Here is a transcript of the Symmetry in 2020 audio presentation, which was originally published on YouTube. Join listeners and readers who follow Dr. Fischer's thoughts on policy and trends.
Hi, I’m Dr. Philip Fischer, former head of fixed income and municipal bond strategy for Bank of America. I also have over two decades of experience with Merrill Lynch. I’m a former finance academic, an author of a book on muni bonds, and now I run eBooleant Consulting. eBooleant can help institutions and institutional investors look through the fog to understand and reduce portfolio risk in fixed income while striving for return.
Welcome to Symmetry in 2020 and its Risks, a special audio presentation from eBooleant Consulting. And now to Dr. Fischer, and our host for this presentation, Linda Purpura.
Linda Purpura, interviewer
Welcome to everyone joining us. So, Phil let’s jump right in. What concerns you most about 2020?
I want to focus on three overriding factors driving our economy here, along with their interactions. They are demographics, technology, and war. They are the engines under the hood of this economy, though their impact is not always seen in everyday events.
In 2019 the pluses and minuses from these trends were roughly offsetting, so the risk to the economy is not from the individual changes in each factor, but the net changes as perceived in the markets. Volatility in the economy has been and should be expected to be low in 2020. But that is the volatility of the net price changes.
Individual economic factors have had a lot of volatility, especially technology. For us though the risk comes when the underlying changes don’t exactly match at the macro level. For example, slowdowns in the real sector caused by these factors have been offset by easier Fed policy. The net result has been relatively stable markets. But things don’t always work out. At the end of last year, the market perceived that the Fed was not going to be as accommodative as in the past and volatility kicked up. The stabilizers were not working. Risk in 2020 is about a failure in the underlying factors and the inability of economic stabilizers to compensate for the change. And there is risk.
I guess you’ve seen a lot of volatility.
I’ve been in this business for several decades and I can say with certainty that surprises will emerge. They always do. Nature likes to blend a bit of chaos to frustrate our plans for an orderly world. Left to its own devices, the passage of time doesn't produce the utopian garden but instead the jungles of Borneo. So, when we look ahead at 2020 and especially at the technological innovations coming to the fore this year, we see it is the year of opportunity but one set for surprises, good and bad. 2020 doesn’t stand for perfect foresight but for an attempt to repeat the balancing act of 2019 in a sea of tumult.
So, are you positive or negative on the markets?
I’m positive but markets can be too optimistic. Market volatility, whether measured by the VIX index for equities, or the MOVE index for bonds, has been gravitating to low levels all year. But we shouldn’t lose sight of the systemic risks of the climate change, or technological disruptions or war.
Let’s look at some macro factors supporting a positive view for the economy. A 2.0% GDP average US growth in 2020 looks in the offing. This should not be too hard a target. The economy has demographics and tech at its back. Demographics are not to be underrated. Commentators are often negative on demographic trend saying that it is holding down GDP growth because aging populations consume less on a per capita basis. But, numbers count and one important reason for optimism is that, for all the indignities which the world foists upon us, Homo sapiens are clearly a favored species. In fact, the numbers are stunning. The United Nations projects that the world population will grow from its current level of 7.7 billion Billion! —to 8.5 billion in 2030. That’s only eleven or so years. Then off to the races with 9.8 billion in 2050 and 10.9 billion in 2100. India will grow the most followed by African nations and the United States.
Let’s talk about global diversification.
I remain solidly US centric and have heavy underweights on most of the rest of the world. Eleven years of consistent growth in the US economy is not to be taken lightly. Nor do I think it's going to be easy to derail the process in the US.
First, there is inertia to it. Not only has this been a steady rise in US GDP, it is a very consistent one. Part of that is the consequence of Federal Reserve policy, or in some cases, non-policy. But we will get into that later.
But the US economy is not to be mistaken for the world economy. The rest of the world shares some of the same opportunities that we see for ourselves, but they are generally different in kind and not merely a matter of degree. The US economy continues to exhibit its specialness and I expect that to continue in 2020.
Specialness, interesting. So, what are the manifestations of its specialness?
A lot of people use American Exceptionalism as the term. I use a softer version – specialness. I’m not talking about politics here, rather economics. We don't have to look any farther than the equity markets to understand what makes the economy special. First, let’s look at the landscape for technology and then consider the risk it brings.
We have been in a technological revolution focused on information technology since at least 1957 when the transistor was invented at Bell Labs in New Jersey. Any number of times, we've expected that the rate of growth in chip density would stop. Indeed, there are many people who think that Moore's law of making computing costs fall has run its course.
I don’t think so. It will be interesting to see if we look back on 2019 as having offered the clarion call when a new type of computer, the quantum computer. None but the likes of Google have proclaimed "quantum supremacy." 2020 will give us a lot of information about the future of information technology, which includes a host of capabilities not the least of which is really smart artificial intelligence.
This growth of human technological capability comes with risks though because it is not evenly distributed among the human populations. And while it looks like it should be relatively easy to reverse engineer and to copy—or in some cases to steal. It’s harder than it looks.
Technology transfer is supposed to remedy the concentration of technological prowess in different geographies. But even in the US, technology transfer has proven to be slow and messy. Every hamlet in America knows that it’s supposed to be the new crossroads for STEM. But few succeed. This is having tragic consequences as economic opportunity and social opportunity decline in regions of the heartland and south. In fact, overall US life expectancy continues to fall in one of the wealthiest countries in the world.
Doesn’t the China conflict accelerate all this tech development?
Part of the reason for my optimism, oddly, is the expectation that competition i.e. war of some sort, will continue to intensify with China. This should be expected to generate continuous fiscal stress with large deficits no matter how the election turns out. In addition, the impetus for technological innovation is likely to be at historical highs in a US Chinese conflict.
It will surprise some that I think that the impact of the trade war with China has largely played itself out. The shock value is over, and the policy moves are in play. For example, the US is moving to eliminate tools like the WTO, which China had relied upon as a tool. The US has effectively reduced the number of WTO justices from 7 to 1, rendering the world court incapable of providing final decisions in numerous cases before it. Whether the organization itself will survive is a matter of conjecture.
Technology development, as well as concentration, in 2020 will continue to accelerate as President Eisenhower's warning about the military--industrial complex comes home in spades again. As we moved to a world in which the US and China become increasingly adversarial, with Russia a constant threat, military budgets are exploding again. This time is little different from the past with special concentrations of effort being devoted to information technology quantum computing and the litany of what is considered to be the forefront of modern technology. Remember the US Space Corp was just affirmed by Congress.
China, for its part, has spent the better part of two decades preparing while the US looked the other way. That is over, and the US military budget now has approximately $1 billion allocated to the military branches for artificial intelligence applications. And that is just what we were told.
Yes, but where’s the risk here?
There are many risks globally but the narrow AI risk in the markets is flash crashes for the equity market and its extension into debt markets. The AI traders have little respect for market stabilization. In addition, when there are trends, the AI traders act in concert and skip buying on the dip.
But you’re just as concerned about the combined effects of technology and population as much as each one alone.
2020 will offer more growth globally and especially in the United States. While I am not a devotee of the Club of Rome's dire view of the potential for global growth, nevertheless there is a limit at least to the rate of growth. And right now, that limit seems to be global warming.
So, how bad is climate change?
2020 will again see some effects from global warming. I continue to be quite concerned about the California coastline due to wildfires. Yet for all its cause célèbre we are not looking at the end of the world in 10 years or even 100 and we do have some experience in climate manipulation as we will see. Even though technology helped create global warming, it is technology to which I look to for a solution to global warming.
First, we should note that global temperatures can in fact be affected by human behavior. During the period from 1940 to 1975, for example, global temperatures fell about 0.1 degrees Celsius. This occurred despite rising carbon emissions and appears to have been the result of sulfur in the atmosphere. Efforts to reduce sulfur and acid rain since the early 1970s worked. That success by the mid-1970s contributed to the rise in atmospheric temperatures since.
Second, we should note here that the economic impact of global warming is even more controversial in certain circles than the science underlying it. The consensus is that global temperatures are rising, and cumulatively that is clearly a problem. Nevertheless, we should expect 2020 to look a lot like the year before. Hot, even perhaps a record, but life will go on. Insurance should cover it. For the United States, coastal areas remain at the highest risk with floods, fires, and bad weather generally.
This in no sense means that we should fear a climate recession in 2020. And, economists are far from settled about the long-term economic consequences of rising temperatures. For some parts of the globe, one could even argue that it is positive. In fact, the optimal temperature rise for the globe may be quite high.
So, yes, the US is growing in population, which is a compelling reason for its economy to grow but it will not necessarily put out more greenhouse gasses. Other factors like new technologies will mitigate against this. The US is going to continue to be the hot bed of modern technology – no pun intended – and along with Europe find solutions for the global warming problem as it did for the hole in the ionosphere.
Can you elaborate on technology solving technology’?
That technology is producing disruptive discontinuities in our economy has passed from insight to folk wisdom over the last couple of years as we have seen the FANGS lead the stock market. Moreover, the modern era of hydraulic fracking in the oil industry began in 1998 and in the last couple of years roiled the energy industry as American crude imports reversed and the US suddenly became the world's largest producer. Now, there is arguably too much oil in the world. But also, too much natural gas which is replacing coal in electrical generation.
This is just one illustration of new technology reversing old technology problems. It is interesting to look at the Scientific American's list of emerging technologies. Many of the most promising new technologies are designed to undo the problems created by the old ones.
The list starts with bioplastics for a circular economy. Plastic is one of the kingpins of modern business and one of the curses of modern oceans. Ways to make plastic biodegradable wood products are in the offing and promise enormous health benefits. The list goes on with social robots, miniature metal lenses, disordered proteins as drug targets, smarter fertilizers, collaborative telepresence, advanced food packaging, and safer nuclear reactors. It's not your usual list but that's the beauty. What the list shows is that the technology surge we are seeing is extremely broad-based and unrelenting. It has its surprises, but I expect that 2020’s developments will mirror 2019’s.
Is technology’s only downside pollution?
No. Tech plays out in both the macro and the micro. In macroeconomics we expect convergence. We expect that over time the world’s economies will all share the benefits of improved economic performance since the internet has made so much information almost free. The problem is that convergence does not always occur between countries or regions, even in the long run. The US itself is a good example. Some areas of the US, particularly the Deep South have not caught up economically, relative to the North, since the American Civil War in the 1860s. The power of tech generally will continue. Where it is good it is very good even though the process is not obvious. Tech makes companies and states richer despite the Solow Paradox, which is that adding tech does not necessarily, add productivity.
The wealth effects by region of the country, however, are becoming severe economic and political problems. As Brookings says:
the [tech] sector has instead been concentrating in a short list of superstar metropolitan areas. Most notably, just five top innovation metro areas—Boston, San Francisco, San Jose, Seattle, and San Diego—accounted for more than 90% of the nation’s innovation-sector growth during the years 2005 to 2017.
The macro effects of tech extend from international wealth allocations to US cities and indeed to the individual.
Let’s explore the effect of tech on the economics of the individual.
We can go back to the externalities of regional growth when we think about individuals. A rising tide does lift all the boats on the block. People, however, are not boats and it is clear that it is hard for a person to do well when the local economy is failing.
The concentration of innovation and technology within the United States become self-evident as one reviews the macro data. The number of utility patents awarded each year by state, the facts speak for themselves. In 2018, California headed the number of utility grants in the United States with 39,814 patents issued. On the other end of the economic specter, Mississippi had 160 issued. That’s 250 times as many. California by the way has about 13 times as many people as Mississippi. This is not different than it would have been for numerous states in such a comparison. And I'm certainly not interested in picking on the good folks of Mississippi. It is simply to illustrate that technology transfer even in a relatively homogeneous country like the United States is a difficult proposition for many reasons. And at the individual level that helps to produce a galloping Gini coefficient for the US and the world.
States—tech isn’t the only thing happening there.
The states are where the rubber hits the road. State economies are complex. Let’s consider the effects of tariffs and military expenditures on state economies. They are far from homogeneous. The impact of Trade tariffs with China is relatively narrow. The states most directly affected from tariffs would include Alabama, Michigan, Pennsylvania, South Carolina, Texas and Wisconsin. While the amounts involved are certainly not a threat to the state economies, they are local issues which in an election year ring larger than usual. For example, in Wisconsin, the exports at risk from retaliatory tariffs by China include cheese, toilet paper, and ginseng.Not the high-tech stuff that hits most newspapers.
The other side of the coin for the states as it relates to the US China conflict is more positive. Concern about China has been one material factor in inflating the size of the US military budget recently. The size of the US military domestically is large, even compared to the US economy as a whole. The military has 420 installations in the states and territories. The overall impact of domestic defense spending constituted 2.3% of total US GDP in 2015, according to the National Conference of State Legislatures.
The largest amount of total defense spending going to individual states, according to the Department of Defense Office of Economic Adjustment, includes Virginia, California, Texas, Maryland and Florida, in that order. Of these, the first three certainly receive the lion’s share. Nor is it immaterial. Virginia, for example, receives $53 billion a year in spending from the Defense Department. This accounts for 11.8% of state GDP for Virginia. The next highest state is Hawaii at 9.9% of state GDP. Other sensitive areas include the District of Columbia, Alaska, and Maryland which receive slightly less than 6% of state GDP.
How about state budgets? Any thoughts there?
Yes, 2019 was especially kind to state budgets. Most states have fiscal years ending in June, for historical reasons, and found themselves with surpluses. The surpluses resulted from generally conservative budgeting; almost all the states must have balanced budgets. Steady growth at the federal level, and changes in federal taxation also fed through to state revenue increases. State budgeting in 2020 can be expected to be more complicated because of uncertainties regarding individual tax timing.
The states have not been profligate with regard to their finances, spending their surpluses generally on debt reduction or one-time expenditures. Indeed, The Great Recession of 2008 – 2009 chastened the states so much so that reserve funds, so-called “rainy day funds,” were significant beneficiaries of state surpluses in 2019. The most outstanding example of this was California.
The state’s new governor Gavin Newsom has followed Jerry Brown in his efforts to build up the state’s rainy-day fund. State budget estimates indicate that a moderate recession like the dot com episode in the early 2000’s would generate a budget deficit of approximately $20 billion in California’s 200+ billion-dollar budget. A repeat of the Great Recession could produce a deficit double that. This year’s anticipated $7 billion surplus may push the total rainy-day fund to around $18 billion. While that doesn’t solve everything, it should help the state manage the next recession better than it did during the Great Recession. But the real measure of the state’s fiscal concerns becomes clear with more comprehensive views of the surplus. The Orange County Register thinks that the surplus is more like $36 Billion.
Generally speaking, the states are in the best fiscal position in recent memory. Individual states can be expected to experience budgetary gyrations from commodity price moves as they have in past years. But all the states are investment grade rated and can be expected to receive aid in the event of a disaster.
Fiscally, they should be able to manage a new issue market of about $380 Bill with little trouble.
Not so fast. Not everything is rosy at the state level. But what about pensions?
One area of longer-term concerns remains state pension funding. While most states are managing their pensions, clearly there is some degree of fiscal stress. The states of most concern are those, which have adopted state constitutional provisions limiting the abilities of the state legislature to change existing laws affecting payment of pensions. Recently, Illinois has been a concern here. But state and local efforts have ameliorated pension funding issues. For 2020 state pension funding issues are manageable.
And since we care a lot about muni bonds, what about taxes?
Pressure on taxes at both the federal and state level can be expected to continue upward in 2020. Nor will the expected Trump win in November change this, in part because of progressive candidates featuring higher individual and corporate tax rates as major parts of their platforms in Congress and the state houses. The tax issues are not helped by the continuing rise in the federal deficit, which is now headed well past $1 trillion a year.
At its heart, pressure for higher taxes is rising as much from concerns about income inequality as about fiscal responsibility. The technology discussions provided above, which show the beneficial side of rapid technological change, have the flipside in increasing wealth concentration. The standard measure of wealth concentration is the Gini coefficient. In a perfectly egalitarian state where everyone has identical levels of wealth, the Gini coefficient is zero. In an oligarchy where one person has all the wealth, the Gini coefficient is one. The Gini coefficient in many countries, and this is certainly true of the US, has been rising rapidly in recent years.
Taxes are a standard method of wealth transfer designed in part to manage wealth concentration. Numerous economists as well as liberal politicians now support aggressive increases in wealth transfer taxes both at the individual and corporate levels. Pressure on tax levels from wealth concentrations can be expected to increase in 2020 no matter who wins the presidential election. A good discussion of this topic is provided in the November 2019 Scientific American article on “The Inescapable Casino.” I like this piece because it places wealth concentration in a scientific context. The economic processes we observe with wealth concentration are broadly speaking a natural phenomenon far beyond the geopolitics of the US.
And now to one of the big elephants in the room—low interest rates.
Let’s just say;
Lower and lower.
The Fed has achieved its dual mandate of stabilizing prices and reducing inflation. The Fed, for its part, has few remaining tools and a very thin theoretical base. The Fed’s ability to use moral suasion has diminished with the weakening of its theoretical tools i.e. the Phillips Curve which at this point is either so flat or non-existent that its usefulness as a policy tool is lost.
But it’s not just the Phillips Curve that has failed the Fed. For example, low productivity is supposed to put upward pressure on rates. Our recent low productivity has done nothing of the sort and isn’t expected to do so any time soon. 
International trade was high on the list of culprits of low inflation, but Chinese trade is falling rapidly. No one was supposed to win a trade war, but a case can be made for the US at this point. Now technology is carving out the lead for low inflation and the inverted yield curve. I don’t expect anything different in 2020. Even with a presidential election and all the other events we expect, 2020 should largely mirror 2019. Try the 10-year Treasury bond at 1.25 percent by year end. And this is hardly a worst case. The yield curve will probably invert for a while forcing the fed into another easing cycle.
And negative interest rates?
Greenspan says they are inevitable, and the Fed abhors them. They are a clear barrier to higher rates in the US. This alone should act to keep the US out of a recession. Unemployment should be expected to remain at decades low levels though the labor market participation is unlikely to improve much. This presumes a Trump election win and Republican control of the Senate. Another scenario would be a Democratic sweep in which individual and corporate tax rates can be expected to return to historic highs. Initial target rates for individuals can be expected to be around 45% for individuals and for corporations, 35%. Interest rates and GDP growth should be expected to respond sharply and negatively.
I, however, remain an optimist and expect S&P 500 returns on the order of 7
% in most sectors, and bond market performance providing coupon returns, despite an inverted yield curve.
So Phil, I’ve kept you here a while. Talking about themes -- will be war?
I hope not. Not the kind of major powers war. Though, yes we are in one, at least an economic war with China that demands careful watching. And that is a bit of a cold war. The risk that it may turn to a hot war is a great risk for 2021 and forward though we in no sense want China as an active enemy of the US.
(Music comes in under last sentence of Phil and continues through Linda’s text.)
Thanks, Phil. Be sure to check out eBooleant’s website to contact Dr. Fischer. This episode was produced by Doug Oberhamer. I’m Linda Purpura, thanks for being with us.
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