Photo Credit: ByLorena
In a week that saw NVIDIA, the largest company in the world, report strong earnings that sent its stock sharply higher and reinvigorated optimism in the artificial intelligence (AI) trade, fiscal and monetary policymakers continued to provide the biggest headlines. This was especially true on Friday, when Federal Reserve Chair Kevin Warsh took the stage at the Federal Reserve Bank of Kansas City’s annual Jackson Hole Economic Policy Symposium and provided insight into both the principles he believes should guide the monetary policy framework and his much-awaited assessment of the current U.S. economy. Taken together, these developments help frame the investor question we believe matters most: how the economy and markets transition from a post-Great Financial Crisis (GFC) era defined by aggressive monetary and fiscal support to one in which both policy levers may be more constrained, and what that means nearer term for growth, inflation, rates and market leadership.
Long Term
The post-GFC era, from 2009 until today, has been marked by a seemingly never-ending expansion of monetary and fiscal policy “intervention” as policymakers attempted to revive a badly bruised U.S. and global economy, one that Chair Warsh reminded us was widely believed to be in a period of secular stagnation. After pushing rates to zero, the Federal Reserve (Fed) repeatedly embarked on large-scale bond purchases that expanded its balance sheet, commonly known as quantitative easing, while also providing forward guidance on its potential future actions. In many ways, both tools were designed to compel investors and economic actors to take risk and pull the stagnant economy higher.
On the other side of the equation, fiscal policymakers, on a bipartisan basis, continued to provide a healthy amount of stimulus to the economy. The result has been a continued increase in U.S. debt held by the public to roughly $32 trillion, or about 100 percent of GDP, the highest level since the end of World War II. The cost of this aggressive monetary and fiscal policy mix appeared minimal for much of the period because the Fed was trying to push inflation up to its 2 percent target while the interest cost on Treasury debt was moving lower, keeping annual interest expenses contained.
Those two realities likely helped contribute to the incredibly strong run in equity markets, during which nearly every economic threat, including COVID, proved remarkably short-lived given the large amount of stimulus that was deployed in response to almost every problem. This shaped our outlook during that period. We certainly believed the economy and markets could experience hiccups, but we also believed those disruptions would likely be short because of the sheer amount of stimulus policymakers were willing to throw at any meaningful pullback. Longer-term followers will recognize this discussion from our COVID-era outlooks, when we expressed our optimism that equity markets would snap back quickly as policymakers unleashed an extraordinary amount of stimulus to bridge the economy through the shutdown.
This is where last week’s fiscal and monetary policy pronouncements may herald a meaningful shift for investors to contemplate. Early last week brought additional information on the potential for the U.S. Treasury to intervene in bond markets in an attempt to pull down yields. On Monday, CNBC reported that two senior Treasury officials said the Treasury could use its nearly $1 trillion Treasury General Account to help fund longer-term Treasury buybacks, thus increasing the “firepower” to pull yields lower from the original $4 billion commitment. While much of the discussion focused on whether this would work, we believe the more important question is why it is being considered.
This is where rising Treasury debt is now being met with higher interest costs. Consider that the average interest rate on outstanding U.S. Treasury debt is 3.44 percent, up from the recent low of 1.42 percent in January 2022 and the highest level since September 2008, just before the GFC ushered in a period of heightened debt growth. This has pushed annual net interest expense on U.S. Treasurys to more than $1 trillion, an amount now larger than what we spend on defense. It represents 3.1 percent of annual U.S. economic output, placing it in a near dead heat with 1991 as the highest level in data going back to 1940. Complicating the future reality is that the entire U.S. Treasury yield curve now ranges from roughly 3.7 percent to 5.2 percent on the 30-year Treasury. Simply put, each additional dollar of debt now increases U.S. interest costs. This helps explain the administration’s desire for lower yields and the broader effort we discussed in last week’s commentary to create additional demand for Treasurys, including through stablecoin legislation and actions tied to foreign Treasury demand.
Warsh’s comments fit squarely into this same broader transition. He has spent much of his recent past highlighting concerns about the Fed’s repeated use of quantitative easing, and he used much of his Jackson Hole speech to sharpen his critique of forward guidance. Indeed, he committed to ending forward guidance, which he noted was adopted by him and his colleagues during the GFC and was “essential then” but which he now believes has overstayed its welcome. Most notably, he stated, “Markets should form their own expectations of output, employment, and inflation and stay sharply attuned to risks.” That is a meaningful shift from the post-GFC framework and one that investors should not dismiss. Quantitative easing and forward guidance were designed, at least in part, to lower perceived risk, encourage investors and economic actors to take more risk, and use stronger asset prices and easier financial conditions to help pull the broader economy higher. Importantly, he discussed not only how forward guidance can limit the Fed’s ability to move, highlighting the slow response to inflation in 2021 as an example, but also what he called a “hall of mirrors” problem. In his view, forward guidance can create blindness and unpreparedness for future events, raising the likelihood of policy errors. As he noted, “The most serious harm is likely to befall those without financial assets.” Put differently, if the Fed gets inflation wrong, it is not financial high fliers who bear the greatest burden. It is hardworking Americans who are left to deal with inflation that is too high or jobs that suddenly appear less secure.
This is why we believe the secular backdrop is changing. The good news is that artificial intelligence (AI) is pushing growth higher and creating the potential for meaningful productivity gains over time. The bad news is that both monetary and fiscal policymakers may be less able—or in some cases, less willing—to provide the same level of stimulus to the U.S. economy in the future. While we remain optimistic about both the U.S. economy and markets over the long term, the reality is that forward equity returns may be lower and economic and market hiccups may last longer than investors have become accustomed to. Put simply, we believe buying dips remains a viable long-term strategy, but the gratification from doing so may be less immediate.
Near Term
The economic data last week confirmed much of what the Chair discussed: a strengthening economy supported by healthy AI capital investment that has remained resilient despite repeated shocks, alongside a stable labor market that appears to be meeting the Fed’s mandate of maximum employment. That backdrop matters because Warsh made clear that the Fed remains committed to returning inflation to target. While many have wondered which inflation measure the Fed may emphasize, he stated, “The Fed’s price-stability objective of 2 percent, as measured by the personal consumption expenditures (PCE) price index, is a firm, fixed target.” Recent inflation data did little to change that view. PCE inflation checked in at 3.7 percent year over year for July, with the six-month annualized pace at 4.1 percent. He also noted, “While this summer’s PCE and Consumer Price Index (CPI) readings were better than expected, they do not tell me that underlying trends have meaningfully improved,” and he reminded listeners that inflation has been above the Fed’s 2 percent target for 65 straight months.
Just as important, Warsh said he would be “hard pressed to describe broad financial conditions as restrictive.” Taken together, above-target inflation, resilient growth, and financial conditions that are not clearly restrictive help explain why markets increased the odds of additional tightening. The result was an uptick in rate hike expectations, with markets pricing in a 57 percent chance of a 25-basis-point increase at the September meeting, up from 36 percent, while also adding another 25-basis-point hike by March.
This brings us full circle. We have long stated that AI has become more interest-rate sensitive given the large amount of debt and equity capital needed to bring it to life. Unlike earlier stages of the technology cycle, when investment could be funded largely from free cash flow, the current buildout may be more exposed to future rate increases. This reality raises risks to both the AI story and the broader U.S. economy if the Fed is forced to embark on a series of rate hikes to quell sticky inflation.
But the investor risk is not just about interest rates. It is also about where the value from AI ultimately accrues. Warsh’s comments on AI rhyme with our plea for investors not to become overconcentrated or overconfident in any one stock, sector, or theme. As we have expressed, we believe AI will have far-reaching implications and benefits for the U.S. economy, albeit with many unknowns or, as Warsh stated, “major lines of inquiry.” Most important, and consistent with our recent comments, was this passage:
“Among the other yet unknowns is the resulting market structure. It’s not obvious where the returns on capital will land or on what timescale. Early on, how much of the surplus goes to owners of scarce assets, AI labs, chipmakers, energy producers, and cloud providers? Over time, how much of that value accrues to businesses and consumers?”
That uncertainty is central to our point. Much of the surplus has so far gone to the labs, chipmakers, and other companies bringing AI to life. Over time, that value may begin transferring to the broader economy and to the companies that use AI most effectively.
That is why we continue to urge diversification rather than concentration given the uncertainty around where AI moves next. Much like prior innovations, today’s winners could become tomorrow’s losers, and value will continue to shift across the economy and markets. Stay focused on the intermediate to long term, stay invested, and remain true to the allocation dictated by your financial plan.
