E

CO

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COPE

The Economy Observer

2 September 2020

Trying to make sense of US economic policies

When success seems worse than failure

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Last week, the US Federal Reserve (US Fed) gave a clear verdict through its actions. Amid the ongoing debate on global

inflation, the Fed seems to have chosen its side – ‘inflation is not an imminent threat.’ Not only has the Fed replaced

inflation by employment (or growth) as its primary mandate, but has also relaxed inflation target. It now seeks to

achieve an

average

inflation of 2%

over time.

Not surprisingly then, the divergence between the real economy and the

stock markets has widened further, with the latter conquering new all-time highs.

In this note, we have penned down our thoughts on ‘Why the US Fed seems oblivious to the growing divergence

between the stock market and the real economy?’ We argue that by pushing the stock markets higher, the Fed is trying

to create a positive ‘wealth effect’ for American households, whose exposure to equities is as high as ~45% of the total

financial assets – the highest in almost past half the century and also the highest compared to any other nation. With

the US Monetary Policy being totally aligned with its Fiscal Policy, there is only one clear objective – making Americans

feel prosperous and wealthy. Overall, it appears that the US policymakers are all-out now to lead better recovery.

These economic policies are expected to lead to one of the four exhaustive possibilities: (a) lower growth with lower

inflation, (b) higher growth with lower inflation, (c) lower growth with higher inflation, and (d) higher growth with

higher inflation.

The first scenario qualifies as an ‘economic failure’, which would lead to Japanification of the US economy. The second

possibility, though most desirable, in all probability is the least to occur. The third option – also called ‘stagflation’ –

would take the world economy back to the horrors of the early-1980s. The fourth option, which ironically also qualifies

as the ‘success of economic policies’ would bring forth the worst possible nightmare by potentially pricking the massive

bubble in the financial markets, including debt markets.

As of now, we believe that the first option (economic failure) is most likely to materialize – higher inflation is not on the

cards in the foreseeable future. However, any signs of higher inflation or of economic policies leading to higher growth

could create immense pressure in the financial markets with the outcome being worse than the one associated with a

scenario of failure.

US Federal Reserve has changed its long-term goals and strategy…:

Mr. Jerome Powell, Chairman of the US Federal Reserve (the US Fed), created a stir

in the financial markets last week – the US Fed promoted ‘employment’ as it

primary mandate and ‘inflation’ is now secondary. Further, the secondary mandate

has been relaxed with the FOMC now seeking to achieve an ‘average’ inflation of 2%

over time.

With no clarity on ‘over time’, speculations are rampant. Abundant

reports are claiming that the first rate hike may come after 5-10 years, and it may

take as many as 42 years (in 2060s) – based on an assumption that the US Fed

decides to iron out the lackluster inflation witnessed since Jan’07.

By pushing inflation down

on its priority list, the US

Fed appears to have chosen

its side on the inflation

debate and it certainly does

not see it as an imminent

concern.

By pushing inflation down its priority list, the US Fed appears to have chosen its side

on the inflation debate and it certainly does not see it as an imminent concern.

Growth or employment is now the top target for the US Fed, which indicates that

the rates – irrespective of the definition of ‘over time’ – would certainly remain low

for much longer than previously anticipated.

Nikhil Gupta – Research Analyst

(Nikhil.Gupta@MotilalOswal.com)

Yaswi Agarwal

– Research Analyst

(Yaswi.Agarwal@motilaloswal.com)

Investors are advised to refer through important disclosures made at the last page of the Research Report.

Motilal Oswal research is available on

www.motilaloswal.com/Institutional-Equities,

Bloomberg, Thomson Reuters, Factset and S&P Capital.

Since the Monetary Policy effectively works through the financial markets, a

confirmation of low interest rates for longer-than-previously expected time period

has pushed equity markets to an all-time high. The US’ S&P 500 crossed the 3,500-

mark for the first time ever while the S&P Global 100 index touched an all-time high

of 2,400-mark at the end of last week. In midst of all this, a pertinent question is

‘Why

the US Fed seems oblivious to the growing divergence between the stock

market and the real economy?’

Worse, it appears that the US Fed’s policy is fueling

it on purpose. Is there any logic to this reaction? Well, of course there is.

Unarguably, the US’ Monetary Policy affects the entire world economy through the

connected financial markets. Economies may be domestic, but money is global.

Decisions of the US Federal Reserve have immense externalities for all financial

markets, including Emerging Markets. However, the Federal Reserve’s focus area

(like all Central Banks in the world) is the domestic economy. The positive or

negative externalities are the issues to be handled by the recipient nation.

Since the US Fed appears to have made up its mind to make its Monetary Policy

growth-enhancing rather than worrying about inflation, it is doing its best to make

American households feel more prosperous and wealthy. A Central Bank definitely

has its limitations when its objective is to reach the household sector. And

therefore, since the US Fed, so far, has resisted direct money transfer to American

citizens (Yes, we know it sounds weird, but so did the US Fed buying junk bonds till a

few months ago!), it is attempting to work via the financial markets.

As much as 46% (amounting

USD43t) of all financial

assets of US households

were held in equity shares

as at end-CY19.

American households are unique with regards to their exposure to the equity

markets. Total financial assets of US households amounted to USD94t (or ~440% of

GDP) as at end-CY19. As much as 46% (amounting USD43t) of all financial assets (on

outstanding basis) were held in equity shares (corporate, non-corporate or mutual

funds). Another 32% were in the form of long-term/retirement assets (such as

insurance and pension entitlements, I&PEs) and only about 14% were held in the

form of deposits

(Exhibit 1).

Moreover, the share of equities in household financial

assets has risen almost continuously from its near all-time trough of 33% in 2008 to

45.5% in 2019, marking the highest rate since 1972

(Exhibit 2).

Exhibit 2:

…the highest ratio in almost the past half century

(since 1972)

62

54

46

Share of equity@ in HH financial assets (%)

Exhibit 1:

Equity@ assets accounted for 45% of all financial

assets of American households in 2019…

Share of various assets in HH financial assets (%)

Equity, 45.5

Others, 1.6

Debt

securities#,

6.9

Deposits,

14.5

I&PEs*,

31.5

38

30

@ Corporate/non-corporate equities and mutual fund shares

# Including loans

* Insurance reserve & pensions entitlements

Based on the balance sheet data

Source: US Federal Reserve, MOFSL

2 September 2020

2

The risk appetite of

American households is the

highest v/s their

counterparts in several

other major nations.

Notably, the risk appetite of American households is the highest compared to their

counterparts in several other major nations

(Exhibit 3).

Canada and Spain are the

only two other economies, where households have an exposure of more than a third

of their total financial assets into equities. The other extreme is India, where equity

exposure is only 14% of total financial assets. The numbers become starker if we

look at equity assets of households by GDP in respective countries.

Exhibit 3:

American households have the highest exposure of equity assets in their financial balance sheet

HH equity exposure in financial assets (%)

37.9

26.6

28.1

28.8

42.0

45.5

14.0

15.0

15.1

16.0

18.1

18.6

20.0

21.4

21.8

India

Japan Singapore

UK

S Korea Australia Taiwan Germany

Italy

Russia

France

China

Canada

Spain

US

CY19 data for all countries except China (CY16), Taiwan (CY18) and India (FY19)

Source: CEIC, Reserve Bank of India (RBI), MOFSL

Back in

2003,

when Dr. Ben Bernanke was a member of the US Federal Reserve’s

Board of Governors before serving as the Chairman of the US Federal Reserve during

2006-14, he (along with Mr. Kenneth Kuttner of the Federal Reserve Bank of New

York) concluded that real transmission of the Monetary Policy to stock markets

happens by affecting the perceived riskiness of stocks. Last week, when the US Fed

relaxed its inflation target, it indicated that interest rates would remain low for a

longer-than-expected period. Thus, the perceived riskiness of stocks is definitely

reduced by the US’ Monetary Policy and is boosting equities.

Owing to government

transfers, the US’ PDI has

increased 8.1% YoY in the

first seven months of CY20

(Jan-Jul’20), marking the

highest growth since the

late 1980s.

…and is now totally aligned with its Fiscal Policy:

In fact, the US’ Monetary Policy is in conjunction with the Fiscal Policy, wherein the

government has transferred a huge sum to its citizens and supported them during

the COVID-19 pandemic. As the debate goes, the support seems to be more than

required. Personal disposable income (PDI) in the US has increased 8.1% YoY in the

first seven months of CY20 (Jan-Jul’20), marking the highest growth since the late

1980s

(Exhibit 4).

As discussed

earlier,

almost the entire PDI growth is on account of

government transfers. Excluding the current transfer payments, nominal PDI

declined ~20% YoY in the first seven months of CY20, by far the worst-ever

contraction in the post-World War period.

Moreover, since American households have higher exposure to equity assets,

dividends received from the equity ownership has also affected PDI. In fact, the

share of these dividends had increased to an all-time high of more than 7% of PDI in

CY18-19, beating the previous high of 6.8% in 2008

(Exhibit 5).

The share of dividends had

increased to an all-time

high of >7% of PDI in CY18-

19.

2 September 2020

3

Exhibit 4:

Government transfers led nominal PDI has grown

at 32-year highest pace in 2020*

16

12

8

4

0

Nominal PDI (% YoY)

Exhibit 5:

Dividend income has become a bigger and

important source of PDI in the US

8.0

6.5

5.0

3.5

2.0

Share of dividends in personal income (%)

7.0

1960

1970

1980

1990

2000

2010

2020*

Source: US Federal Reserve, MOFSL

* For the first seven months of 2020 (Jan-Jul’20)

Overall, it seems pretty clear that the US authorities – fiscal as well as monetary –

are now committed to boosting the household sector, and have conclusively left

behind inflationary worries. The divergence between the stock markets and the real

economy is a testimony to this policy stand.

As explained

earlier,

we also believe that higher inflation in the US is unlikely in the

imminent future. Since we do not expect strong growth recovery, we also believe

that low-to-moderate inflation is more likely to grip the economy in CY21. If so, it

appears that the so-called bubble in the stock markets may continue for a long

period of time. This seems even more obvious because if the financial markets show

any signs of worry, the US Fed stands ready to intervene in the bond markets

directly and equities indirectly.

Thinking the unthinkable – Make a wish carefully

However, reality could change for the worse with the unexpected resurgence in

inflation. What if inflation (measured by the Fed’s preferred core PCE index) moves

up from 1.3% YoY in Jul’20 to 2% early next year and moves toward 2.5% by mid-

CY21? Note that while the Fed has rephrased its longer-term goals and Monetary

Policy strategy, it still aims to achieve inflation

moderately above 2% for some time.

How would the bond markets react then? Of course, the Fed is expected to support

yields, but would it, considering inflation has moved toward its relaxed target? Has

the Monetary Policy been so disjointed with the inflationary implications?

Sooner or later, the global economic policies will lead to one of the only four

possible scenarios – (a) lower growth with lower inflation, (b) higher growth with

lower inflation, (c) lower growth with higher inflation, and (d) higher growth with

higher inflation

(Exhibit 6 on the following page).

The first scenario will qualify as an ‘economic failure’ leading to Japanification of the

US economy. The second possibility, ‘the true economic success’, though most

desirable, has the least probability to occur. The third option – also called

‘stagflation’ – will take the world economy back to the horrors of the early-1980s.

The fourth option – which ironically also qualifies as successful – would bring forth

the worst possible nightmare by potentially pricking the massive bubble in the

financial markets, especially debt markets.

4

However, reality could

change for the worse with

the unexpected resurgence

in inflation.

The global economic

policies will lead to one of

the only four possible

scenarios – lower growth

with lower inflation, higher

growth with lower inflation,

lower growth with higher

inflation and higher growth

with higher inflation.

2 September 2020

In short, it actually does not matter what leads to higher inflation but if that

happens, the world economy will witness the worst possible collapse. For instance,

if higher inflation is led by better-than-expected recovery, then economic policies

leading to the growth revival would qualify as ‘successful policies.’ However, its

impact on the debt markets would be scary. Not only would bond yields rise sharply,

but also the Fed would find it more difficult to support them. If there are any

thoughts of this scenario being a boon for the equity markets, it needs to be

reviewed. A fundamental shift in inflation trajectory (led by recovery) could actually

demand a repeat of the 1980’s Volcker’s performance, pushing yields further higher

and leading to a collapse in the stock markets.

It doesn’t matter what leads

to higher inflation, but this,

to our mind, is the only

potent threat to the

ongoing rally in the global

equity markets.

On the other hand, if inflation is led by some external event, such as oil prices,

would the Fed ignore rising inflation amid the weak recovery growth? What would

stagflation do to the financial markets?

In short, it doesn’t matter what leads to higher inflation, but this, to our mind, is the

only potent threat to the ongoing rally in the global equity markets.

EXHIBIT 6: FOUR EXHAUSTIVE ECONOMIC SCENARIOS – DO WE REALLY WANT TO SUCCEED

High growth, Low inflation

“Economic Success”

(Most desirable but least

likely scenario)

High growth, High inflation

"Troubled Success"

(Bond yields surge, creating

havoc in financial markets)

Low growth, Low inflation

"Economic failure"

(Japanification of the US

economy; financial markets

continues their dream run)

Low growth, High inflation

“Stagflation”

(Return of early-80s horrors;

Financial markets collapse)

INFLATION

Source: MOFSL

Also, if higher inflation becomes a reality, the turmoil in the bond markets – the size

of which is in multiple to that of the stock markets – would make the crash in the

latter look dwarfed. Remember, sovereign bonds worth USD15-16t are trading with

a negative yield, almost double from USD8t in Mar’20, but still lower than the peak

of USD17t almost a year ago.

2 September 2020

5

There is no easy way out of

these dangerous economic

policies adopted around the

world during the past 12-13

years, which got

exponentially exaggerated

in light of the COVID-19

pandemic.

Overall, there is no easy way out of these dangerous economic policies adopted

around the world during the past 13-14 years, which got exponentially exaggerated

in light of the COVID-19 pandemic. If these economic policies are successful in

pushing growth higher, the future will be extremely uncertain and highly volatile

considering that for the first time ever, the Central Banks will have to stitch together

an unprecedented exit strategy. On the other hand, if these economic policies

remain a failure with subdued growth and weak inflation, the divergence between

the real economy and the stock markets may simply continue to widen without any

breaks. Amid these facts, it is questionable if the policymakers (or market

participants) are actually wishing to succeed or fail.

2 September 2020

6

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The person accessing this information specifically agrees to exempt MOFSL or any of its affiliates or employees from, any and all responsibility/liability arising from such misuse and agrees not

to hold MOFSL or any of its affiliates or employees responsible for any such misuse and further agrees to hold MOFSL or any of its affiliates or employees free and harmless from all losses,

costs, damages, expenses that may be suffered by the person accessing this information due to any errors and delays.

Registered Office Address: Motilal Oswal Tower, Rahimtullah Sayani Road, Opposite Parel ST Depot, Prabhadevi, Mumbai-400025; Tel No.: 022 71934200/ 022-71934263; Website

www.motilaloswal.com.

CIN No.: L67190MH2005PLC153397.Correspondence Office Address: Palm Spring Centre, 2nd Floor, Palm Court Complex, New Link Road, Malad(West), Mumbai- 400 064. Tel No: 022

7188 1000.

Registration Nos.: Motilal Oswal Financial Services Limited (MOFSL)*: INZ000158836(BSE/NSE/MCX/NCDEX); CDSL and NSDL: IN-DP-16-2015; Research Analyst: INH000000412. AMFI:

ARN - 146822; Investment Adviser: INA000007100; Insurance Corporate Agent: CA0579 ;PMS:INP000006712. Motilal Oswal Asset Management Company Ltd. (MOAMC): PMS (Registration

No.: INP000000670); PMS and Mutual Funds are offered through MOAMC which is group company of MOFSL. Motilal Oswal Wealth Management Ltd. (MOWML): PMS (Registration No.:

INP000004409) is offered through MOWML, which is a group company of MOFSL. Motilal Oswal Financial Services Limited is a distributor of Mutual Funds, PMS, Fixed Deposit, Bond,

NCDs,Insurance Products and IPOs.Real Estate is offered through Motilal Oswal Real Estate Investment Advisors II Pvt. Ltd. which is a group company of MOFSL. Private Equity is offered

through Motilal Oswal Private Equity Investment Advisors Pvt. Ltd which is a group company of MOFSL. Research & Advisory services is backed by proper research. Please read the Risk

Disclosure Document prescribed by the Stock Exchanges carefully before investing. There is no assurance or guarantee of the returns. Investment in securities market is subject to market risk,

read all the related documents carefully before investing. Details of Compliance Officer: Name: Neeraj Agarwal, Email ID: na@motilaloswal.com, Contact No.:022-71881085.

* MOFSL has been amalgamated with Motilal Oswal Financial Services Limited (MOFSL) w.e.f August 21, 2018 pursuant to order dated July 30, 2018 issued by Hon'ble National Company

Law Tribunal, Mumbai Bench.

2 September 2020

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