U.S. Fiscal Dominance & the Global Rebalancing

Written By Brian Schreiner

Weekly Investment Update | By Brian Schreiner

“Fiscal dominance” describes an economic scenario where a country's fiscal policy (government spending and taxation) effectively overpowers its monetary policy (central bank actions). It's a conflict where the government's need to finance its spending and manage its debt becomes so critical that it prevents the central bank from doing its primary job of controlling inflation.

In a normal economy, under "monetary dominance," the central bank is independent. If inflation rises, it can freely raise interest rates to cool the economy, and the government must adjust its budget to afford the higher borrowing costs.

Under fiscal dominance, this relationship is reversed. And that’s the situation unfolding today in the U.S. The Federal Government's debt is not so large, and its deficits so high, that it cannot afford higher interest rates. If the Federal Reserve were to raise rates to fight inflation, it could trigger a bond market crash or financial crisis.

At its last meeting, even as inflation remains high, the Federal Reserve cut interest rates for the second time this year and announced the end of its "quantitative tightening" (QT) program.

Under these conditions of fiscal dominance, the Central Bank may be able to help the Government avoid a debt crisis, but risks losing its independence and control over inflation, which could lead to currency devaluation, and broader economic instability.

Financial Repression

The End of American Exceptionalism?

“American Exceptionalism,” the belief that the U.S. economy and markets are fundamentally stronger than the rest of the world, has driven U.S. stocks to outperform foreign stocks for over a decade. Despite having just 4% of the world’s population, U.S. stocks account for 64% of global market capitalization. But now, a new set of challenges—extreme valuation levels, rising debt levels and protectionist trade policies—may be bringing this era to an end.

The dominance of the government's fiscal priorities over the Fed’s mandates is being felt by Main Street in the forms of high inflation and higher taxes/tariffs. The Fed is under pressure to increase the money supply to stimulate the economy and provide facilities to help finance the government. Specifically, they need to keep interest rates low in order to reduce the government’s borrowing costs and debt refinancing operations and they keep monetary policy relatively loose to keep the economy growing. These policies put upward pressure on inflation and downward pressure on interest rates, which hurts the workers, savers and investors. There’s a term for this too: “financial repression.”

If it feels like the government is bidding against you, it’s because it is. Financial repression is the use of financial and regulatory means by the government to divert resources from the private economy to itself. The resulting environment—slowing growth, high inflation and low interest rates—makes it hard for Main Street to get ahead and widens the wealth gap between the lower/middle class and the upper class.

Global Rebalancing

Offering both potentially superior fundamentals and higher yields, we believe emerging markets present attractive alternatives to both U.S. stocks and U.S. bonds. The G-20 emerging markets debt-to-GDP is around 69.4%, significantly lower than developed markets the G-20 developed markets at 126.5%.

In our September 21 letter, The Case for Emerging & Frontier Market Debt we discussed the compelling investment opportunity for this sector which continues to play an important role in our clients’ portfolios.

India, for example, offers a compelling story offering low correlation to the U.S. stocks, gold, oil and the U.S. dollar. Its economy is growing faster than those of developed countries and its demographic trends are among the strongest in the world.

As the U.S. and other developed nations continue to struggle against the headwinds caused by their massive debt loads, fiscal deficits and slowing economic growth, emerging and frontier markets will become attractive alternatives for investors willing to consider asset classes that have been largely ignored in the era of American Exceptionalism.

“In recent years, the garbage lending has not gone to the public markets. The garbage lending has gone to these private markets... The next big crisis in the financial markets is going to be private credit… It's has the same trappings as subprime mortgage repackaging had back in 2006… Where the trouble always comes in financial markets is when people buy something that they think is safe. It's sold to them as safe, but it's not."

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This commentary reflects the personal opinions, viewpoints and analyses of the Alpha Rock Investments, LLC employees providing such comments, and should not be regarded as a description of advisory services provided by Alpha Rock Investments, LLC or performance returns of any Alpha Rock Investments, LLC client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this commentary constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Alpha Rock Investments, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

The S&P 500 Index or the Standard & Poor's 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies. The S&P 500 is a float-weighted index, meaning company market capitalizations are adjusted by the number of shares available for public trading. Note: Investors cannot invest directly in an index. These unmanaged indices do not reflect management fees and transaction costs that are associated with most investments.

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Brian Schreiner
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