Predicting the path of recovery

Mike Pyle: Thank you, Zach.  I'm pleased today to welcome two distinguished guests, Larry Summers and Rick Rieder, both of them in the category of needing no introduction.  But perhaps just briefly before we get into our conversation, Larry Summers, former Treasury Secretary under President Clinton, former National Economic Council Director under President Obama, the former President of Harvard University, Professor of Economics at Harvard, including the John Bates Clark Award winner, and perhaps along with Stan Fischer, Ben Bernanke, Janet Yellen, one of the great scholar practitioners of post-war economics.  Rick Rieder, the Chief Investment Officer of Global Fixed Income of BlackRock, the Chairman of the BlackRock Investment Council, the Portfolio Manager of several of BlackRock’s most successful active franchises, SIO, Global Allocation, as well as somebody who also has a hand in public service, the Treasury Borrowing Advisory Committee, the New York Fed’s Advisory Committee on Financial Markets.  Larry, I'd like to start with you.  Perhaps just set some context for us if you would.  You were President Obama’s NEC Director during the peak of the global financial crisis a little more than a decade ago.  Maybe talk to us a bit about the similarities and differences between that moment and this one, you know, also a very historic crisis.

Larry Summers: Crises preoccupy.  They frighten.  They’re centrally about confidence.  People look to government and policy for reassurance.  All those elements are the same.  There’s more danger of underreacting than there is of overreacting.  That's another crucial respect in which these crises are the same and in which all crises are the same. 

This crisis, much deeper, peak to trough GDP, peak to trough unemployment, almost any measure much larger than the financial crisis.  Different source, coming from a fundamentally non-economic source, the pandemic.  And so, the playout less in the hands of economic policymakers than it was at that time.  Much more room coming into the crisis to ease financial conditions, to bring down rates, than there was this time.  And so, fiscal policy I believe is ultimately going to be much more important and health policy is going to be much more important and much less of the total effort is going to fall on financial policy than the last time round.

Mike Pyle: Fantastic, Larry.  To follow-up, particularly on the policy side, how would you assess the economic policy response to this crisis to date, you know, in the United States and globally to its scale, its speed, the degree of coordination between fiscal and monetary policymakers?  Looking ahead, you know, how do you assess the risks of the policy response from here?  And I guess, finally, you know, you’ve really done a lot to advance the conversation around secular stagnation around a low real rates environment.  How do you fit this moment and the policy response to it into that framework you’ve been developing over the past number of years?

Larry Summers: A lot of questions there, Mike. Battlefield medicine’s never perfect. But this time we learned the lesson that President Zedillo first stated to me that markets overreact, therefore policy has to overreact.  And so, the response was big and strong.  So, overall, high grades. 

I think we’ve worked harder to put a put in underneath financial markets than we have to put a put in underneath the real economy and I worry that with the fiscal stimulus running out that if Congress doesn’t act strongly we’re going to see very much of a W pattern develop. I think we’ve failed to recognize sufficiently that if people are scared of going to work, scared of going to a restaurant, scared of getting on an airplane that it doesn’t really matter what the interest rate is and it doesn’t even really matter what the budget deficit is. You’re going to have a lot of health problems, economic problems and we have over-invested in the economic solutions relative to the healthcare solutions. 

Finally, I think this is going to mark decisively the change that I’ve seen underway for the last decade in the basic paradigm of macroeconomic policy.  It used to be about maintaining a stable economy and avoiding the temptation of policymakers to overinflate, over-loosen, over-borrow, and overspend, which would lead to inflation.  Today, and I believe for the next decade, the central problem is going to be, as it was in the 1930s, is going to be absorbing all the private savings that are generated by a more affluent population, an economy where more of the rewards are going to capital, a world of longer retirement ages, and a world of greatly increased uncertainty, and a world where the canonical capital good, a chip or the computing power, is – costs next to nothing.  Look at the price of your cell phone.

And so, our challenge is going to be absorbing all that private saving without deflationary stagnation.  That's been the secular stagnation problem I’ve talked about and I think a combination of very low neutral rates and the fact that past a certain point demand isn’t very sensitive to financial conditions anyway means that we’re going to have to rely much more on fiscal type policies to keep the economy growing with adequate demand, employment, and price stability.

Mike Pyle: Thank you, Larry.  Maybe turning to Rick to bring you in on some of these same questions, you know, you were investing through the global financial crisis 12 years ago, Rick.  You know, how from your perspective as a major investor does this moment differ from that one?

Rick Rieder: Thanks, Mike.  And by the way, it’s an honor to be on this panel with Larry ... First of all, I think as Larry described it, it is very different than 2008 in terms of what created this and how that was building.  In 2008, some of the – you could see the underpinnings of what were the stressors being created in the system and then, quite frankly, there was a lot of planning around that.  But then, obviously, there was a shock to it. 

This came on – this is more of a combination of 2008 and 2001, because in 2001 ... so quickly and there was no way to anticipate that at all.  But I'd also say, you know, similar to what Larry described, that the response to this one has been so dramatic.  And just to put some of the numbers down in terms of what Larry’s describing and just put them – you know, I like to look at what they are relative to 2008 and the numbers are just profound.  I mean literally these, you know, when you talk about a fiscal response that’s over $2 trillion and put that up against 2008, in 2008 it was an average of about $470 million a day.  During this period, you’re talking about $11 billion a day, so meaning 20 times the size, meaning the speed at which – just like ... the speed at which this response has come in from the fiscal side is so profound.

And, you know, we’ve run numbers on when you think about the income effect and what Larry described, which is right, that the employment recovery is going to take a longer period of time.  But, when you put this sort of stimulus in, the actual income in the system, and that doesn’t translate easily about the population and that’s the part of what I think the challenge is going to be from here going forward.

But we actually – because you – when you take the stimulus and you put it on, you actually create a higher level of income, of money that’s gone into the system than pre-corona.  So, even the fiscal impact is just – and I would argue the consumption power, at least near-term, the consumption power which you’re seeing play out in things like automobile sales, housing for sure across a series of metrics, across trucking, etcetera, a lot of the high frequency data, credit card data, debit card data that we’re looking at

Monetary policy is tied equally as extraordinary and equally multiples the size of what we’ve seen in the past and I think that’s playing through the system in rapid fashion.  When you talk about a market today that has liquidity over – cash on the sidelines that is about $5 trillion ... that gets into the markets and it creates a lending mechanism ... financing mechanism that we’re seeing play out in things like the credit markets, the investment grade credit market particularly, that is significant.

And Michael, I just have one last thing and then we’ll talk about this later, the stock market.  People always use the stock market as a reflection of the economy.  The stock market is really different than the economy, more so today than we’ve ever seen before.  I was looking at the data the other day and literally 41 of the S&P 500 now is technology and healthcare.  So, you think about a lot of the job loss takes place today, whether that’s leisure, whether that is hotel, whether that’s restaurants and then there are a lot of discussion about airlines, particularly recently on account of the stock market is very different ... which is a reflection of technology, healthcare demographic trends.  So, the markets can actually react very, very differently than the economy.

Mike Pyle: Fantastic, Rick.  I mean looking ahead, describing that distinction between the market response and the economic response, you know, how do you think about the signposts that you're focused on around markets, the signposts that you’re focused on around the economics that could flow through to the markets, and how do you think about the risks on the policy side as we kind of roll the calendar forward the next handful of quarters?

Rick Rieder: I’ve never in my career ever seen anything like the sheer size of what is the monetary policy stimulus and what it means for markets generally.  That is, when you take interest rates to zero, and not just take interest rates to zero and then put tremendous amounts of liquidity in the system, but you create an asset allocation dynamic, you create a dynamic that impacts markets that is truly historic.  And when the Chairman of the Federal Reserve says historic quotes like we’re not even thinking about thinking about raising interest rates and you move things like the forward curve in the treasury market, I mean it’s looking at two year two year forwards that are still implying less than a 40 basis point move in interest rates, so you’re talking about long-term zero interest rate policy.  Then you think about risk asset markets and you think about, gosh, if I'm going to keep the risk-free rate pinned for years, you know, I always talk about when you think about different asset classes, the fan of dispersion, meaning as you get into go all the way down to equity, that fan of dispersion widens out.  But, when you pin the risk-free rate at zero for years, you create incredible dynamics around risk markets broadly and I think you’re seeing that play out across the markets in incredible fashion.

You know, some of these numbers, if the Fed, if you think about it by the end of this year, if the Fed’s going to take the balance sheet to a $10 trillion number, I just, just I’ll put that number – I've used this in other forms.  When you put that number into the equation, the entire globe – the entire US aggregate index is about a $24 trillion index.  So, they're not buying pro rata to the ag, for sure.  But, just put in perspective that you’re going to take a balance sheet that’s going to be roughly, you know, 40% of the ag.  When you take out 40% of the fixed income market, you’re basically telling the world you’d better figure out something else to do.

And so, why I think you’ll continue to see this movement into – you’ve seen it into equities, you’ve seen it into alternatives and, you know, the return that is required across markets is extraordinary, particularly when you have an aging demographic which gets into pension funds and insurance companies.  So, anyway, this is – I mean the impact on markets and what policy is doing is pretty extraordinary in real-time. 

And then, your question about how do you follow this from here and what is a risk from here, gosh, we’re going to go through an evolution.  We’re going to go through potentially a change, or not, in terms of, and let others comment on this, in terms of what the leadership is in the United States.  And there’s going to be some evolution I would think around tax policy potentially. 

I don’t think the central banks have to necessarily foreshadow all of their tools that they could utilize in – immediately.  So, things like yield curve control is something they could consider doing.  But, if they don't have to do it, they don’t need to.  And I think preserving some of that flexibility I think is really important.I think policymakers having some flexibility to react is really important and giving those tools up I think are potentially dangerous.00:38:29

Mike Pyle: Before we close out the section on macro and maybe move a little bit more to about micro, just want to turn quickly to Larry.  You know, any observations, reflections based on I mean what you’ve heard from Rick and how the conversation’s played out?

Larry Summers: Two observations: One, I think he’s right that it’s not yet time and it may never be time for yield curve control.  A central bank should conserve its weaponry, not fire it all at once.  It’s doing fine keeping the long end pegged low without yield curve control, so why commit that inflexibility?  In general, yield curve control is like pegging an exchange rate.  It’s something that’s much easier to enter than it is to exit, and I'd advise against it right now.

Here’s an analogy that I’ve found helpful that comes off of what I thought was a very good point that Rick made.  In discussions of Europe, we’re used to the concept that there can only be one safe rate in Europe set by the ECB.  But there are very different needs for monetary policy in Mediterranean countries than there is in Germany or the Netherlands.  And so, you tend to set a rate, particularly a few years ago, that’s right for Europe as a whole and that tends to lead to a lot of asset price inflation in the quality core. 

Something like that is happening in the United States today.  We’re setting a monetary policy for all of America.  But, for the S&P economy that’s an extremely loose monetary policy and is creating a situation that asks for trouble.

Finally, let’s just be really clear about one thing.  We said, many people said, I actually didn’t, that we kind of now had a stable financial system after 2008.  The magnitude of what we’ve had to do to keep the financial system stable illustrates that we do not yet have a financial system that is on its own resilient without a hyper-aggressive central bank and that needs to be the cause for a lot of soul searching in both the private sector and the public sector.  We stress tested our system of financial regulation and it didn’t come through so well, because our system of financial regulation once again was a hyperactive central bank. 

Mike Pyle: Let's shift gears to microeconomics by, you know, Rick, first to you.  This crisis has created major cross-sectional dispersion in markets, winners and losers.  You know, the winners in this crisis so far, interestingly which have been sort of the same set of winners, you know, the past number of years, quality growth, especially in technology, the United States, the regional exposure in particular because of the concentration of those tech-oriented growth names here.  You know, how do we think about the durability of those names from here and, on the flip side, you know, where do you see opportunity in the parts of the market that have perhaps been disfavored so far, whether by sector or geography?

Rick Rieder: Thanks, Mike.  So, you know, the first thing that’s interesting and I'm ... by the credit markets because I mean they have become in a large way the only game in town and if you’re, particularly if you’re looking for income in the fixed income markets, as you think about what the Fed has done in terms of neutralizing the immense amount of Treasury issuance so that functionally they are the buyer of the Treasury market and increasingly the agency mortgage market.

So, the credit market, if you are looking for income is one of, you know, we can talk about the securitized market but not that large and very bifurcated, which I’ll talk about in a second.  But the credit markets are functionally the only game in town.  So now, let’s talk about credit.

The way we’ve traditionally thought about credit is am I going to take risk in the high yield market or less risk in the investment grade market.  And I actually think that whole set of monikers doesn’t make a lot of sense anymore.  And to your point about winners and losers, what was rated at a given level a year ago or six months ago is not necessarily who the winners and losers are today.  It’s much more akin to what is the sector you’re operating in.  And, in fact, if you are an investment grade company in the energy space versus a cable company in a high yield space, you can have the exact opposite reaction you would think based on rating.

So, winners and losers I think are very much in credit determined by, and we’ve studied this actually.  The volatility and the risk-adjusted return is much more sincere to industry/sector/company than it is to rating today.  You know, you think about what the Fed’s doing and how they’ve constrained themselves, you know, to a large extent I agree with, into the one to five year investment grade space, you know, funding companies at 40, 30-40 basis points total yield.  You know, that – those assets I would argue there’s not a lot of value.  But in some of the sectors in high yield, there’s real opportunity but it’s very much bifurcated and, you know, quite frankly, I think we still think some of the areas that we talk about cable, healthcare, technology, etcetera, are still very attractive in the high yield market.

Away from that, and then you talk about areas of the securitized markets.  You know, we’re going through an incredibly complex time and, you know, we have residential real estate is in very good shape and, you know, when we think about the housing market, the home builder market, even most parts down to the lower quality end of the residential market.  But then, you go to and you think about commercial real estate, Mike, it’s really hard figuring out how, maybe not how multi-family progresses from here, but things like office, retail, hotel, those, that is really hard.  And, you know, how much risk you want to take in those areas is something that we’re really, you know, thinking about.  We’re, you know, we’re erring on the side of being more high quality in how you think about that.

And then, maybe I’ll just spend one minute on regional, the regional dynamics.  The world is separating itself in an incredible way, and Larry is much more thoughtful about this than I am.  But, you know, think about areas of growth like China that the resilience and the ability for China to come back from this is – has been heretofore very impressive. 

But, the one last one that I think is interesting is actually I think that Europe is coming out, relatively speaking, in a more positive fashion than we’ve seen in a really long time.  And we can debate, you know, what created a willingness to functionally mutualize debt, assuming Eurozone Recovery Fund passes, or to create real fiscal stimulus evolution.  But it is happening.  And for the first time, I actually think Europe are also actually seeing some better results from a virus point of view and we can talk about the different regions within that.  But I actually think Europe is really interesting as a diversifier for investing today because, you know, we can debate what it took to get here, but I actually think Europe is really interesting.

Mike Pyle: So, Larry, maybe sticking with a similar theme, thinking about the parts of the global economy that have been particularly challenged during the crisis.  I guess one model, perhaps especially early on, was this idea around freezing economies in place with massive policy support and then hoping to restart them with as little long-term scarring as possible.  Perhaps harder to see that working as the shock endures.

But I think, first, you know, just how much restructuring and reallocation do you think the economy is going to have to go through overall in the period of time ahead?  Are there industries that seem especially likely or unlikely to make those transitions, perhaps travel, hospitality, offices, retail, real estate, what have you?  And also, to Rick’s last point around the US versus Europe, you know, thinking about the different policy responses, especially around the labor market there, you know, UI here.  There’s something like ... in Germany.  How do those different systems allow the labor market shock to be managed and smoothed in different economies?

Larry Summers: So, let me say a few things about all those questions, Mike.  First, general principle, things that were in motion and were accelerated by corona, more use of information technology, less travel, more video conference.  All those things aren’t going back to the way they were.  Commercial office usage, not going back to where it was.  Road warriors, many fewer than there were before.  So, there are a variety of – telehealth, way up.  There are a variety of areas where we’re going to see ten years’ change in ten months because of coronavirus and people just have to think through what they are.

Second, this is going to be with us for a long time.  What we’re learning is that the health consequences for the people who had it are going to be continue – are likely to be more continuing than we had first realized.  I know that there’s all this optimism about vaccines.  Everything in my life experience tells me that when you have a very advanced, very complex, very large-scale, very complicated project, it never comes in on time and there are surprises, but the surprises are much more likely to be negative than positive. 

So, I believe next July 4th will be more like this July 4th than it is like the July 4, 2019 in terms of the way we’re all living, and I don’t think everybody has fully adjusted to that reality.  Even when we have a vaccine, people will need more than one.  It won’t last forever.  There’ll be a lot of people who are scared to take it.  It’s not going to be the silver bullet that many people see it as being.

The right paradigm for viewing the recovery or for viewing the economy through this period is collapse.  We’re mostly through that.  That's good.  Bounce back, hard bounce back.  The bad news is we’re mostly through that, too.  And slog.  And slog I believe is likely to be with us for quite some time. 

Rick may be right about Europe and I think there’s a larger chance that he’s right than I have at many other moments.  But I would caution that there’s a lot of complex politics left to play out in Europe and Europe without Mrs. Merkle is potentially a very different place than Europe with Mrs. Merkle.  And so, we don’t really know where that’s going to go.  And starting from today’s risk premium in Europe, there’s more to go wrong than there is to go right.  And while I have a variety of issues with respect to stress testing, transparency, and the health of US financial institutions, they are Rocks of Gibraltar compared to many European financial institutions.  So, I wouldn't be quite as optimistic as Rick was.

I think we’ve got three big aftershocks to worry about:  More health problems, second wave, all of that; loan and commercial real estate problems; and emerging market debt problems.  And those are what we have to worry about going forward. 

Mike Pyle: Larry, Rick, so appreciative that you would spend the time with us today that you have.  Thank you so much for the insight and perspective on where we are in our economy and markets, in policy.  On behalf of BlackRock’s institutional clients, thanks to you both.  And with that, back to you Zach.

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