In prior decades, the federal government would have felt entirely unable to borrow a sum of this magnitude. However, the Federal Reserve has made it clear that it is willing to monetize the federal debt to whatever extent is necessary in this crisis. Over the past year, the Fed has increased its holdings of U.S. Treasury bonds by $2.2 trillion and its current $20 billion weekly pace of purchases would add a further $1 trillion to that stockpile over the next year. Even this may be exceeded in the months ahead, if Treasury borrowing is seen as potentially putting upward pressure on long-term interest rates.
The Federal Reserve’s Federal Open Market Committee meets this week to discuss this and other aspects of monetary policy. They are unlikely to make any further dramatic moves except to recommit to doing whatever is necessary to aid the economic recovery. However, the Fed Chair, Jay Powell, may also comment on the idea that the Fed will adopt an “average inflation targeting” policy later this year. This would involve accepting an inflation rate running above their 2% target for some time to make up for all the time inflation has spent below 2% in recent years.
While this policy may have a veneer of intellectual respectability, it is a risky idea in a world where central banks have gradually been removing the implicit guarantees that backstop fiat money. If inflation does begin to accelerate, it is by no means clear that inflation expectations will be slow to follow. If consumers, businesses and workers suddenly begin to expect much higher inflation, they may collectively try to convert cash balances and financial assets into consumer goods, real estate, commodities and foreign assets. This, in turn, could lead to higher interest rates, higher taxes and a lower dollar. This is unlikely to occur this year but could become a more significant threat late next year or in 2022, particularly if Washington does not remove fiscal and monetary stimulus as the economy recovers.
Europe—A Less Imperfect Union
This risk is unsettling, given today’s relatively high valuations in U.S. fixed income and equity markets. However, one broad antidote for this risk could be European equities. As we illustrate on page 51 of the Guide to the Markets, Europe has had significant success in taming the spread of the coronavirus in recent months and this is enabling the continent to continue with a phased reopening of its economy.
In addition, last week, in a watershed agreement, European Union leaders agreed to a €750 billion coronavirus relief fund, financed by E.U. institutions themselves and directing resources to the poorest member states. While this move was clearly triggered by the extraordinary circumstances of the pandemic, it established a crucial principle that the European Union was willing to provide some fiscal aid to nations in an emergency. The lack of this fiscal support was, in large part, responsible for the European debt crisis and this new move towards fiscal coordination, albeit with significant conditions, should reduce the riskiness of the euro and, by extension, euro-denominated assets going forward.
It should also be noted that European equities carry lower P/E ratios than their U.S. counterparts and that Europe will likely have less need to raise taxes in the aftermath of the pandemic than the U.S. Moreover, Europe runs a significant trade surplus, in sharp contrast to the U.S., and a rise in the euro could amplify equity returns for U.S. investors.
It has to be acknowledged that the tech sector is less important in European equities than in the U.S. Indeed, this has been a key reason for European stocks underperforming their U.S. counterparts in recent years. However, for investors who are worried about a slowing in the U.S. recovery, the consequences of excessive monetary and fiscal stimulus and lofty U.S. equity valuations, European equities could provide a logical antidote.
David Kelly is chief global strategist at JPMorgan Funds.