Macro Minute: What If?

The consensus today is that the global economy, led by developed countries, is heading into recession in the next few quarters. The debate ranges between hard or soft landing. Bloomberg’s recession probability forecast stands at 65% today. To add to this bleak outlook, we have Fannie Mae and Visa, companies with real economy visibility, forecasting an 85% chance of recession. 

Some of this doom and gloom is based on the past relationship between surveys and hard data. Soft data points to the worst economic environment in half a century, only comparable to the Great Financial Crisis.

Financial markets are also forecasting an imminent recession when looking at the shape of the yield curve. The spread between 2-year and 10-year US Treasuries is the lowest since the high inflation period of the 1970s.

If we could point to only one data point to explain such dreary levels of survey responses and market pricing, it would be the speed and magnitude of the change in short-term nominal rates. The Federal Reserve hiked 425 basis points in nine months. This represents the fastest and largest rate-hiking cycle since the 1970s. The market and economists alike are saying that the current level of interest rates is incompatible with the economy’s structure. Markets believe that this level of rates will invariably cause the economy to contract, inflation to go back to 2% in the short- and long-term, and the Fed to start cutting rates in the second half of 2023.

The conclusion is valid if we accept the assumption that the trends of the 1985-2019 decades are still in effect, and that what we have seen over the past two years was just the effect of transitory impacts of Covid measures. 

Having said that, markets are already broadly pricing these assumptions with a reasonably high confidence level. As investors, we must ask ourselves, ‘what if?’ What if there is a deeper reason for the past two years’ economic dynamics? What if we are not living through (only) transitory effects? Then, looking at nominal rates to predict a recession and a turning point for inflation would be misguided. And if so, the US treasury market would have to reprice materially in 2023, causing a structural shift in the global economy and financial markets.

Inflation in the period from 1985 to 2019 averaged 2.6%. This is when we saw the third wave of globalization, increased working-age population, plentiful fossil fuel energy, and the unquestioned Pax Americana. With inflation at such low levels, one would be excused if all its conclusions were based on nominal rates assumptions. But inflation is only low sometimes. From 1950 to 1985, as well as from 2019 to today, inflation averaged 4.5%. When inflation is higher, nominal measures become less important and it is essential to look at real interest rates. Here, we use the Fed Funds Rate deflated by YoY CPI.

Real interest rates tell a very different story. We have seen a sharp increase in real rates since the beginning of 2022, but that move started from a historically low level. Today, real rates are still extremely negative, even after 425 basis points of hikes from the Fed in 2022. The conclusions we draw from looking at this measure are very different from those based on the nominal rate. We see a monetary stance that is not restrictive and, therefore, supportive of growth. With that, we also see the probability of recession at very low levels in the next few quarters, and little reason for the Fed to start cutting rates in the second half of 2023 (let alone the 125 basis points of cuts the market is pricing in between 2H23 and 2H24 – see graph below). This measure helps explain why the labor market is so strong, something that keeps confounding central bankers and analysts alike. It also helps explain why surveys are so pessimistic. In periods of inflation, people tend to have a very pessimistic view of the economy, even when real growth is positive. 

We must then ask ourselves. What if real rates are more important for the economy than nominal rates? What if the structural trends of less globalization, a decrease in the working-age population, scarce fossil fuel energy, and a multipolar world materially increase R*? What if the recent weakness in inflation numbers is just a transitory effect as part of a long-term structural inflationary period? What if growth surprises to the upside in 2023, even with the Fed keeping rates above 5%? What if?

Macro Minute: A Tale of Two FOMCs

he FOMC’s November meeting might have been one of the most important meetings in a long time. 

At 2:00 PM EST, we saw a statement that was believed to be dovish by most and confirmed by market moves. It said that the FOMC expects that “ongoing increases in the target rate will be appropriate,” which even the most dovish observers would agree, but added that “in determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”

Thirty minutes later at the press conference, Chair Powell struck a hawkish tone, focusing on the least dovish parts of the statement and provided more hawkish commentary, leading the markets to react accordingly.

He mentioned that rates would be higher for longer: “The incoming data since our last meeting suggest the terminal rate of Fed Funds will be higher than previously expected, and we will stay the course until the job is done.” There is no pause in sight: “It’s very premature to think about a pause in our interest rate hiking cycle.” And lastly, he would rather do too much than too little: “Prudent risk management suggests the risks of doing too little are much higher than doing too much. If we were to over-tighten, we could use our tools later on to support the economy. Instead, if we did too little, we would risk inflation getting entrenched and that’s a much greater risk for our mandate.”

In sum, we saw an intentional dovish shift in the language of the statement, followed by a much more hawkish message at the press conference. We have two main takeaways.

First, we might be seeing the first signs of a fracture happening within the FOMC. That is exactly what happened in the 1970s and it was the main reason that led Volcker to shift to a monetarist approach of targeting monetary aggregates, even though he was not a monetarist. Volcker was an incredible central banker not just because of his technical expertise, but also because he was a savvy politician. He understood that he could not bring all members of the FOMC along to raise rates as much as was necessary to curb inflation. In changing the way the Fed did monetary policy, he saw a way to unburden the FOMC members from this responsibility. He understood that it would otherwise be politically impossible to keep raising rates.

Secondly, Powell changed the shape of the distribution of potential rates outcomes with his comment on “prudent risk management.” If the FOMC follows Powell’s lead, we could see rates going higher for longer, but only at much smaller increments. That will be the compromise. With eight meetings in 2023, we are talking about a potential hawkish rate increase of 200-250bps for the full year (compared with 425-450 in 2022). On the other hand, if they find themselves to have overtightened, they will have roughly 500bps or more to cut, depending on when that happens. The risk of maintaining a paying rates position at the short end of the curve, which was probably one of the best risk-adjusted trades of the year, materially increased.

In A Tale of Two Cities, Dickens opens the book with a sentence that has become famous: “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity (…)” This meeting might have marked the end of the golden age of monetary policy where consensus was the norm and developed markets’ central banks did not have to struggle with their dual mandate or politics.

Macro Minute: GDP Deep Dive

Last week, just before the end of the month, we got the Second Quarter Advance GDP Estimate from the US Bureau of Economic Affairs (BEA). The quarter-over-quarter annualized number for real GDP printed a disappointing -0.9%, compared to a median expectation of +0.4%, but still better than the 1Q number of -1.6%. 

GDP releases are very important events for markets. Companies use them to help make investment decisions, hiring plans, and forecast sales growth. Investment managers use them to refine their trading strategies. The White House and Federal Reserve both use GDP as a barometer for the effect of their policy choices. 

These numbers are especially important for turning points in the economy. For some (but not the National Bureau of Economic Relations – the US agency responsible for classifying recessions), two consecutive quarters of negative real GDP growth is defined as a recession. If we took the early GDP releases at face value, this would imply that we are in a recession today, dating back to the first quarter. For all the above reasons, it is worth digging into how the BEA derives this number and how reliable the early releases are.

One of the tasks of the BEA is to calculate US GDP, measured as the total price tag in dollars of all goods and services made in the country for a given period. It is the sum value of all cars, new homes, lawnmowers, electric transformers, golf clubs, soybeans, barbeque grills, medical fees, computers, haircuts, hot dogs, and anything else sold in the US or exported during the period. When calculating current (or nominal-dollar) GDP, the agency adds the value of all goods and services in current dollars. But this herculean task does not end there, because what matters for most people is the real growth in the economy. And so, after tallying up everything in current dollars, the agency has to then make adjustments to try and come up with an estimate of the value of what was actually produced in the economy (e.g., ex-inflation). 

Imagine an economy that only produces two things, potato chips and mobile phones. Suppose that the economy is selling $1.1 million of goods this year, an improvement of 10% compared to the $1 million from last year. That $1.1 million number represents the nominal GDP for the economy this year. But that number does not tell us how much of that 10% increase is due to more goods being sold and how much derives from price increases. 

If last year there were 50,000 bags of chips sold for $10 and 500 mobile phones for $1,000, and this year there were 55,000 bags of chips and 550 mobile phones sold for the same price as last year, the economy had real growth of 10% and zero percent inflation. 

Alternatively, if this year the economy sold the same number of chips and mobile phones as last year but did so at a price of $11 and $1,100, respectively, the economy had zero real growth and 10% inflation. 

However, things are not so simple, for the methodology is designed not only to remove price inflation but also to adjust for the quality of the goods being sold. Let’s assume that this year the economy sold 55,000 bags of chips for $10, and 550 phones for $1,000 (the same as the first example). But in this example, the bags of chips sold this year only contain 40 chips versus the 50 chips in each sold last year, and the mobile phones sold this year have better computational power and an extra camera versus last year’s. In this case, the agency would have to account for those changes by calculating a positive price increase for the potato chips and a negative one for the mobile phones, even though the number consumers saw on the price tag did not change. Now imagine that the BEA must do this not just for all the goods sold in the US economy, but also for every service provided, and to deliver an advance estimate one month after the end of a quarter. 

Which brings us to the question, how reliable are early GDP estimates? The answer is… it depends. Each revision incorporates more and better data and is believed to be a better estimate of the true value of GDP. For example, comprehensive data accounts for only 25.5% of advance estimates and 36.8% of second estimates, but it accounts for 96.7% of what we can call “final” estimates[1].

To assess the reliability of the GDP estimates we can look at revision patterns to understand if there is a bias in these revisions and how large they can be. To assess bias, we calculate Mean Revision (MR) where components tend to be offsetting and a large positive or negative number would indicate bias. To understand how large revisions can be, we calculate the Mean Absolute Revision (MAR) and the standard deviations, which are both complementary measures of the distribution for the revisions around their mean. We calculate these revision metrics for the Advance release that comes out one month after the end of a quarter, comparing with both, the Second releases (two months after the end of a quarter) and what we here call the “final” estimates (also called, comprehensive revisions, which are released approximately five years after the advance release).

What we find is that inflation has a meaningful impact on reliability. More specifically, it creates a pronounced bias for advance releases in underestimating real GDP growth. This makes intuitive sense. The task of calculating real GDP becomes even more challenging during inflationary environments. Looking at the numbers, we find that in periods of low inflation [3,4], bias is virtually inexistent with MRs for Second and Final at +0.10% and -0.01%, respectively. While during periods when US CPI is above 7%, MRs are +0.40% and +0.80%, respectively. That means that, on average, in high-inflation environments, Advance GDP numbers are underestimated materially. It is also important to note that MARs and standard deviations are essentially unchanged from one environment to another. This means that the size of revisions is similar in both circumstances. 

To clarify the point, let’s look at last week’s 2Q 2022 GDP Advance release of -0.9%. We can say that the second estimate will be between -1.5% and +0.4%, while the final estimate will be between -2.6% and 2.4%, with 90 percent confidence. This distinction between inflationary and non-inflationary environments is important because if we used the low-inflation scenario numbers, we would say that the second estimate would be between -1.9% and +0.2%, while the final estimate would be between    -3.6% and +1.7%, with 90 percent confidence. [5]

One way to increase the reliability of activity numbers is to look at the average of GDP and GDI. In theory, GDP and GDI should be equal, but in practice, GDP and GDI differ because they are constructed using different sources of information – both are imperfect in different ways. If both GDP and GDI are interpreted as the sums of unobserved, true economic activity and measurement errors, it is possible to infer that the weighted average series of the two is a more reliable measure of activity than either GDP or GDI alone, assuming some of the measurement errors are averaged out.

In short, calculating GDP is a mammoth undertaking, early estimates of real GDP tend to underestimate growth in inflationary environments, and you are better off taking a holistic view of the economy when data is as volatile as it is today. 

P.S. We talked a lot about real GDP, but we should not neglect nominal GDP. Historically, S&P earnings growth tended to stay in line with nominal GDP. And that is how corporate sales, revenues, and profits are recorded. In the second quarter of 2022, nominal GDP in the US was approximately +7.9% QoQ annualized.  

P.P.S. For a depiction of how and when GDP revisions and their vintages are made and maintained by the BEA, please see below.

[1]  Comprehensive revisions are performed every five years and include major updates to classifications and definitions for the entire GDP time series – for more information, please see the endnote

[2] Holdren, Alyssa – Gross Domestic Product and Gross Domestic Income – Revisions and Source Data (June 2014)

[3] Fixler, Francisco, Kanal – The Revisions to Gross Domestic Product, Gross Domestic Income, and Their Major Components (June 2021)

[4] Using 1996-2018 period used in above paper, when US CPI inflation averaged 2.2%

[5] Revisions follow a normal distribution and therefore we can calculate the combined probability that the true value of real GDP growth in the 1Q and 2Q was below zero, i.e., two consecutive quarters of negative GDP growth. P (2Q < 0% | 1Q < 0%) = 36%.

Macro Minute: Flip or Flop

With so much talk about a recession lately, it is hard not to look for clues in housing numbers. This past week, we had numbers for US housing starts and building permits. While homes only directly account for roughly 5% of GDP, related goods and services can account for nearly 20%. Aside from 2001, the US has never gone through a recession when housing is doing well. Conversely, the US has never emerged from a recession without the help of housing (2009 being the exception with a rebound while housing was stagnant). Fort these reasons, it comes as no surprise that so much attention is given to the release of housing data.

Housing starts record how much new residential construction occurred in the preceding month, while building permits track the issuance of construction permits. The number for both releases is reported in number of units, with the latest number for housing starts and building permits disappointing the Bloomberg median survey at 1.549 million and 1.695 million, respectively. But how disappointing are these numbers, if at all?

First, let’s look at housing starts. The month-over-month number came in at -14.4%, and comparing the latest release with the same time last year, the number of starts contracted by -3.5%; however, these numbers are very volatile and prone to significant revisions. When looking at the rate of change of the 12-month moving average in May versus the previous month, we encounter only a -0.28% contraction, and when comparing the average with the same period last year, we find a growth of +9.5%. Building permits decreased by -7% MoM and increased +0.2% compared to last year. Using the same 12-month moving average to smooth volatility, the rates of change from the previous month and last year are +0.2% and +6.4%, respectively. We can see some deceleration, but we are still at very healthy levels compared to the past.

One thing to keep in mind is that looking at housing starts and building permit numbers only gives us an idea of the real component of the economy. But for prices and company earnings, it is Nominal GDP that matters. Therefore, we have constructed a nominal index for housing starts and building permits using the S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index. When looking at that number, we see some deceleration, but in aggregate both starts and permits are still running at very high growth rates.

We cannot draw firm conclusions from a single piece of evidence, but what a closer look at housing starts and building permits shows is that the probability of recession may not be as high as one perceives from reading headlines.

Macro Minute: Speak Harshly and Carry a Small Stick

In the early 1900s, President Theodore Roosevelt was known for the aphorism “Speak Softly and Carry a Big Stick.” The idea behind this adage is that it is the availability of raw power, not the use of it, that makes for effective diplomacy. In the case of Roosevelt, that policy worked very well. His two terms in office had been almost completely without conflict. “He has managed, without so much as firing one American pistol, to elevate his country to the giddy heights of world power.” – Literary Digest, December 22, 1906

Possibly empowered by the policy success almost 100 years earlier, in the early 2000s, the Fed decided to embark on a policy of forward guidance. Forward guidance is the act of communicating to the public the future course of monetary policy, namely, the path of interest rates. Said guidance, which along with the control of short-term interest rates and quantitative easing, had the aim of controlling the interest rate curve without so much as “firing one American pistol.” In hindsight, it worked. Forward guidance not only kept interest rates low through the expectations channel, but also helped dampen interest rate volatility (and along with that, equity and fx volatility).

However, the deflationary forces that provided the Fed with the availability of raw power began to dissipate around 2015. Raw power allows the Fed to introduce QE and rate hikes without needing to backtrack. This was ultimately eliminated once Covid incited a degree of globally coordinated fiscal and monetary policy never seen before. Since then, the Fed has flipped Roosevelt’s policy on its head. Today, the Fed is using FOMC press conferences and governors’ speeches to speak harshly on inflation. But when the time to act comes, we believe that the Fed does not have the same firepower as before. On one hand, it cannot materially tighten financial conditions without causing an enormous problem for the refinancing of historically high levels of debt (both corporate and government). On the other hand, with inflation rampant, it cannot continue to serve as a backstop to financial markets.

Going forward we believe that the Fed will speak harshly of inflation, but will consistently be behind the curve, possibly un-anchoring inflation expectations and the long end of the interest rates curve.

Macro Minute: US Labor Participation

This week, we will once again touch briefly on labor force participation and attempt to make sense of the US Employment Situation Report from Friday.


US labor force participation has been the subject of much discussion lately. Beginning in the 1960s when more women entered the workforce, it has steadily risen, moving from 59.1% to 66.9% by the year 2000. Since then, it has drifted lower and settled near 63% pre-Covid. A drop of almost 4% on the labor participation rate is equivalent to around 10 million jobs. At first glance this seems negative, but we find that most of this was due to strong levels of enrollment in post-secondary education among those aged 16 to 24. This trend began in the late 1980s, and accelerated into the 2000s, hence a deluge of social science majors and a dearth of truck drivers.

Turning to today, let’s analyze some of the most common arguments for explaining the slow recovery of the labor force participation rate.

(1) Self-employment is keeping labor participation low – One way to try to test for that, is to track the difference between the household and the establishment employment data. The household employment figure captures the self-employed, farm workers and domestic help, something the BLS payrolls survey doesn’t do. Here what we find is that household employment suffered more than payrolls during 2020, and still hasn’t recovered to pre-covid levels.

2) Women have been kept out of the labor force because of childcare – There is some indication this may be true. We saw nearly the same number of exits from the labor force for men and women in 2020 (3.9mm & 4.2mm in April ’20, respectively). Those aged 25-34 were the second most affected at the time, accounting for more than 1mm women exiting the labor force. By September 2021, there were still 550k less women aged 25-34 in the labor force than in January 2020, the largest discrepancy across all age brackets. With schools reopening, that number was cut in almost half to 283k in November.

(3) Retirement is keeping people out of the labor force – It is hard to see that clearly in the data. The age group 55 and over (55-64 & 65 and over), suffered the least in both genders and have the least amount of people out of the labor force (when compared to January 2020 levels). Today there is 100k more men 65 and over in the labor force than at the peak in January 2020.

Macro Minute: Fiscal Cliff vs. Excess Savings

Looking ahead to 2022, much has been written about the pending fiscal cliff and its impact on Real GDP Growth. As the impact of fiscal stimulus dissipates and the federal government mulls tax increases, analysts expect fiscal impulse to shift from positive to negative next year.

Figure 1: Effect of Fiscal Policy on Real GDP Growth (3Q CMA) [Source: Goldman Sachs]

In our estimation, given the levels of excess personal savings reached in the past 20 months, we believe there is enough pent-up savings to compensate for the forthcoming negative fiscal impact on GDP. Using seasonally adjusted personal income minus personal consumption expenditures as a proxy for personal savings, we find that from April 2020 through September 2021, Americans generated over $2.8 trillion in excess savings, amounting to approximately 12% of GDP. That compares with approximately 4% of fiscal drag projected for 2022.

Macro Minute: What’s going on in the US Labor Market?

With job openings, participation rate, and unemployment central to the current discourse on markets, the topic of this month’s memo is the United States labor force.  

Focusing on the four largest sectors (which add up to more than 60% of payrolls and job openings in the US economy), we can see that wage inflation is a pattern that predates the onset of covid. In other words, wage inflation is not simply a result of covid supply shocks, it is based on fundamentals in the economy, and therefore it is not transitory. 

1 – Trade, Transportation & Utilities (19% of total Payrolls, 18% of total Job Openings)  In 2018, demand for work (job openings) started to grow much faster than supply (using payrolls as a proxy). As a result, average hourly earnings growth for this sector has surged from an average of 2.25% percent in 2018 to over 4% today (and 3.35% pre-covid). 

2 – Education & Health Services (16% of total Payrolls, 18% of total Job Openings) Hereto the story is very similar, but it started even earlier. In 2014, demand for work accelerated faster than supply of workers, driving an increase in earnings from 1.5% to 3.4% today (and 2.5% pre-covid).

3 – Professional & Business Services (14% of total Payrolls, 18% of total Job Openings) In Professional & Business Services, we saw two waves. The first in 2014 and the second in 2018, causing an increase in earnings from 1.5% to 2.3% in the first wave, and from 2.3% to 4% today (and 3.3% pre-covid).

4 – Leisure & Hospitality (10% of total Payrolls, 14% of total Job Openings) Leisure & Hospitality is the only sector in the top 4 that has gone through two opposite cycles since 2014. The first was with the demand for work growing faster than supply starting in 2014, increasing earnings growth from 1% to 4% in 2017. The second cycle took place starting in 2018, with labor supply growing faster than demand, and earnings growth falling to 3.5%. Today we are back at 4% growth, last seen entering 2018. It is worth noting that today, the demand for work in this sector is at historical highs while supply is back near the levels of 2010.

Labor Supply Shock

The last point has to do with the temporary labor supply shock that happened due to covid. Comparing jobless claims numbers between states that ended extra unemployment benefits before the September 6th deadline and those that adhered to the target, we see that the states that finished earlier have a much more accelerated and consistent contraction in claims across latter weeks. With this in mind, we expect some of this labor supply shock to normalize as we get farther from the deadline. However, when we look at the pre-covid trend, we believe that this will not be enough to avoid wage inflation.

Special Report – A Changing Paradigm

As an investment philosophy, we believe that the best way to deliver above-market returns is to find something cheap, take a position, and hold it for the long term. We tend to avoid market timing and “short-term” investments.

Looking across asset classes, we find that many equities are overpriced on a historic basis by virtually every metric and expect future returns to be much lower than in the past decade, save for a couple of undervalued sectors like energy and materials. When the stock market is on fire, as it has been almost non-stop since 2008, investors ignore companies that specialize in raw materials and other goods. With investors too distracted by their ever-increasing portfolio of technology companies, there was a loss of interest in investing any money in increasing the productive capacity of raw materials, agricultural products, and other hard assets.

In real estate, housing around the world is already too expensive to represent a compelling investment. In the US alone, the S&P Case-Shiller Home Price Index sits a lofty 26 percent above its 2006 peak, with a 17 percent increase year-over-year for the nine US Census divisions. To put this in context, housing prices have been rising more than 5 percent above inflation for the past decade.

Products like copper and lumber seem expensive but as an asset class, commodities are the cheapest. When you factor in inflation, even after the recent run up in prices, most commodities are trading closer to their historical lows. We will further explore this asset class in detail in future reports.

Figure 1: Inflation-Adjusted Commodity Prices

Bonds have never been this expensive in history and are clearly in a bubble. As we write this letter, 10-year real yields in the United States are at their historical lows of -1.2 percent. With the Fed’s new inflation targeting policy of slightly above 2 percent, real rates could still theoretically go down to somewhere slightly below negative 2 percent, assuming the Fed cannot reduce nominal interest rates meaningfully below zero. However, for that to be true one needs to accept that we are living through some type of global secular stagnation[1] process, from the demand or the supply side.

Herein, we hope to show that such a scenario is extremely unlikely. First, we believe it highly probable that the environment of slower growth and inflation from the past few decades has more to do with a series of temporary “headwinds” arising mostly from consecutive deleveraging processes caused by the fact that almost all recent crises were balance sheet crises, and therefore deflationary. Secondly, we argue that even if we were living through secular stagnation before, we are not anymore. The underlying forces in play for the past few decades began reversing around 2015, and the Covid crisis created a catalyst for an acceleration of these forces.

If you wish to receive a full copy of this report, including our directional views across asset classes, please contact [email protected].


[1] Secular stagnation is defined as a prolonged period of low growth. While prolonged and low are not further specified, many economists define low as an average annual real output growth rate of no more than one to 1.5%, and prolonged as covering at least several business cycles. The term secular does not require stagnation to persist forever.

Special Report – US Elections: Part 3

To conclude this series of Special Reports examining the 2020 United States election, we want to take a closer look at one of President-Elect Biden’s cabinet picks, what the selection could mean for sustainability and fiscal policy, and developments at the Fed regarding climate change. Part 1 detailed our probabilistic approach to predicting a Biden win, while Part 2 dug into his policy platform, fiscal approach, and where we could see bipartisan support (hint: tech antitrust).

Election Outcome

As a quick refresher, let us first level-set on how things have shaken out since November 3. In a pattern many analysts suspected would occur, Republican voters turned out en masse for in-person voting on Election Day, giving President Trump and other Republicans early leads at the polls, but as mail-in votes were counted across the country, President-Elect Biden edged into the lead in a handful of key states and two runoffs were set for the Georgia senate races. President Trump contested the election results in many states, but elections were certified, and electoral votes cast by each of the battleground states in question (Georgia, Pennsylvania, Wisconsin, Michigan, and Arizona), guaranteeing a Biden presidency.

In Georgia, two hotly contested senate races determined the final composition of the Senate. At the caucus level, the final tally now shows 50 Republicans and 50 Democrats, with both Messrs. Warnock and Ossoff defeating Republican incumbents. We wrote in our final update to investors on October 27 that there was a 66.1% chance of a Blue Wave in D.C., including the scenario in which we have arrived. A surprise double Democrat win has given the incoming administration (with the vice-presidential tiebreaker) the ability to freely legislate. Caucus moderates, like Independent Angus King from Maine, and centrist Democrats from states with more practical, fiscally conservative electorates will be critically important to the passing of any legislation and are likely to serve as a dampening mechanism against some of the more extreme agenda items coming from the party’s fringes. However, we do expect this split to result in a streamlined nomination process for executive branch members and judges – expediting the rate at which we expect to see implementation of the President-Elect’s policy platform.

President-Elect Biden’s Cabinet

Partisan gridlock aside, the executive branch is expected to leverage its powers to advance its policy agenda, thus rendering the members of Cabinet ever more important. As is tradition in the Cabinet Room of the White House, the President and Vice President sit at the middle of a long table, opposite one another, with the members of Cabinet (e.g., department heads) organized around the table according to the date the department was established (and de facto, by importance). To the right of the President, and first ranking department head, sits the Secretary of State. And to the right of the Vice President sits the second ranking department head, the Secretary of Treasury.

Mrs. Janet Yellen, the nominee for Secretary of Treasury, needs no introduction. In her acceptance speech, the former Fed chair pointed to five issues as part of her agenda within the Biden administration: (1) inequality, (2) stagnant wages for non-college graduates, (3) communities that have lost industry with no new jobs to replace it, (4) racial disparities in pay, jobs, housing, food security, and small business lending, and (5) a gender disparity keeping women out of the workforce. While opinions differ on how to interpret the data to either support or refute those positions, one thing is clear, Janet Yellen, who as Fed Chairwoman said it was in fact “her job” to discuss economic inequality before Congress, will be attempting to address income inequality in America that may likely be as bad, if not worse, than it was after the Gilded Age preceding the Great Depression.

The Secretary of Treasury is the lead go-between for the executive branch and Congress on matters of fiscal policy and budgetary spending. Yellen can be described as a progressive Keynesian, believing that government intervention should be utilized as necessary to restore full employment and demand. She is a stated supporter of broader unemployment benefits and has been characterized in the media as “pro-labor.” As Fed Chair, her monetary policy toolset was limited to interest rate control and quantitative easing – as she navigated the post-crisis period, she maintained low interest rates, encouraging employment but consequently also causing asset price inflation which in many ways exacerbated the inequality issue.

Stepping into her new role, Mrs. Yellen will have a wholly different set of levers to pull. With a second wave of Covid-19 spreading and vaccine rollouts being less successful than forecast, there is a good chance that as part of the follow-on coronavirus relief package to come after Inauguration Day, we see her reinstate the expanded unemployment benefits that expired last summer. She has also come out in favor of fiscal support for state and local governments, a contested view on Capitol Hill. She recognizes these entities as important employers, and notes that if they are not helped, there will be large layoffs and more difficult to solve problems in the future. It is important to remember that state and local governments are required to maintain balanced budgets and cannot raise money selling treasury securities like the federal government, meaning in times of low revenue (e.g., low sales tax revenue, low metro ridership), states and municipalities are required to cut costs (e.g., jobs, subway service). Abroad, she will be central to negotiating America’s position in trade deals, and as a believer in globalization, will likely be a measured, stark contrast to the outgoing administration. Finally, she has stated a desire to leave the system more guarded – the New York Times characterized it as, “putting training wheels on capitalism.” An example is her support for budgetary stabilizers, which would kick in when the economy declined and do not require Congress to vote and pass a fiscal package but would automatically increase unemployment benefits.

Given her background, we expect the Federal Reserve Bank and executive branch to be far more in sync, and for Mrs. Yellen, who has gone on record discussing how recent asset inflation has not carried over to working people, to be instrumental in shaping the country’s fiscal agenda.

Federal Reserve Joins NGFS

Last month, the Federal Reserve officially joined the Network of Central Banks and Supervisors for Greening the Financial System, a collection of central banks meant to exchange ideas and best practices to account for environment and climate risk in the financial sector. The Fed has recently began paying more attention to climate change and can thank former Chair Yellen for being the first Chair to begin examining the impact of broader economic and global issues on the financial sector. In April 2019, Mark Carney, former Governor of Bank of England and Chair of the NGFS, penned an open letter detailing four recommendations from the coalition’s first report seeking to translate commitments into action: (1) integrate monitoring of climate-related financial risks into day-to-day supervisory work, financial stability monitoring, and board risk management, (2) integrate sustainability into central bank portfolio management, (3) collaborate to bridge the data gaps to enhance the assessment of climate-related risks, and (4) build in-house capacity and share knowledge with other stakeholders on management of climate related financial risks. For a myriad of reasons, particularly given our investment strategy, it is both exciting and encouraging that the Federal Reserve is participating in the organization.

Together at the Group of 30, Yellen and Carney wrote that governments should treat climate change and fighting global warming like monetary policy, because both require considerable long-term decisions that can be undermined by short-term partisan pressures. Carney is pushing for all listed companies to report on their exposure to climate risks for by 2023 and substantiated his reasoning in a recent talk at the Dallas Fed. As governor of the BoE, he oversaw the insurance industry and noted that those who oversee property and casualty insurance, in addition to reinsurance, are keenly focused on climate change. Over the past decade they are consistently repricing coverage because, “what was once the tail has become the central scenario in terms of extreme weather events.” He went further to echo a sentiment we share, that it was necessary for the BoE to get involved in climate change because it was prudent responsibility. Ultimately they recommended a change to capital ratios for banks based off who they lent to – banks would be required to maintain greater reserves for lending to brown industries versus green. While on the surface this may seem partisan, it is important to recognize the following – as society slowly starts to more seriously consider these issues, climate policy will be stricter and banks could end up with very large stranded assets. As such, Carney believes that banks need to be stress tested for vulnerabilities associated with climate change in the same way they are tested for exogenous shocks after the 2008 crisis.   


The United States still faces a myriad of threats: the Covid-19 pandemic, a sharp economic downturn, and attacks on its democratic institutions. In 1936, as Roosevelt accepted his party’s nomination in Philadelphia he said, “Governments can err, presidents do make mistakes, but the immortal Dante tells us that divine justice weighs the sins of the cold-blooded and the sins of the warm-hearted in different scales.” It is our belief that recent events have not created an irreversible rupture in the social fabric of this country, and its result will be one of compromise to the exclusion of extremists. Trump’s impeachment process could mark the start of a new era of bipartisan cooperation. Like Roosevelt, the new Democratic president has the opportunity to implement far-reaching reforms through a Green Bipartisan New-New-Deal that will reform the United States infrastructure, increase income distribution and maintain its strategic role in the world for decades to come. Combined with Janet Yellen’s penchant for fighting unemployment and inequality, and the Fed’s increasing posture on climate change, we think that 2021 can be a big year for sustainability and investments that incorporate such thinking. We hope you enjoyed your holiday season; our team is excited for what’s ahead and look forward to you reading our future commentaries.

Sincerely,

The Norbury Partners Team