"Medicine" by the barrel
ROB HARRIS 06-Jul-2020
In Berkshire Hathaway’s 2008 Annual Letter, Warren Buffett wrote: “Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects.”
Those aftereffects most likely refer to the potential for higher inflation. And if the economic medicine dispensed around the dark days of the Global Financial Crisis was significant, what does that say about the most fiscal and monetary measures deployed this year. So while the Fed tossed markets a lifeline, the potential ramifications should be on the minds of all investors going forward.
To put things into perspective, consider the barrelful of medicine now being deployed:
• Since mid-March, fiscal and monetary stimulus has provided more than $2.3 trillion in much-needed liquidity to individuals, small businesses, healthcare facilities, and distressed companies.
• For further context, the U.S. national debt is approaching $24 trillion. Comparing this to the 2019 GDP of $21.4 trillion, the country’s debt-to-GDP ratio is roughly 110%. Relative to other countries, the U.S. ranks in the top 15 countries according to this metric. It’s not always good to be at the top of every list.
• On top of this stimulus, the Federal Reserve kicked in with another round of Quantitative Easing. The Fed lowered the fed funds target rate to a range of 0.00% - 0.25%, pledged to purchase an unlimited amount of U.S. government bonds, announced a strategy to back state and local governments, and promised to buy investment-grade credit for the first time in history.
There are several ways for investors to distill all this. Assuming the inflationary pressures do not become extreme and get out of hand (e.g. what the United States experienced in the 1970s), this barrelful of medicine may prove positive for the global economy despite any short-term pain of a recession. Over the long run, the present value of debt just might decline meaningfully, and policy makers might be able to manage this by hiking rates incrementally and shrinking their balance sheets to curtail inflation. This is likely to be the game plan and should give investors greater faith in the current underlying fiscal and monetary position of the country.
Yet what does all this mean from a more granular investment standpoint? For starters, if we enter a period of rising inflation, cash and fixed-rate assets would undoubtedly lag. In turn, some of the beneficiaries might be:
1. Companies that exhibit pricing power to offset the cost pressure of inflation. These are likely to be found in the consumer staples, technology, industrial, and energy sectors. With the exception of tech, these are largely considered “value-oriented.”
2. Companies that would benefit from interest rate and yield curve normalization. Examples would include asset-sensitive banks and insurance companies. These, too, are associated with value strategies.
3. Companies that provide essential products and services—most notably healthcare. By their very nature many providers of healthcare are able to pass a significant portion of costs borne by inflation to the consumer.
Through the middle of June, equities have rallied sharply after the plunge in March, signaling their approval of the Fed’s prescription. And while the popular equity indexes have rebounded, not all companies and sectors are well positioned for a post-pandemic world that looks conducive to higher inflation. Investors should stay alert and not hesitate to re-allocate accordingly where they see value.