How Much Of The Future Can We Borrow For Today?
Ben Bernanke wants you to borrow and spend today. He also wants you to stop buying safe investments like Treasuries, CDs and anything else with a guarantee attached. He wants you to buy corporate bonds, junk bonds and stocks. He really, really wants you to buy a house. What he doesn’t want you to do is save or pay down your debts or anything else that might allow you to spend more at some indeterminate time in the future when he isn’t the Chairman of the Federal Reserve. The Presidential candidates also want you to spend today and stop thinking about tomorrow, although Mitt Romney would be happy if you held off until early November.
Economic policy since the beginning of the crisis has all been designed to force you to do something today that you might be planning to do tomorrow. Cash for clunkers was designed to get you to buy a car today. The home buying tax credit was designed to get you to buy a house today. All the tax changes – reduced payroll taxes, the extension of the Bush tax rates, accelerated depreciation, etc. – were temporary and designed to force action today before taxes rise again. The Fed’s quantitative easing programs are intended to push up inflation and force individuals to buy now before prices rise more. Or if you prefer they are intended to reduce interest rates and entice you to borrow today and spend the money on a house or a car or an investment. Frankly, the Fed doesn’t care what you spend it on as long as you spend it today.
The obvious question that comes to mind is What About Tomorrow?
The sun’ll come out tomorrow
So you got to hang on till tomorrow,
come what may!
Tomorrow, tomorrow, I love you, tomorrow
You’re always a day away
Yes, tomorrow is always a day away and so it seems is the recovery we’ve been waiting on for the last four years. And so we keep borrowing a little more of tomorrow to get through today until….until what? Until there’s nothing left? Until tomorrow somehow generates more growth we can use today? What if tomorrow says no, you can’t have anymore?
Investing is always about looking forward into the future to see the possibilities, probabilities and payoffs. We don’t buy stocks today because of what companies did yesterday or today. We buy the stock of companies because of what they will do tomorrow or more accurately, what they will do in the far future. All investing is about discounting future cash flows back to today. When the sum of the future cash flows of a company is believed to be rising – absent any change in interest rates – so will the stock price. When the future cash flows of a company are believed to be falling, so will the stock price. This is true of the market as a whole too. When the future cash flows of the companies that make up the S&P 500 rise, so do stock prices. That’s why investors spend so much time trying to figure out how the economy will perform in the future. More growth tomorrow means more cash flow and higher stock prices. Less growth tomorrow means less cash flow and lower stock prices.
Since the Fed has limited ability to influence those future cash flows – at least in real terms – their main tool to affect asset prices today is to reduce the rate at which those cash flows are discounted. And they’ve done an admirable job of it too. With interest rates on safe investments at zero and real rates negative, any future cash flow at all looks appetizing to the yield starved investor. And so investors go out and buy the corporate bonds, junk bonds and stocks that the Fed wants them to buy. And voila, the Fed gets its wish for higher asset prices today which they believe will increase spending today. Unfortunately, if there is no change in the future corporate cash flows available to stock or bond investors, the only thing the Fed has accomplished is to reduce the future returns on the assets they’ve inflated through the change in the discount rate. Fed policy pulls forward to today the returns we would have enjoyed tomorrow.
And of course, we don’t really know how today’s Fed policy will change those future cash flows. If the Fed’s policies produce inflation – which seems to be the plan – there is the possibility that future cash flow in nominal dollars will rise too. On the other hand, inflation might just cause a rise in costs that reduces profit margins and actually decreases future cash flow. Or it is possible that revenues and costs rise together producing no change in future cash flow. We don’t know, and neither does the Fed, how inflation might work its way through the economy. One thing we do know though is that one day, interest rates will rise and those future cash flows will be discounted using a higher rate. And unless the Fed is right and inflating asset prices today increases spending not only today but also far into the future, stocks will have to fall.
One of the reasons I’ve turned more negative recently is that the higher stock and bond prices go, and the less rosy the economic future looks, the lower the future expected return on those assets. At some point, unless we get a change in economic policy that actually raises future potential growth – and therefore the long term cash flows available to investors – the potential return just doesn’t compensate us adequately for the risks of holding these assets. There is only so much return that can be borrowed from the future. And I see nothing in the economic statistics or current economic policy that makes me believe that the immediate future will be much better than what we’ve recently experienced.
I do believe that the very long term future for the US economy is fairly positive but only if we start addressing our structural problems today. Our population is still growing and we have a very productive workforce. We spend more on R&D and venture capital than the rest of the world. Technology continues to advance in ways we could only dream of a few short decades ago. Our rivals in the economic sphere are facing difficulties that are much worse than our own. In addition to all their other troubles, Europe and China are both in or approaching demographic declines that will make it difficult for them to compete with the US. But we can’t waste our advantages by continuing to borrow from the future and ignoring our very real problems in the present. We need to get our fiscal house in order and enact policies that focus on future growth. How we accomplish that isn’t as mysterious as the politicians and economists say but it is urgent. We’re running out of future from which to borrow.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: email@example.com or 786-249-3773.
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