by Jurrien Timmer, Director of Global Macro, Fidelity Investments
Key takeaways
- The Fed and other central banks have successfully guided the market through the decline and emerging recovery with quantitative easing. The net effect is lower interest rates and a lower dollar with increasing inflation expectations.
- The same process was used in the 1940s to offset the increase in federal debt due to World War II. Though the backdrop was different, the similarities could mean that equities could continue to recover, interest rates could stay low, and the economy could pick up speed.
- But nothing is freeāhistorically, periods of rising federal debt have led to periods of higher taxes.
One of the most noteworthy aspects of the "COVID Crash" has been the success with which the Fed and other central banks have been able to first stem the market's decline and subsequently help control the emerging recovery.
Case in point, the chart below shows that while inflation expectations have been marching higher and credit spreads have continued to tighten, this has not come at the expense of higher nominal yields, which last week fell to 0.50%. As a result, real rates, as measured by the TIPS (Treasure Inflation-Protected Securities) real yield, have been falling further below zero. The 10-year real yield in the US is now ā1.04%, a level not seen since just prior to the Taper Tantrum in 2013.
Typically, nominal yields will fall when deflationary pressures mount and then will rise as animal spirits return in the form of higher TIPS breakevens. That has not happened so far. So far it has been a reflationary free lunch of falling nominals and rising inflation expectations, leading to negative real rates.
Perhaps the bond market is sending us a deflationary signal which has thus far gone unheeded by credit spreads, TIPS breakevens, and equities. That's a favorite argument among the bears, but, in my view, a more likely scenario is that the Fed is successfully repressing nominal rates with a combination of quantitative easing (QE) and forward guidance.
In the process the Fed is devaluing both the US dollar and the rapidly rising federal debt load. Second to a growth/productivity miracle, devaluation through negative real rates is a central bank's favorite way of managing debt.
The 1940s
The current backdrop continues to remind me a bit of the 1942ā1946 QE cycle (not that I was there, of course). Following the Great Depression of the 1930s, in 1942 the US government went into high gear to enter World War II (following the attack on Pearl Harbor), and in the process ran up a massive amount of government debt. Federal debt as a percent of GDP increased from 39% to 116% during the first half of the 1940s.
Not only did the Fed monetize this debt by increasing its balance sheet 10-fold, but it also repressed the entire yield curve by capping short rates at 3/8% and long rates at around 2.5%. During this period, inflation ran up, but with the Fed repressing rates at very low levels, real rates were on a steady march to increasingly negative levels. Sound familiar? Not the war part, of course, but the debt/QE/repression* part.
Let's take a look at some charts. A good way to measure how equities fare in a reflationary "money illusion" is to price the market in gold terms, which is what I have done below. During the 1940s the US was on its "adjusted" gold standard (with gold fixed at $35), so for this exercise I am deflating the 1940s market by the Consumer Price Index (CPI), while for the current cycle I am deflating it by gold. Not apples-to-apples I admit, but, I think, a fair proxy for a "reflation-adjusted" analog.
The chart below shows the S&P 500 (SPX) today vs. the 1940s. The solid black line shows the SPX gaining 46% from the March lows through last Friday. However, in gold terms the SPX is only up 7% from the March lows. That puts it right on par with the 1942 cycle, which is one reason that this analog is so interesting.
Another reason is in the bottom panel, which shows real rates. For the current cycle I am measuring this as the 10-year TIPS real yield, and for the 1940s, I am measuring it as the nominal yield minus the 5-year inflation rate. Again, not apples-to-apples, but there was no TIPS market back then and I wanted to show what investors are expecting right now (as opposed to waiting for the CPI data to come in). I use the 5-year inflation rate to smooth out the extreme war-related volatility.
As you can see, not only is the reflation-adjusted price behaving the same, but so are real rates.
Now let's look at the Fed's balance sheet. The chart below shows the percentage growth from the 1942 low. Again, a close similarity between now and then. Negative real rates plus massive balance sheet expansion is the ultimate reflation, and that's what the Fed did in the 1940s to offset the increase in federal debt. During the 1942ā1946 period the Fed increased its balance sheet 10-fold.
Now, one caveat here is that the starting point for the Fed's balance sheet in the 1940s was much lower than it is now. In 1942, the Fed's balance sheet as a percent of GDP was a mere 2%, whereas today it is 36%. I'm not sure how that might affect the outcome, but it's possible that the Fed will reach the point of diminishing returns faster this time around, much like the Bank of Japan did a few years ago when its balance sheet grew to 100% of GDP.
During the 1940s the Fed was able to control short rates for a multi-year period to within just a few basis points, hovering around 0.40% to 0.38% between 1942 and 1945.
One major difference between then and now is that the yield curve was much steeper then, at around 220 basis points (bps). A basis point is 1/100 of a percent. This time it is a mere 44 bps. It makes me wonder if the Fed thinks it has created too much of a good thing on the rate front. After all, it will be difficult for banks to be profitable if both rates and the yield curve are near zero.
While the above charts suggest that the Fed is creating a successful reflation which will continue to drive stocks higher, one important caveat is valuation. The market was orders of magnitude cheaper back then, as one would expect following the Great Depression.
Today the equity risk premium (ERP) is at 3.7% after peaking at 6.2% in late March. (The ERP is the additional return that investors expect to earn over Treasury bonds or the risk-free rate of return). Back in 1942 the ERP stood at 11.1% when the market bottomed. That equates to a trailing P/E ratio of 7.4x (vs 23.7x today). From the 1942 low, the ERP improved rapidly to 7.7% by the time the analog overlays to today. Ultimately it fell to 4.5% in 1944, which is in line with historical averages.
This stark difference in the valuation backdrop is certainly a caveat to the otherwise bullish implications of the SPX price analog. From 1942 to 1945 the real SPX price index gained 80%, coming off a 7.4x P/E at the low. We don't have that low starting point luxury today.
Debt and taxes
The above charts show an interesting analog for today's dynamic of rapid debt accumulation and the Fed's mitigation through QE and forward guidance (financial repression). One thing that we can learn from history is that the "price" for rising debt can be higher taxes, at least it was prior to the 1980s. The chart below is an annual plot going back to 1900. It shows debt-to-GDP in the top panel, and marginal tax rates in the bottom (personal income, capital gains, and corporate).
Note how tax rates skyrocketed during World War I, and then again during the Great Depression and World War II. In all those cases the run-up in debt appears to have led to a big increase in tax rates. That's certainly something to keep in mind as debt levels keep rising during the current cycle.
Especially the "New Deal" decade of the 1930s could be relevant to today. That was a decade of mean-reversion from the imbalances of the Roaring Twenties (when the "business of America was business"). The 1920s led to rising wealth inequality and an increasing emphasis of capital over labor. Those same issues are center stage again today, so this could be an important analog. During the 1920s the Republican party controlled both houses of Congress as well as the White House, but the pendulum swung all the way to the other side when FDR took over in the 1930s.
As for the very high tax rates in the chart above, an important thing to keep in mind is that the top marginal tax rates during the 1930s and 1940s applied only to very high-income thresholds. For instance, in 1932 the top marginal tax rate was raised from 25% to 63%, and then in 1936 it was raised again to 79%. However, the income threshold to which that rate applied was $5 million, which in today's dollars would be $77 million!
With that as a backdrop, it is worth noting that in 1942 when the US started ramping up for the war, the top marginal tax rate was raised again from 88% to 94%, while the income threshold was lowered from $5 million to $200,000! While $200,000 in 1942 dollars is still $2.6 million in today's dollars, that is a serious tax hike. That's wartime fiscal policy for you.
Yet, this tax hike did not prevent equities from embarking on a powerful bull market. As my Fidelity colleague, Denise Chisholm, has recently pointed out, tax hikes have to be taken in context and are not always bearish for equities.
In summary
The 1940s are in many ways not a great analog (nothing is), as there are many differences between now and then, including wartime productivity and employment growth, demographic trends, and the aforementioned valuation backdrop. Also, back then the rapid rise in debt started at a much lower point than today (39% of GDP then vs. 107% today), as did the Fed's balance sheet expansion. That suggests to me that today's debt/QE dynamic is more likely to produce diminishing returns.
At the same time, there are compelling similarities as well, and therefore I think it's a useful analog to keep in mind. While many analysts will point to the 1930s when they talk about debt bubbles, there is in fact a precedent for a large debt increase that was successfully "absorbed" by the Fed through a combination of quantitative easing and financial repression. It is possible that it could happen again, with all the caveats mentioned above.
If so, equities could continue to recover while rates stay low, credit spreads tight, and real rates negative. And with this dynamic, precious metals could continue to gain while the dollar continues to decline. They are all real-time barometers for this fiscal/monetary experiment, as is the real-vs.-nominal yield chart shown at the top of this report.
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About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
