Welcome to Season 2, Episode 11 of Meet the Expert with Elliot Kallen®!
Elliot Kallen and Lara Rhame discuss the federal deficit crisis, the current macroeconomic, policy and financial trends, and what Baby Boomers need to do to secure their retirement.
Managing Director and Chief U.S. Economist, FS Investments
Lara Rhame is Chief U.S. Economist and Managing Director on the Investment Research team at FS Investments, where she analyzes developments in the global and U.S. economy and financial markets.
What’s going on in the U.S. economy in general?
We’re in a holding pattern right now; we’re all taxiing for takeoff. We’re seeing mixed messages for growth, and we’re also beginning to see rapid, strong acceleration to robust liftoff later in the year.
We’re seeing a lot of pent-up consumer demand. But is this enough to supercharge the economy?
There has been concern about the different COVID-19 variants, inconclusive answers about vaccine efficacy, and more. Despite mass vaccinations, we aren’t expecting an instant economic recovery. It’s very likely that we’ll experience lingering effects of the pandemic for some time.
For instance, COVID-19 has changed the way we do business and interact with each other. When we look at the travel industry, it’s unclear whether international travel will return by the end of 2021. It remains to be seen how much of “normal life” will return. It could be a multi-year process before we start to see huge parts of our economy — air travel, vacations, tourism, conferences, concerts, sporting events — return.
High cost-of-living (HCOL) cities like San Francisco and New York City, which used to hold the most high-paying jobs, have been hit the hardest. Work-from-home (WFH) policies have allowed folks to move out of a HCOL area. We’re just at the beginning of these multi-year changes that will start to take place
Increasingly, the reality is descending upon everybody that we’re not just going to flip a switch and go back to where we are — vaccine or not.
How will WFH impact the prices of commercial real estate?
As of now, we’re seeing a negative impact on the prices of commercial real estate. We’re also seeing pressure on banks to forgive commercial mortgages. And later down the line, we may start seeing a negative impact on the prices of residential real estate, and certainly on commercial loans and lending.
What do you predict will happen in commercial real estate?
Real estate investment managers still believe there’s opportunity in commercial real estate. Office buildings in the suburbs are doing well because people are moving away from the city and companies are happy to move to the suburbs.
When leases are up and not renewed, we’ll continue to see the paradigm shifting away from big city centers and towards suburbs.
How does civil unrest undermine local economies?
A number of America’s largest cities are seeing a lot of social unrest and increasing rates of homelessness. What changes do you predict on a macroeconomic scale?
A lot of cities and states have difficult budget situations. All of these pressure points were pushed right over with COVID-19.
For one, you’ve had so much movement out of the high-tax states. For example, California levies high taxes to fill budget gaps, and saw a mass exodus during the pandemic. About half of the largest 20 cities have experienced significant drops in rent, some of which include Miami, Downtown Dallas, Chicago, San Francisco, and New York City.
In Philadelphia, where I live, residents were able to escape the 3 percent wage tax by working from home in further suburbs.
It’s also a very local story — in Philadelphia, the rents have not fallen significantly because former NYC residents relocated down to Philadelphia. And because Philadelphia has a smaller supply of high-quality housing, not a lot of properties have gone vacant.
What’s going on with the federal budget deficit?
For the last 12 to 14 months, the Fed has been pouring huge amounts of money into the economy. For the first time, the total debt of the U.S. government surpassed the GDP — which is a staggering number! We’ll easily pass $30 trillion of total debt by the time Biden leaves office. What does that mean for our economy, moving forward?
This even predates Biden. Before the pandemic, we saw a significant rise in spending. Then the pandemic happened, and after spending another 3.5 to 4 trillion dollars, we passed 100 percent of GDP in U.S. government debt outstanding. We’ve now shot up to 125 percent of U.S. GDP in debt outstanding.
Can that pace be sustained? No. It’s just not feasible. And hopefully it won’t be necessary if we can just get the economy to a place of more normal, stable growth.
A helicopter drop approach doesn’t work for long-term stimulus. Politicians like sending checks because it’s popular and easy to understand, but what we really need is a solution for the infrastructure problem. Three administrations have passed through the White House and it’s because of the intransigence of the system in Washington DC that we can’t get any real, meaningful infrastructure investment passed.
So, from the deficit side, there’s no sign that it’ll fall anytime soon.
Who’s going to pay for the stimulus and coronavirus bailout?
Right now, interest rates are at historical lows. If the government is going to take advantage of low interest rates and issue debt, this is the time to do it. The Fed is buying huge amounts of government debt, which gives the government an open door to continue spending because the Fed is absorbing it all.
Should we be concerned about inflation?
The U.S. economy and federal budget have been battered by the pandemic. On top of massive economic disruption, the government’s response has pushed the federal budget further out of balance than it’s been in decades. Is inflation a concern?
As far as inflation and hyperinflation, that’s not a big concern. We’ve seen other countries experience what we’re currently experiencing — like Japan — the government deficit is much higher, and debt is a much higher percentage of GDP. The central bank owns it all. You don’t see problems with inflation; in fact, Japan is struggling with disinflation.
The bigger concern is five years from now, in 2026. Many of the Baby Boomers will be spending their savings. They won’t have this demand for safe assets; instead, they’ll be selling it all off. Interest rates will naturally rise more than we’ve seen in some time.
The government is going to have to crowd out every other kind of spending because they need to service the debt. That includes spending on defense and basic services for the country; they’re just going to find themselves unable to spend on anything else except for servicing the debt.
This is a concern when it comes to GDP. It gives us less wiggle room in the future recession 10 years from now.
Today though, near term, we have bigger problems than the federal deficit.
What should we expect as the national debt continues to tick upward?
Someone is going to have to pay for all this deficit that we’re accruing. It’ll probably be our children. We’re at 125 percent of GDP in annual deficits; at some point, we’re going to be 200 percent. What’s next for the nation?
The reality is, if you’re really worried about the federal deficit, you need to save more. The federal government may not be able to give you the same benefits that they have given our parents. They aren’t going to be the safeguards for us in old age. Baby Boomers need to save now if you’re worried about the government’s ability to provide for you in the future.
How will Biden’s proposed tax hike affect Americans?
President Biden released his proposed 2022 fiscal year budget which called for an increase of the top capital gains tax rate to 39.6 percent. Top earners may pay up to 43.4 percent on long-term capital gains, including the 3.8 percent Obamacare surcharge.
He’s also proposed doing away with Section 1031 like-kind exchanges.
If taxes start going up at the state and federal levels, that’s going to change how much we can spend and save. We’re concerned, and our clients are concerned.
Our Washington D.C. team believes that a really dramatic rollback of tax cuts is unlikely. Biden knows that they’re popular, but the majority in the Senate is narrow.
And yes, income inequality has gotten a lot worse. But instead of trying to address it with some dramatically higher tax rates for large swaths of higher-income households, what he’s going to try to do is to get some movement on the minimum wage, better services, and spend more for services that help raise the lowest quartile of households — not as much diminish the highest quartile of households.
These new administrations really have limited time to accomplish anything before the midterm cycle begins again.
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What’s the stock market outlook for the rest of 2021?
Except for April, March and May, equities have had a really good run. Last year they had an unbelievable run powered by technology companies. FAANG is powering our economy. Is this sustainable?
LR: No one knows. The reason it’s been so strong is the falling interest rate of last year. 0 percent interest has pushed people so far out on the risk curve that they are “all in” on equities.
Markets have priced to assume this is a near-term disruption in earnings, but by Q4, we’re going to be back to pre-COVID times. That’s a pretty good earnings outlook.
Now, one of two things can happen:
- If long-term interest rates rise much past 2 percent — and with our deficit, we might even see 2.5 percent — you start to see people realize that all of the volatility in the equity markets really isn’t worth it. Investors will begin to shift toward more stable investments.
- The Fed has thrown $4 trillion of liquidity at the equity markets. That’s just a staggering number. If you squeeze the donut, the jelly’s gotta go somewhere! The markets are hypercharged right now. And any sign of that rolling back will have just as big of an impact.
I’m very bullish on equities next year. Whether tech is going to be the leader, or we get a violent rotation in leadership, that’s a significant question for the coming year. However, it’s going to be a rough ride.
What advice do you have for the conservative investor?
We’ll end higher than where we started, but it could be painful along the way. I think it’s going to be most painful for the conservative investor. The investor that’s 60, 80 or 100 percent in bonds — not looking for volatility — isn’t going to have a lot of options. You can’t put them in convertible bonds or high-yield; that’s too much volatility. You can’t put them in inflation-related bonds; there’s not enough inflation to make any money. U.S. Treasuries and core bonds are going to go down in value. So, where does the conservative investor go?
LR: There’s the need and room in portfolios for that fixed income piece. You just have to be much more tactical.
We’ve seen a lot of significant inflows back into floating rate products. This is a class of assets that’s seen significant outflows in the last several years. There are rumors of the Fed raising rates at some point. Expectations for rate hikes by the end of 2024 have gone from 1 rate hike to over 5 rate hikes. In an environment like this, floating-rate notes are an important way to hedge yourself against higher interest rates.
High-yield is really interesting. It’s performed well, but it’s not the fifth percentile of historic valuation like equities are. There’s still room to go there within high-yield.
But the spread between high-quality high-yield and lower-quality high-yield is very wide. That means there’s still room for that gap to close on the risk frontier.
Conservative investors have been overly complacent that equities only go up. If we get a year of turbulence, the conservative investors are going to fare very badly. That means you need to shorten your duration risk. Go for the real estate fund, the floating-rate base with the shorter duration.
Hiring is weak. What’s happening with the national labor shortage?
60 percent of our clients are entrepreneurs. We all know that outside of the cost of insurance, labor rates are the dominant expense to a company. There is pressure in California and New York to increase wage rates, and workers expect more raises than ever before. Can a small business survive if labor and wage prices continue going up?
LR: The real problem with labor is that you’ve got a small group that’s better-educated, has technical skills, has office skills, and has more higher-end service-oriented skills.
Then you have an enormous group that doesn’t have those skill sets.
At the broadest level, job openings have declined, there are still 9 million people out of work. There are another 4 million people who’ve just dropped out of the workforce.
It’s a deep structural problem. You can see it in the student loan debt crisis. The idea that everyone needs a college education is untenable.
Vocational careers are a necessary part of our economy. You’ve seen companies, like Boeing and large automakers, who’ve created yearlong vocational programs with apprenticeships that cost a fraction of college and give people a higher manufacturing wage.
We need to think of ways to rearrange the economy. The answer is not giving people a $15 minimum wage. The answer is giving them a cheap, useful education that they can use toward a vocational career.
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