wins
On Aug. 10, TradeSmith Daily explained two terms every investor should know: Financial Repression and Fiscal Dominance.
To briefly summarize them, financial repression is when a central bank deliberately keeps interest rates low — ideally below the rate of inflation — to inflate away the value of debt. This is a means of coping when a nation’s debt load becomes too large.
Fiscal dominance, which often goes hand in hand with financial repression, is the term that describes what happens when government spending dominates the landscape, and central bank monetary policy is forced to accommodate that spending.
In normal times, central bank monetary policy can focus on stable inflation rates, full employment rates, or other measures that keep the economy running smoothly.
In times of fiscal dominance, the government is spending so aggressively that central bank decision making is dominated by a pressing requirement to manage the flood of new debt (or new currency creation, which amounts to the same thing).
The 2020s will be a decade of fiscal dominance because the U.S. economy is too weak, and too debt-burdened, to stand on its own. If the government fails to keep spending, the economy is at risk of imploding under the weight of all the debt that has already been piled on top of it.
At the same time, millions of unemployed workers who have not had income for months are reaching the end of their savings, and a great many small businesses are maxing out their emergency budgets.
For a sovereign country, fiscal dominance is typically a forced state rather than a voluntary state. Meaning, if a government is forced to spend wildly, with debt levels already high, it is probably doing so to keep the game going and has no other choice.
The U.S. stock market knows this stuff. A complex adaptive system can’t literally “know” something, per se, but the stock market is responding to government spending, or the lack thereof, more than any other variable now.
From a stock market perspective, more government spending (active fiscal policy) is good, because it keeps the game going. A halt in government spending (shutting off the taps) is bad, because it means the U.S. economy could implode, and market liquidity could dry up.
The stock market remains bullish, with the major U.S. indexes pushing to multi-month highs this week, because it expects the spending to come — if not before the election, then not too long after.
In the past few weeks, we’ve seen exactly how government spending, or the lack thereof, is driving the economic narrative. This also applies to the stock market, as we can more or less observe in real time.
- When it looked like another big round of fiscal stimulus was coming, as negotiated between House Speaker Nancy Pelosi and U.S. Treasury Secretary Steven Mnuchin, the market was happy about that.
- When President Donald Trump tweeted his intention to outright cancel the talks prior to the election — a bizarre move — the market instantly tanked (as noted earlier this week).
- But then the president seemed to quickly change his mind, tweeting about airline bailouts and the Payroll Protection Program (PPP) funding later that evening, and the market decided he was blustering or bluffing.
On Thursday, the market surged higher, confident the taps were still open — and the president confirmed the market’s instincts.
“Within a day of tweeting that he was calling off bipartisan talks for a coronavirus stimulus deal,” Axios reported on Thursday, “President Trump phoned House Minority Leader Kevin McCarthy and indicated he was worried by the stock market reaction and wanted a ‘big deal’ with Speaker Nancy Pelosi…”
So now the market is hopeful for near-term stimulus — and even if nothing is done immediately, the market seems increasingly confident that heavy government spending will occur in 2021, under a unified Democrat consensus via “Biden Sweep” (the scenario where Democrats control the White House, the Senate, and the House of Representatives).
The idea that regime change in Washington could be bullish for stocks is confusing to some investors, who are used to thinking of Democrats as pro-labor and thus anti-stock market. The New York Times caught the flavor with a recent article headline: “Wait, Wall Street is Pro-Biden Now?”
We would say no, actually, Wall Street is just pro-government spending, because spending means lots of new liquidity, some of which will inevitably slosh into markets.
If a flood of new currency is pumped into the economy via new congressional spending, and better yet “helicopter dropped” directly into consumer wallets, the stock market boom can continue.
Monetary policy alone can’t always rev up economic activity. This is because, to get things moving, either the banks have to lend, or consumers have to spend — and ideally both should occur.
Without seeing credit creation via new lending, and money moving through the system via consumer purchases and profitable business transactions, monetary liquidity just pools in bank vaults, like stagnant water reservoirs left untouched.
The central bank, meanwhile, cannot force the banks to lend or hunkered-down consumers to spend. They can only encourage the process with cheap money, ample financing, and low interest rates. A lender of last resort has no power if nobody wants to borrow or spend.
Congress, however, is different. When the government chooses to borrow directly, and spend directly or hand out cash, that changes the game.
If an unemployed American with a threadbare bank account gets an extra $2,400 per month in spendable funds, for example, those funds will be used to buy necessities and pay rent. The funds will then flow to landlords and businesses and start moving through the system.
The same holds for small businesses that take government funds. If it is Congress that borrows, and cash is handed out, chances are good the cash will be spent, which then creates monetary velocity as the cash moves through the system. This is why everyone (or almost everyone) wants government spending these days: Interest rates at zero can only do so much.
And for workers and businesses who don’t really need the funds that Congress sends their way, that extra liquidity is likely to wind up in financial assets. That is the part the stock market likes.
When government spending and currency creation get out of control, and the currency winds up in the hands of citizens and businesses that will spend it, rather than banks that won’t lend it, share prices tend to go up.
This has long been true across different countries and historical periods. For example, in the Weimar Germany hyperinflation years, stock speculation was rampant, at least prior to the final stage.
In the window of time where a currency’s value is falling rapidly, but hasn’t yet reached a point of oblivion, nominal equity prices can rise dramatically. For this reason, fiscal dominance can be a market-bullish phenomenon.
This is also a function of attractive businesses holding a store of value, even as the underlying currency sees a steady loss of value.
Say that, over the course of a few disastrous years, the value of the dollar falls 50%. Would that mean, say, the value of Amazon (AMZN) shares (which are priced in dollars) should also decline 50%? The clear answer is no, because that would not make sense.
If Amazon retains attractiveness as a world-class store of value, and the relative worth of the U.S. dollar is cut in half, it would make more sense for Amazon’s shares — which are still priced in dollars — to double as compensation for the currency erosion.
If that sounds weird, try to imagine a 50% fall in the dollar as functioning like a reverse stock split. If it suddenly takes twice as many dollars to buy shares as it did before, then, all things being equal, dollar-denominated share prices should double to make up for it.
It is never quite that simple, but the basic idea holds. Part of the reason that share prices rise when a currency melts down is because, to the degree that underlying companies remain attractive as stores of value, their share prices, which are valued in depreciating currency, should adjust upward.
What this also implies is that, if the stock market goes up in the presence of rampant money printing and heavy government spending, that doesn’t have to reflect a bullish economic outlook.
It might, in fact, reflect a terrible economic outlook, with upward stock price movement an inverse reflection of downward currency movement. It certainly wasn’t a bullish economic outlook that drove the roaring markets of the Weimar Germany period.
If the government sends large sums of currency to households in 2021, and does so without igniting strong economic growth, that could also create “stagflation” — a 1970s-style situation where prices are rising at a fast clip due to shortages and supply-chain gaps, but the economy is still struggling.
But even in that 1970s scenario, there are areas of the market that will do extremely well, and companies that could see their share prices soar.
A key theme here is that, in times of fiscal dominance, Wall Street becomes politically agnostic. The policies still matter and can have very different impacts on different areas of the market.
But in the big-picture sense, in a fiscal dominance era, the markets care much more about government spending — and spending policy consensus versus spending policy gridlock — than they do about which political party controls the levers of power.
The era of fiscal dominance we are now in — which could easily last the whole decade — will reflect government spending activity in the untold trillions, not just in the United States but around the world.
Wall Street just wants the taps to stay open — because oceans of currency sloshed directly into bank accounts will slosh into markets, too — and Wall Street’s biggest fear is seeing those taps shut off.