Morningstar - Q4 2020 - 74

Investors

Lifting All Boats
Bush: With fiscal stimulus also come deficits and debt.
Rick, you've said it's a myth that debt is a looming
problem. How concerned should investors be about this
level of federal debt and potentially quite a bit
more if we get another fiscal deal?

Rieder: My opinion has evolved over the last
couple of years, somewhat because of that aging
demographic. The system today is set up
structurally to be a lender, and we can support
more debt.

Getting more people to work is job one. I've
been reading a phenomenally good book
called The Deficit Myth that talks about the velocity
of tax revenues. If we get nominal GDP to
the right place, we can diffuse the additional
debts on the system, particularly if the Fed is doing
its job of keeping the interest rate down.
If the interest rate moves up significantly, then you
could have a problem.

Mathias: What the Fed has done is incredibly
significant. It's easy to underplay it,
because it's a big institution, and the way
that they talk and the way that they act
can be obscure. It's hard to see what it means
in the real economy.

They changed the way they're going to react
to employment. In the past, they had said
they would act if they felt unemployment was too
low or too high. They were willing to act
if there were deviations from where they felt
employment levels should be, the full employment level. Now, they're saying they're
going to act only when we need more employment.
That change from deviations to shortfalls
is enormous.
What it means is the Fed is not going to be
pressured to raise rates for a very, very,
very, very, very long time. It means that this entire
concept of NAIRU, the nonaccelerating
inflation rate of unemployment, that we all spent

We can't underplay the importance
	
of what the Fed is doing with this change in
inflation strategy.
Anne Mathias

As long as the Fed is going to stay there,
and as long as the U.S. is the reserve currency
in the world-as long as the dollar
doesn't come under tremendous pressure,
and I don't think it will-there is room
to go. The Fed has to buy more Treasuries, has
got to functionally monetize the debt. I
think they can reduce the amount of mortgages
they're buying and should start doing
that soon. But as long as they're successful
in keeping the rate down, the system can
absorb a bit more debt.

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Morningstar Q4 2020

so long learning about and talking about
is just gone. It's not going to be an important part
of the trajectory anymore. It changes everything about how the Fed communicates and what
the Fed is going to do. It creates an environment
where the Fed does not have pressure to
raise rates, and where it's harder for the market
to predict when the Fed will start raising rates.
At the end of the day, it may mean that nominal
interest-rate curves are a bit steeper than
they are now, but they are effectively capped,

because if you can't predict a Fed rate increase,
you can't have a curve that just gets steeper
and steeper. So nominal interest rates are going to
stay at a level below where they normally
would be in an inflationary environment. This
makes it easier to service debt, and it creates a
longer credit cycle, and it creates the potential for
more asset price bubbles.
Financial conditions are going to be important
in the sense that we're going to be asking
ourselves how much of an asset price bubble the
Fed will be willing to tolerate. That is a real
change. It makes it interesting to think about how
to use inflation-protection strategies in active
portfolios. We can't underplay the importance
of what the Fed is doing with this change
in inflation strategy.
Bush: We hear a lot about how what's happening

in the stock market is really divorced from what's
happening on the ground in the economy. Do you buy
that argument? Meanwhile, we've had strength
in a lot of risk markets, but negative real yields in the
TIPS market. Does this all make sense, or is there
something about the markets that's not incorporating
information from the economy?

Rieder: I get asked on TV all the time:
What does the stock market not understand about
the economy? I actually think it understands a lot.
The tangible trends for small businesses are
really difficult today. And then, when you add the
aggregate market capitalization of airlines,
restaurants, hotels, and such, that makes up about
1.5% to 2% of the equity market, but it's 35% of
employment in the economy.

Think about the paradox there. The Fed's
job is maximum employment, and the equity
market's job is to take free cash flow generation
that companies are throwing off and to
determine the discount rate on that. Many
companies, particularly the big tech companies,
are operating well in the virtual economy.
They become like bonds in a lot of ways, and you
pay a higher multiple for that income. That
income is in the form of dividend yield for some
companies. But for other companies, it's
just free cash flow generation and the discount
rate. I think equities will keep pressing
higher because of that discount rate dynamic.
Morningstar - Q4 2020

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