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Critical conversations from BlackRock Fundamental Equities

At BlackRock Fundamental Equities, diversity of thought and sharing of ideas are central to expanding our collective intelligence and informing our investment decision-making. That knowledge exchange is not confined within our own walls but extends to the global experts with which we engage.

The Expert-to-Expert series features candid conversations between our investment pros and the business heads, politicians, policymakers and academics who are leaders in their fields and influencers in our global economy. Through their expertise, we bolster our own. We invite you to bookmark this page and visit often for new entries throughout the year.

An investor's guide to an unprecedented recovery

March 2021 - After an unprecedented year, investors can expect an equally unmatched economic and market recovery. U.S. Fundamental Equities CIO Tony DeSpirito discussed the potential implications with former FOMC member William Dudley.

Carrie:
Welcome to “Expert to Expert,” a BlackRock fundamental equities video series that pairs our investment pros with the business heads, politicians, policymakers, and academics who are leaders in their fields and influencers in our global economy. Together, they explore the topics that are driving markets and shaping investor decision-making. In our first episode, Tony DeSpirito, CIO of US Fundamental Equities, hosted a virtual sit-down with noted American economist William Dudley, a former New York Fed President and Vice Chairman of the FOMC. They discuss the implications of bluer and greener government in the US and explore the evolution of a most unusual economic cycle. I personally am all ears and thrilled to turn the floor over to our experts. Gentlemen?

Tony:
Bill, it's great having you with us here today. I know you have a wealth of knowledge. And there's so much to be talking about right now, particularly at this point in time where policy, whether it's fiscal policy or monetary policy, is having such a large impact not only on the economy but also on markets. And of course, you historically had a big role in setting monetary policy as a high-ranking member of the Fed. You worked closely with both current Chairman Powell as well as Treasury Secretary Janet Yellen. And so you have a really great perspective on what's going on.
I think a great place to start our conversation is to really get your assessment of monetary and fiscal policy. And certainly, COVID-19 was an enormous crisis about health, about the economy, the likes of which we've never seen before. And policymakers really came to the rescue. They acted quickly. They acted in a big way. They acted globally. And we had a coordination between monetary and fiscal policy that, quite frankly, I think we've rarely seen historically.
I personally give them good marks for what's happened so far. I'd be interested to hear your thoughts. But more importantly, I'm interested to hear about what's next. How do you see all this playing out, Bill?

Bill:
That's a lot to unpack. Well, let's first start with the response to the COVID crisis.
I think you're absolutely right. It was unprecedented in speed and unprecedented in scope, both in terms of fiscal and monetary policy. It was pretty easy to know that that was the right thing to do because we had a sudden stop of the economy, so it was sort of all hands-on deck on both the monetary policy and fiscal policy front.
But when you look back a year ago and see what happened on monetary policy and fiscal policy, it was pretty extraordinary. By the end of March, so only a few weeks after the pandemic really started to take hold in the US, we had interest rates at 0, the Fed had initiated a whole bunch of special liquidity programs, and the government had already enacted the CARES Act, which was over $2 trillion of fiscal stimulus. So I think that was completely appropriate. And it basically provided a cushion, a floor, under the economy so that people would be able to make it through the pandemic to the other side.
Now, the good news is, where we are today, things look a lot brighter because the vaccination process is unfolding, and it looks like we're going to be able to reduce the social distancing and bring a lot of businesses back on stream that have been on the sidelines because of the pandemic. We also have an extraordinarily easy monetary and fiscal regime.
And the goal, quite frankly, is to try to get the 9 and 1/2 million people that are still out of work back to work quickly because this pandemic has been very uneven in terms of its impact on people and households. People who are high income who can work from home have been inconvenienced, but the persons in the front line who happens to work for a hotel or some sort of position in leisure and hospitality-- they may have lost their job. They may have been unemployed for many, many months. So the impact of a pandemic is quite unequal. There's about 9 and 1/2 million people that we need to get back to work.
So what's happening right now is monetary policy is on its maximum stimulative setting. Not only are interest rates at 0, the Fed has basically said we're going to keep interest rates at 0 for a long time. And the Fed's still buying $120 billion of treasuries and agency mortgage-backed securities each month.
And on fiscal policy, it's also on full throttle.
So the good news is we're going to get-- things are going to better. The economy is going to come roaring back in the second half of the year. And I think the $64,000 question is, how fast are we going to actually get those 9 and 1/2 million people back to work? If it happens fast, that's good. But if it happens fast, it also means that the policy regime will turn more abruptly than it did following the Great Financial Crisis.
The economic expansion began in 2009. We reached a 3 and 1/2 percent unemployment rate about a year ago, and no inflation arrived. And so that's the template people are using for this current expansion. That's the wrong template because the causes of this pandemic are completely different. This slowdown economic activity are completely different. And the policy response is much more powerful. So the economy is going to come bouncing back.

Tony:
So I think one of the things you said there that's really critical is, this recovery is going to be very different from that of the global financial crisis. And that's important for investors because I think investors naturally go to the playbook of the last crisis. Is there a historical analogy that we should think about in terms of this recovery?

CAPTION: Our experts see no historical precedent for the current recovery

Bill:
Not really. We haven't had a pandemic like this for over 100 years. And I would hesitate to say that what happened in 1918 is relevant to what's going to happen today. I think if the economy comes back, the biggest thing to keep your eye on is what's happening to labor utilization because if we actually are going to end up with an inflation problem, it's going to be because we put too much pressure on resources through a very stimulative monetary and fiscal policy.
And the way to keep an eye on that is not just watch the unemployment rate. The unemployment rate only captures those people who are actively looking for work. What we need to do is look at all those people who have left the labor force because they don't have any good employment prospects right now. How fast can we get them back into the workforce?

Tony:
And what do you think the answer to that question is? When do you think we will be back to full employment?

Bill:
Well, it's anybody's guess because we've never had an economic recovery quite like this one. But I think that the likelihood is it's going to happen quite a bit faster than people expect because what's restraining the economy is somewhat artificial. It's a pandemic. And if the pandemic goes away, then the economy should come bouncing back.
And the second thing is that there is a lot of stimulus in the system. We compare where we are today to where we were in 2009. Just look at the level of the stock market. Its many times higher than it was in 2009. And financial conditions today are very accommodative.
Also, the household balance sheet is in very good shape except for those 9 and 1/2 million people who are unemployed. If you look at the personal savings rate of the most recent month, it was over 20%, the personal savings rate. And that's even before this most recent round of stimulus is distributed to households. So there's plenty of jet fuel in the engine to push the economy ahead quite briskly over the next few months.

Tony:
As an investor, I'm paid to worry about what can happen, what can go wrong. All of us are. And so I do worry about unintended consequences. And I think the last time, maybe, we had strong fiscal and monetary policy would be in the early 2000s. And of course, there we ended up in a housing bubble. The most recent Case Shiller data has housing prices up 10%. Is that something we should be worried about? Is there something else that we should be worried about in terms of unintended consequences here?

Bill:
Well, I think the biggest risk is that things tighten up more quickly, which is sort of good news in the short run for corporate earnings and the stock market. But if they tighten up too quickly, then we'll see inflation sooner than people expect, and then the Federal Reserve will go from very easy to have to actually tighten monetary policy.

CAPTION: Fed monetary policy regime different from the last expansion

One thing that's really important right now is the Fed is undertaking a different monetary policy regime than the last expansion. Before, their goal was to arrive at 2% inflation-- to arrive at a neutral monetary policy setting exactly at the same time that we arrived at 2% inflation and full employment. So the idea was to get to neutral just at the right point in time.
This time, they're going to be late. They basically said that they're not going to start to tighten monetary policy until they think that we're at maximum sustainable employment, inflation has already reached 2%, and they think inflation is going to climb above 2% for some time. So they're not even going to start to tighten monetary policy until the economy is already at full employment and the economy is likely to go beyond full employment. So inflation is likely to shoot above 2%. And that means the Federal Reserve is going to have to take short term interest rates from 0 to probably in the order of 2 and 1/2 to 3%. That transition period for markets, I think, will be quite bumpy.

Tony:
OK, let's get beyond, say, 2022, when we're at full employment. What does the economy look like then? Certainly, if you look at the long history of this economy, you'd say, over decades, we grew at a 3% real rate. That was kind of the trend. And then since the global financial crisis, the trend downshifted to, call it, 2%.
It strikes me personally that, secularly, nothing has really changed, whether it's demographics or productivity, et cetera. And so do we-- once we're back to 22, back to normal, do we then downshift to a 2% growth rate? Or is there something that can be done to get us back to that historical 3% level?

Bill:
I think it's very unlikely. The wild card, of course, is productivity growth. If something is done that somehow lifts productivity growth, then obviously it can go to a faster growth rate. But the growth rate of the labor force is only about a half a percent a year. So labor force growth plus productivity growth gives real GDP growth. And I would guess that productivity growth- 1 and 1/2 percent is probably a reasonable guesstimate.

Tony:
That raises real questions for investors about what's the right investment playbook. I think there's clearly an early cycle playbook, and there's a late cycle playbook. So early cycle-- buy cyclical value stocks. Late cycle-- buy growth, buy bond proxies, buy yield stocks, stability stocks.
And it strikes me, based on what we discussed so far, that right now, investors clearly should be in the cyclical reflation playbook. But there's going to come a point in time where we're going to have to quickly switch back to the playbook of 2016, 17, 18. I'd like to get your thoughts on that.

CAPTION: Outlook for strong earnings recovery in 2H 2021 and 1H 2022

Bill:
I agree with you. I think that the second half of this year and the first half of 2022 will probably be a very strong cyclical earnings recovery. But we may have finished that by the middle of the 2022. And at that point, people might start to worry about running out of resources, that the Fed's going to ultimately have to tighten. They might have to tighten by more than they have in the past. And at that point, the cyclical story is going to be over.
And so I think that the challenge here is that this whole process could transition much faster than what people anticipate, especially those people who are using the Great Financial Crisis aftermath as their template. I think it's going to be much more compressed in time.

Tony:
So I think the big takeaway there is, we all have to be staying on our toes and be forward-looking and be active here.

CAPTION: An active approach is critical to navigating the cycle transition

Bill:
Yeah. I think you're absolutely right. The stock market today is already anticipating what's going to happen in the second half of this year. So really, when you're thinking about what's next, it's really, what's going to happen in 2022 and 2023?

Tony:
Let's shift gears a little bit to legislation. Biden successfully got through the COVID-19 package, $1.9 trillion. And it seems to me he did so without having to spend a lot of political capital. And I think the administration has clearly articulated that infrastructure spending is next on the list.
And I think it's an interesting area because, certainly, this is one that both Democrats and Republicans have talked a lot about over the years. Now, they have very different ideas about what infrastructure spending means and how to implement it. So I'd be interested in hearing your thoughts, given where we are with a very divided Congress, of, what is it reasonable to expect the Biden Administration to achieve on infrastructure? And then obviously, we'll come back to the next order, which is going to be, what's the impact on the economy and on stocks?

Bill:
So I'd be on the pessimistic side because of what we just saw in Congress in terms of passing this $1.9 trillion fiscal package-- no support from any Republican senators. And the reason why I cite that is there was no support from any Republicans, even though this was a very popular measure. If you look at the polling results, a very high percentage of households in the United States actually support what the Democrats did, yet they got no support.
Now, infrastructure spending is probably similarly popular as this fiscal package. But if you only have 50 Democrats that you have to keep in line, there really isn't much margin for error if the Republicans aren't willing to be bipartisan in this process. So I think the bar on everything from here is going to be more difficult.

Tony:
I like to be optimistic. I would like to have bipartisanship. And I did see some potential for that in the COVID bill. It would have been a smaller bill, but I did see the potential to have some Republican votes-- maybe a handful, maybe a dozen-- on a smaller bill.
And so I wonder, well, what about infrastructure? Could we get a smaller bill that would be bipartisan?

CAPTION: New legislation hard to pass in divided government

Bill:
It's certainly possible. I think there's a lot of support in the country for doing something on infrastructure. But I also think there's some wedge issues in infrastructure that make it more difficult. For example, if we're talking about infrastructure from the Democratic side, climate change and issues like that are going to be part of the thought process.
There's also the rural-urban divide in terms of where do you spend the money? And there's a rural-urban divide politically as well. So I think it's going to be hard. The Trump administration tried to bring infrastructure bill forward, and it didn't really get anywhere.
So I'm on the pessimistic side, even though, clearly, there is a need for a lot more infrastructure spending. And when you think about government spending, infrastructure is one where you really think that government spending can do a good thing because there's a lot of bottlenecks in the US economy. And coming back to our prior comments about productivity growth, one way you raise productivity growth is by eliminating bottlenecks in the economy. And one of the big bottlenecks we have is infrastructure.
Think about just the trains that come from New Jersey into New York City. They're constrained by the fact that there isn't much capacity under the Hudson River. We've been talking for years about expanding that capacity, and yet nothing's happened.

Tony:
What about the deficit? That's another area where the parties have had controversies over the years? Now, we do have a big deficit. And our debt to GDP, our total debt to GDP, is at record levels.

As investors, we like to talk about debt as it doesn't matter until it matters. And then once it matters, it's the only thing that matters. Certainly, that's true of a company, maybe different for a government, particularly like the United States.
But this has, in the past, been a hot button political issue. It could be an economic issue. Is it something we need to worry about?

Bill:
I think that it is something that we need to worry about, but not today. You're absolutely right. The debt levels are much higher. But debt service costs haven't gone up at all. And they haven't gone up at all because interest rates are so low.
So to me, the whole issue of the federal debt is really tied to the trajectory of interest rates. Once interest rates start to rise, then debt service costs will start to go up very, very rapidly. And that will actually increase the problem of ongoing budget deficits. So again, I think this is a problem not for today, but down the road when the Federal Reserve actually starts to tighten monetary policy.

Tony:
And it strikes me that that actually serves as a natural cap on growth actually because if growth gets too overheated, rates get high. Then debt servicing becomes an issue maybe not just for the government, but also for consumers and businesses.

Bill:
Yeah. That's one thing that would obviously slow the housing sector down. If interest rates go up, that would take some of the steam out of the housing market, which is actually performed remarkably well over the last year through the pandemic.

Tony:
With a deeply divided government, it strikes me that everyone can get behind the fiscal stimulus package. But maybe raising taxes is a little harder. What should we see-- what should we forecast there?

CAPTION: Recovery takes priority, making near-term tax increases difficult

Bill:
I'd be very surprised to see anything in the very near term for the obvious reason that the priority is economic recovery. And to talk about tax increases at a time that you're trying to generate a strong economic recovery seems that you're working at cross purposes. Medium to longer term, I'm sure the Democrats want to raise taxes on higher income people. The distribution of income in the United States has been badly skewed over recent years. And I think the Democrats want to do something to lean against that.
But getting that through Congress-- I think that's going to be very, very hard to do. One thing that could be done more easily is maybe give the IRS a little bit more resources so the taxes that should be paid that aren't being paid get collected in the future. Maybe that's something where you can find a way to get more tax revenue without actually changing the tax code in an explicit way, just better tax enforcement.

Tony:
And how about corporate taxes? I know raising personal taxes is a little bit more of a political hot button, but it seems like raising corporate taxes-- that may be something you could get all of the Democrats to coalesce around and hence pass?

Bill:
Perhaps. But I think that there were good reasons for what was done on the corporate tax side. Our corporate tax rates were high relative to other countries in the world. And that was causing all sorts of artificial gymnastics by corporations to try to move income from the United States to other countries, which had more gentle treatment of corporate taxation. And so the corporate tax changes in the US redress some of that imbalance. And so I think that-- do you really want to undo that and cause more corporate gymnastics just for tax avoidance in the United States?

CAPTION: Dudley: Limited changes to corporate tax policies

So I think that-- I wouldn't expect a huge number of things to happen on the corporate side. Maybe you close some of the corporate tax loopholes. The most obvious one that people have talked about closing for a very long time is covered interest. And it hasn't been closed. And that'll be a good test. Does it get closed finally in a Biden Administration?

Tony:
So let's switch gears to regulation and its potential impact on both the economy and markets. What are your broad-- I'll start with, what are your broad thoughts about where we should, as investors, be watching for regulatory changes that could have the most impact on markets?

Bill:
Well, my expertise is really about the financial sector, so let me speak to that. I think generally, the assessment of what happened over the last year is that the banking system actually came through the crisis in very good shape. And so I think there is not a huge appetite on anybody's part to dramatically increase the regulatory burden on the commercial banking sector. I think people feel we're in a pretty good place. The higher capital requirements, the liquidity requirements have all stood us in good stead.
I think the shortcomings in the financial sector have really been in the non-bank financial sector. We had another rescue of the money market mutual funds. We had a lot of turmoil in the Treasury market, in the mortgage-backed securities market. So I think when you think about what the Yellen Treasury is going to be looking at, I think they're really going to be looking at, what can we do to make the nonbank financial system more resilient and robust?
And they have a tool to address that, the Financial Stability Oversight Council, which, frankly, under the Trump Administration, basically fell into disuse. So the question is, what can the Financial Stability Oversight Council do to try to address some of the structural weaknesses that we've seen in the non-bank financial sector?

Tony:
I agree the banking sector came through this financial situation or crisis, the COVID crisis, with really flying colors. But there are some who say, look, it wasn't a real challenge because policy was so strong, and so it wasn't like other recessions. And we still need to do more.
Is that just a minority voice? Is that just a wrongheaded voice? What are you thinking on that?

Bill:
Well, there's a trade-off here. If I raise the capital requirements on banks, I make the banks more secure and resilient to financial shocks. But at the same time, if I do that, I raise the cost of intermediation. And I also reduce the size of the banking sector because some of that activity moves out into the non-bank financial sector.
So where you strike that balance between financial resiliency versus having a very smart banking sector-- I think that's something that people can debate. I think that people generally feel that the banking sector has done very well. Now, you're absolutely right. There were extraordinary interventions. And the banking sector would not have performed as well if we didn't have those extraordinary interventions.
But generally speaking, I think people think that the reforms that were enacted post the great financial crisis, the Dodd-Frank Act, all the international reform efforts have worked pretty well. We had tremendous market stress in March and April of last year. The derivatives market held up well. Central clearing worked. The banks had enough capital and liquidity. There'll be some tweaks around the margin.
Now, there's a whole debate about, when you're hit with a big financial shock like this, should banks be able to continue to pay dividends? The US said yes. Europe said no. So there's disagreement about how you husband your capital when you're under a period of stress.
I think one thing that's helped in the United States is the stress tests. The fact that every year banks go through a stress test for an economic environment that's considerably worse than what's expected gives the Fed and the private sector confidence that the banking system is going to be with us, even under more adverse conditions.

Tony:
Well, it's certainly nice to see the regulatory policy came through, and it worked.

Bill:
Yeah, I think it worked very well. If you remember back when we were implementing all these things, the banking sector said this is going to be awful. Loans we're not going to be available. The cost of funding was going to go up dramatically. And the reality is, that didn't happen.

CAPTION: DeSpirito maintains an optimistic outlook for U.S. banks

Tony:
Yeah. And as an investor, I've been saying for some time that the banking sector is safer and sounder, but the market hasn't-- the stock market hasn't fully given them credit for that. And so that's one of the things I certainly look forward to as we come out of this recession, maybe higher multiples on the bank as the market recognizes that they are safer and sounder and that this tail risk is largely been taken off the table.
It's not exactly regulation but, certainly, climate issues are important policy issues over the next-- certainly over the next couple of years, but obviously also over the next couple of decades. And it's an important part of the Biden agenda. It's important for investors too. I think investors are increasingly becoming clued into the fact that climate risk is investment risk. I'd like to hear how you're thinking about what the Biden Administration might do on climate change and what impacts we should be thinking about as equity investors.

Bill:
Well, I think the first thing they're going to try to do is increase the incentives to do things that help mitigate climate change. So what they would like is to increase the incentives for electric cars and to increase the incentives to move away from coal fire utilities, anything that can be done to reduce the rate of carbon formation in the atmosphere.
Now, how far they can get with a 50-50 Senate is anybody's guess. The good news, though, is there's a lot more wind at their back than there was 10 years ago in terms of the economics of actually dealing with the carbon problem because the cost of batteries in electric cars has come down dramatically. And so it looks like electric cars are going to be competitive with gasoline-powered cars very, very soon. Also, the cost of alternative energy sources like wind and solar has also come down significantly.

CAPTION: Climate-related changes more economically viable than ever before

So 10 years ago, it looked like you're going have to subsidize these things enormously to make it work. Now it looks like the economics are a lot more favorable. So I think we can actually make pretty good progress on the climate change agenda, given that the economics of generating electricity from wind and solar have improved so substantially.

Tony:

It's really great to see the economic improvement because, as business analysts, we've been talking about this for some time, that battery costs are coming down every year and that the efficiency of solar and wind is going up every year. And so these are going to become economically viable on their own. And I think you're right. We're at or near that tipping point. And there are, certainly from an equity investment point of view, some clear beneficiaries, whether that's in the industrial space, the auto space, the utility space. So some very clear beneficiaries. And we've got to ferret those out on a company-by-company basis to see what's discounted in versus what's not.
I think the energy sector is interesting to me because, certainly long term, there are some real going to be real challenges as oil demand declines, although, based on our work, it's going to take longer for the actual demand to decline than many think. Plus, I could foresee a situation in the interim, in the medium term, where oil demand is still quite robust, particularly with this recovery that we've talked about being a very fast, sharp recovery, so being a V-shaped recovery in oil demand. But if you think about oil supply being constrained actually, being much more of an extended U-shape recovery in terms of oil supply, particularly as the writings on the wall-- large companies are going to be just more and more hesitant to invest.
So I think that's interesting. I'd like to get your thoughts on that. And then I'd also like to get your thoughts on the financial sector here because there's risks of stranded assets where they lend to companies that aren't going to be around forever. So what are you thinking on that side?

Bill:
Well, you're absolutely right about the process. This transition is decades, not years. So even if electric cars reach the point where they're completely competitive with gasoline cars, it's going to take a long time to actually ramp up production, to mine the lithium to have the battery capacity in place.

CAPTION: Oil prices to remain underpinned by strong demand for some time

So the tipping point in terms of economics is going to be followed by several decades of transition. And so you're right. The demand for energy is going to be pretty-- for oil-- is going to be still very high for many years. And I think you're also right.
The fact that investment in shale got really disrupted by the drop in energy prices and oil prices that we saw last year means that you could have demand outstrip supply. You could actually see some upward pressure on energy prices. Now, the wildcard here, of course, is what does Saudi Arabia and Russia do in terms-- they have excess capacity that they can bring back on stream. And the question is, how high will they let energy prices get before they actually respond to that increase?

CAPTION: Climate change can have real investment implications

In terms of the stranded assets issue, I think that's really important because climate change can make it so that the things that you have invested in turn out to be in the wrong places. So you worry about all the investment that we've made along the coast of the United States. And if the climate evolves in a very bad way and sea levels rise very quickly, some of these assets may not really be saleable. And so people who have leant against those assets, which are oftentimes very long lived, may find that their performance is not as good as they have anticipated.
I know the Federal Reserve, in terms of their supervision processes, is now really looking closely at banks and asking themselves the question of, what kind of exposures do you have that would turn out to be bad if the climate change were to evolve in a way much more rapidly than what people potentially think is the most likely scenario?

Tony:
Yeah. So I think the nice, positive irony there is, this is another example, potentially, where regulation can actually be beneficial to the banks, not just the broader financial system, but also to individual banks.

Bill:
And it's the safety and soundness issue. Basically, if a bank continues to lend into areas that are at risk and the risks manifest themselves more quickly, then that bank could get into difficulty. So it's a real safety and soundness issue. And that's why bank supervision is relevant to this issue.

Tony:
Well, Bill, I want to thank you. This is this has been a pleasure connecting today. There's so much you've given us as investors to think about. I look forward to speaking in a year's time or a year and a half's time, and we can see how all this actually plays out.

Bill:
No, it's going to be a very interesting period because we've just never gone through anything like this, so. We're all making our prognostications, but you should be humble in that process because the uncertainty level is extraordinarily high.

Tony:
I agree. We're in uncharted waters. And it's going to be really important to be forward-thinking and active. So I want to thank you again, Bill. It's been a total pleasure.

Bill:
Thank you.

Carrie:
Investors certainly have a lot to think about today. And Tony and Bill provided some compelling context and insight. For investors, I would offer this key takeaway. Bill and Tony were definitely in agreement that the economy will come roaring back in the second half of 2021 and into 2022. But longer term, there are really no structural changes to the US economy. So as active, fundamental investors, a cyclical early cycle positioning is appropriate in the near term. But investors will need to be nimble in when to pull out the late cycle playbook.
I learned a lot today, and I hope you did too. Thank you for tuning in. And we hope you'll explore future episodes of Expert to Expert.

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Carrie:
Welcome to “Expert to Expert,” a BlackRock fundamental equities video series that pairs our investment pros with the business heads, politicians, policymakers, and academics who are leaders in their fields and influencers in our global economy. Together, they explore the topics that are driving markets and shaping investor decision-making. In our first episode, Tony DeSpirito, CIO of US Fundamental Equities, hosted a virtual sit-down with noted American economist William Dudley, a former New York Fed President and Vice Chairman of the FOMC. They discuss the implications of bluer and greener government in the US and explore the evolution of a most unusual economic cycle. I personally am all ears and thrilled to turn the floor over to our experts. Gentlemen?

Tony:
Bill, it's great having you with us here today. I know you have a wealth of knowledge. And there's so much to be talking about right now, particularly at this point in time where policy, whether it's fiscal policy or monetary policy, is having such a large impact not only on the economy but also on markets. And of course, you historically had a big role in setting monetary policy as a high-ranking member of the Fed. You worked closely with both current Chairman Powell as well as Treasury Secretary Janet Yellen. And so you have a really great perspective on what's going on.
I think a great place to start our conversation is to really get your assessment of monetary and fiscal policy. And certainly, COVID-19 was an enormous crisis about health, about the economy, the likes of which we've never seen before. And policymakers really came to the rescue. They acted quickly. They acted in a big way. They acted globally. And we had a coordination between monetary and fiscal policy that, quite frankly, I think we've rarely seen historically.
I personally give them good marks for what's happened so far. I'd be interested to hear your thoughts. But more importantly, I'm interested to hear about what's next. How do you see all this playing out, Bill?

Bill:
That's a lot to unpack. Well, let's first start with the response to the COVID crisis.
I think you're absolutely right. It was unprecedented in speed and unprecedented in scope, both in terms of fiscal and monetary policy. It was pretty easy to know that that was the right thing to do because we had a sudden stop of the economy, so it was sort of all hands-on deck on both the monetary policy and fiscal policy front.
But when you look back a year ago and see what happened on monetary policy and fiscal policy, it was pretty extraordinary. By the end of March, so only a few weeks after the pandemic really started to take hold in the US, we had interest rates at 0, the Fed had initiated a whole bunch of special liquidity programs, and the government had already enacted the CARES Act, which was over $2 trillion of fiscal stimulus. So I think that was completely appropriate. And it basically provided a cushion, a floor, under the economy so that people would be able to make it through the pandemic to the other side.
Now, the good news is, where we are today, things look a lot brighter because the vaccination process is unfolding, and it looks like we're going to be able to reduce the social distancing and bring a lot of businesses back on stream that have been on the sidelines because of the pandemic. We also have an extraordinarily easy monetary and fiscal regime.
And the goal, quite frankly, is to try to get the 9 and 1/2 million people that are still out of work back to work quickly because this pandemic has been very uneven in terms of its impact on people and households. People who are high income who can work from home have been inconvenienced, but the persons in the front line who happens to work for a hotel or some sort of position in leisure and hospitality-- they may have lost their job. They may have been unemployed for many, many months. So the impact of a pandemic is quite unequal. There's about 9 and 1/2 million people that we need to get back to work.
So what's happening right now is monetary policy is on its maximum stimulative setting. Not only are interest rates at 0, the Fed has basically said we're going to keep interest rates at 0 for a long time. And the Fed's still buying $120 billion of treasuries and agency mortgage-backed securities each month.
And on fiscal policy, it's also on full throttle.
So the good news is we're going to get-- things are going to better. The economy is going to come roaring back in the second half of the year. And I think the $64,000 question is, how fast are we going to actually get those 9 and 1/2 million people back to work? If it happens fast, that's good. But if it happens fast, it also means that the policy regime will turn more abruptly than it did following the Great Financial Crisis.
The economic expansion began in 2009. We reached a 3 and 1/2 percent unemployment rate about a year ago, and no inflation arrived. And so that's the template people are using for this current expansion. That's the wrong template because the causes of this pandemic are completely different. This slowdown economic activity are completely different. And the policy response is much more powerful. So the economy is going to come bouncing back.

Tony:
So I think one of the things you said there that's really critical is, this recovery is going to be very different from that of the global financial crisis. And that's important for investors because I think investors naturally go to the playbook of the last crisis. Is there a historical analogy that we should think about in terms of this recovery?

CAPTION: Our experts see no historical precedent for the current recovery

Bill:
Not really. We haven't had a pandemic like this for over 100 years. And I would hesitate to say that what happened in 1918 is relevant to what's going to happen today. I think if the economy comes back, the biggest thing to keep your eye on is what's happening to labor utilization because if we actually are going to end up with an inflation problem, it's going to be because we put too much pressure on resources through a very stimulative monetary and fiscal policy.
And the way to keep an eye on that is not just watch the unemployment rate. The unemployment rate only captures those people who are actively looking for work. What we need to do is look at all those people who have left the labor force because they don't have any good employment prospects right now. How fast can we get them back into the workforce?

Tony:
And what do you think the answer to that question is? When do you think we will be back to full employment?

Bill:
Well, it's anybody's guess because we've never had an economic recovery quite like this one. But I think that the likelihood is it's going to happen quite a bit faster than people expect because what's restraining the economy is somewhat artificial. It's a pandemic. And if the pandemic goes away, then the economy should come bouncing back.
And the second thing is that there is a lot of stimulus in the system. We compare where we are today to where we were in 2009. Just look at the level of the stock market. Its many times higher than it was in 2009. And financial conditions today are very accommodative.
Also, the household balance sheet is in very good shape except for those 9 and 1/2 million people who are unemployed. If you look at the personal savings rate of the most recent month, it was over 20%, the personal savings rate. And that's even before this most recent round of stimulus is distributed to households. So there's plenty of jet fuel in the engine to push the economy ahead quite briskly over the next few months.

Tony:
As an investor, I'm paid to worry about what can happen, what can go wrong. All of us are. And so I do worry about unintended consequences. And I think the last time, maybe, we had strong fiscal and monetary policy would be in the early 2000s. And of course, there we ended up in a housing bubble. The most recent Case Shiller data has housing prices up 10%. Is that something we should be worried about? Is there something else that we should be worried about in terms of unintended consequences here?

Bill:
Well, I think the biggest risk is that things tighten up more quickly, which is sort of good news in the short run for corporate earnings and the stock market. But if they tighten up too quickly, then we'll see inflation sooner than people expect, and then the Federal Reserve will go from very easy to have to actually tighten monetary policy.

CAPTION: Fed monetary policy regime different from the last expansion

One thing that's really important right now is the Fed is undertaking a different monetary policy regime than the last expansion. Before, their goal was to arrive at 2% inflation-- to arrive at a neutral monetary policy setting exactly at the same time that we arrived at 2% inflation and full employment. So the idea was to get to neutral just at the right point in time.
This time, they're going to be late. They basically said that they're not going to start to tighten monetary policy until they think that we're at maximum sustainable employment, inflation has already reached 2%, and they think inflation is going to climb above 2% for some time. So they're not even going to start to tighten monetary policy until the economy is already at full employment and the economy is likely to go beyond full employment. So inflation is likely to shoot above 2%. And that means the Federal Reserve is going to have to take short term interest rates from 0 to probably in the order of 2 and 1/2 to 3%. That transition period for markets, I think, will be quite bumpy.

Tony:
OK, let's get beyond, say, 2022, when we're at full employment. What does the economy look like then? Certainly, if you look at the long history of this economy, you'd say, over decades, we grew at a 3% real rate. That was kind of the trend. And then since the global financial crisis, the trend downshifted to, call it, 2%.
It strikes me personally that, secularly, nothing has really changed, whether it's demographics or productivity, et cetera. And so do we-- once we're back to 22, back to normal, do we then downshift to a 2% growth rate? Or is there something that can be done to get us back to that historical 3% level?

Bill:
I think it's very unlikely. The wild card, of course, is productivity growth. If something is done that somehow lifts productivity growth, then obviously it can go to a faster growth rate. But the growth rate of the labor force is only about a half a percent a year. So labor force growth plus productivity growth gives real GDP growth. And I would guess that productivity growth- 1 and 1/2 percent is probably a reasonable guesstimate.

Tony:
That raises real questions for investors about what's the right investment playbook. I think there's clearly an early cycle playbook, and there's a late cycle playbook. So early cycle-- buy cyclical value stocks. Late cycle-- buy growth, buy bond proxies, buy yield stocks, stability stocks.
And it strikes me, based on what we discussed so far, that right now, investors clearly should be in the cyclical reflation playbook. But there's going to come a point in time where we're going to have to quickly switch back to the playbook of 2016, 17, 18. I'd like to get your thoughts on that.

CAPTION: Outlook for strong earnings recovery in 2H 2021 and 1H 2022

Bill:
I agree with you. I think that the second half of this year and the first half of 2022 will probably be a very strong cyclical earnings recovery. But we may have finished that by the middle of the 2022. And at that point, people might start to worry about running out of resources, that the Fed's going to ultimately have to tighten. They might have to tighten by more than they have in the past. And at that point, the cyclical story is going to be over.
And so I think that the challenge here is that this whole process could transition much faster than what people anticipate, especially those people who are using the Great Financial Crisis aftermath as their template. I think it's going to be much more compressed in time.

Tony:
So I think the big takeaway there is, we all have to be staying on our toes and be forward-looking and be active here.

CAPTION: An active approach is critical to navigating the cycle transition

Bill:
Yeah. I think you're absolutely right. The stock market today is already anticipating what's going to happen in the second half of this year. So really, when you're thinking about what's next, it's really, what's going to happen in 2022 and 2023?

Tony:
Let's shift gears a little bit to legislation. Biden successfully got through the COVID-19 package, $1.9 trillion. And it seems to me he did so without having to spend a lot of political capital. And I think the administration has clearly articulated that infrastructure spending is next on the list.
And I think it's an interesting area because, certainly, this is one that both Democrats and Republicans have talked a lot about over the years. Now, they have very different ideas about what infrastructure spending means and how to implement it. So I'd be interested in hearing your thoughts, given where we are with a very divided Congress, of, what is it reasonable to expect the Biden Administration to achieve on infrastructure? And then obviously, we'll come back to the next order, which is going to be, what's the impact on the economy and on stocks?

Bill:
So I'd be on the pessimistic side because of what we just saw in Congress in terms of passing this $1.9 trillion fiscal package-- no support from any Republican senators. And the reason why I cite that is there was no support from any Republicans, even though this was a very popular measure. If you look at the polling results, a very high percentage of households in the United States actually support what the Democrats did, yet they got no support.
Now, infrastructure spending is probably similarly popular as this fiscal package. But if you only have 50 Democrats that you have to keep in line, there really isn't much margin for error if the Republicans aren't willing to be bipartisan in this process. So I think the bar on everything from here is going to be more difficult.

Tony:
I like to be optimistic. I would like to have bipartisanship. And I did see some potential for that in the COVID bill. It would have been a smaller bill, but I did see the potential to have some Republican votes-- maybe a handful, maybe a dozen-- on a smaller bill.
And so I wonder, well, what about infrastructure? Could we get a smaller bill that would be bipartisan?

CAPTION: New legislation hard to pass in divided government

Bill:
It's certainly possible. I think there's a lot of support in the country for doing something on infrastructure. But I also think there's some wedge issues in infrastructure that make it more difficult. For example, if we're talking about infrastructure from the Democratic side, climate change and issues like that are going to be part of the thought process.
There's also the rural-urban divide in terms of where do you spend the money? And there's a rural-urban divide politically as well. So I think it's going to be hard. The Trump administration tried to bring infrastructure bill forward, and it didn't really get anywhere.
So I'm on the pessimistic side, even though, clearly, there is a need for a lot more infrastructure spending. And when you think about government spending, infrastructure is one where you really think that government spending can do a good thing because there's a lot of bottlenecks in the US economy. And coming back to our prior comments about productivity growth, one way you raise productivity growth is by eliminating bottlenecks in the economy. And one of the big bottlenecks we have is infrastructure.
Think about just the trains that come from New Jersey into New York City. They're constrained by the fact that there isn't much capacity under the Hudson River. We've been talking for years about expanding that capacity, and yet nothing's happened.

Tony:
What about the deficit? That's another area where the parties have had controversies over the years? Now, we do have a big deficit. And our debt to GDP, our total debt to GDP, is at record levels.

As investors, we like to talk about debt as it doesn't matter until it matters. And then once it matters, it's the only thing that matters. Certainly, that's true of a company, maybe different for a government, particularly like the United States.
But this has, in the past, been a hot button political issue. It could be an economic issue. Is it something we need to worry about?

Bill:
I think that it is something that we need to worry about, but not today. You're absolutely right. The debt levels are much higher. But debt service costs haven't gone up at all. And they haven't gone up at all because interest rates are so low.
So to me, the whole issue of the federal debt is really tied to the trajectory of interest rates. Once interest rates start to rise, then debt service costs will start to go up very, very rapidly. And that will actually increase the problem of ongoing budget deficits. So again, I think this is a problem not for today, but down the road when the Federal Reserve actually starts to tighten monetary policy.

Tony:
And it strikes me that that actually serves as a natural cap on growth actually because if growth gets too overheated, rates get high. Then debt servicing becomes an issue maybe not just for the government, but also for consumers and businesses.

Bill:
Yeah. That's one thing that would obviously slow the housing sector down. If interest rates go up, that would take some of the steam out of the housing market, which is actually performed remarkably well over the last year through the pandemic.

Tony:
With a deeply divided government, it strikes me that everyone can get behind the fiscal stimulus package. But maybe raising taxes is a little harder. What should we see-- what should we forecast there?

CAPTION: Recovery takes priority, making near-term tax increases difficult

Bill:
I'd be very surprised to see anything in the very near term for the obvious reason that the priority is economic recovery. And to talk about tax increases at a time that you're trying to generate a strong economic recovery seems that you're working at cross purposes. Medium to longer term, I'm sure the Democrats want to raise taxes on higher income people. The distribution of income in the United States has been badly skewed over recent years. And I think the Democrats want to do something to lean against that.
But getting that through Congress-- I think that's going to be very, very hard to do. One thing that could be done more easily is maybe give the IRS a little bit more resources so the taxes that should be paid that aren't being paid get collected in the future. Maybe that's something where you can find a way to get more tax revenue without actually changing the tax code in an explicit way, just better tax enforcement.

Tony:
And how about corporate taxes? I know raising personal taxes is a little bit more of a political hot button, but it seems like raising corporate taxes-- that may be something you could get all of the Democrats to coalesce around and hence pass?

Bill:
Perhaps. But I think that there were good reasons for what was done on the corporate tax side. Our corporate tax rates were high relative to other countries in the world. And that was causing all sorts of artificial gymnastics by corporations to try to move income from the United States to other countries, which had more gentle treatment of corporate taxation. And so the corporate tax changes in the US redress some of that imbalance. And so I think that-- do you really want to undo that and cause more corporate gymnastics just for tax avoidance in the United States?

CAPTION: Dudley: Limited changes to corporate tax policies

So I think that-- I wouldn't expect a huge number of things to happen on the corporate side. Maybe you close some of the corporate tax loopholes. The most obvious one that people have talked about closing for a very long time is covered interest. And it hasn't been closed. And that'll be a good test. Does it get closed finally in a Biden Administration?

Tony:
So let's switch gears to regulation and its potential impact on both the economy and markets. What are your broad-- I'll start with, what are your broad thoughts about where we should, as investors, be watching for regulatory changes that could have the most impact on markets?

Bill:
Well, my expertise is really about the financial sector, so let me speak to that. I think generally, the assessment of what happened over the last year is that the banking system actually came through the crisis in very good shape. And so I think there is not a huge appetite on anybody's part to dramatically increase the regulatory burden on the commercial banking sector. I think people feel we're in a pretty good place. The higher capital requirements, the liquidity requirements have all stood us in good stead.
I think the shortcomings in the financial sector have really been in the non-bank financial sector. We had another rescue of the money market mutual funds. We had a lot of turmoil in the Treasury market, in the mortgage-backed securities market. So I think when you think about what the Yellen Treasury is going to be looking at, I think they're really going to be looking at, what can we do to make the nonbank financial system more resilient and robust?
And they have a tool to address that, the Financial Stability Oversight Council, which, frankly, under the Trump Administration, basically fell into disuse. So the question is, what can the Financial Stability Oversight Council do to try to address some of the structural weaknesses that we've seen in the non-bank financial sector?

Tony:
I agree the banking sector came through this financial situation or crisis, the COVID crisis, with really flying colors. But there are some who say, look, it wasn't a real challenge because policy was so strong, and so it wasn't like other recessions. And we still need to do more.
Is that just a minority voice? Is that just a wrongheaded voice? What are you thinking on that?

Bill:
Well, there's a trade-off here. If I raise the capital requirements on banks, I make the banks more secure and resilient to financial shocks. But at the same time, if I do that, I raise the cost of intermediation. And I also reduce the size of the banking sector because some of that activity moves out into the non-bank financial sector.
So where you strike that balance between financial resiliency versus having a very smart banking sector-- I think that's something that people can debate. I think that people generally feel that the banking sector has done very well. Now, you're absolutely right. There were extraordinary interventions. And the banking sector would not have performed as well if we didn't have those extraordinary interventions.
But generally speaking, I think people think that the reforms that were enacted post the great financial crisis, the Dodd-Frank Act, all the international reform efforts have worked pretty well. We had tremendous market stress in March and April of last year. The derivatives market held up well. Central clearing worked. The banks had enough capital and liquidity. There'll be some tweaks around the margin.
Now, there's a whole debate about, when you're hit with a big financial shock like this, should banks be able to continue to pay dividends? The US said yes. Europe said no. So there's disagreement about how you husband your capital when you're under a period of stress.
I think one thing that's helped in the United States is the stress tests. The fact that every year banks go through a stress test for an economic environment that's considerably worse than what's expected gives the Fed and the private sector confidence that the banking system is going to be with us, even under more adverse conditions.

Tony:
Well, it's certainly nice to see the regulatory policy came through, and it worked.

Bill:
Yeah, I think it worked very well. If you remember back when we were implementing all these things, the banking sector said this is going to be awful. Loans we're not going to be available. The cost of funding was going to go up dramatically. And the reality is, that didn't happen.

CAPTION: DeSpirito maintains an optimistic outlook for U.S. banks

Tony:
Yeah. And as an investor, I've been saying for some time that the banking sector is safer and sounder, but the market hasn't-- the stock market hasn't fully given them credit for that. And so that's one of the things I certainly look forward to as we come out of this recession, maybe higher multiples on the bank as the market recognizes that they are safer and sounder and that this tail risk is largely been taken off the table.
It's not exactly regulation but, certainly, climate issues are important policy issues over the next-- certainly over the next couple of years, but obviously also over the next couple of decades. And it's an important part of the Biden agenda. It's important for investors too. I think investors are increasingly becoming clued into the fact that climate risk is investment risk. I'd like to hear how you're thinking about what the Biden Administration might do on climate change and what impacts we should be thinking about as equity investors.

Bill:
Well, I think the first thing they're going to try to do is increase the incentives to do things that help mitigate climate change. So what they would like is to increase the incentives for electric cars and to increase the incentives to move away from coal fire utilities, anything that can be done to reduce the rate of carbon formation in the atmosphere.
Now, how far they can get with a 50-50 Senate is anybody's guess. The good news, though, is there's a lot more wind at their back than there was 10 years ago in terms of the economics of actually dealing with the carbon problem because the cost of batteries in electric cars has come down dramatically. And so it looks like electric cars are going to be competitive with gasoline-powered cars very, very soon. Also, the cost of alternative energy sources like wind and solar has also come down significantly.

CAPTION: Climate-related changes more economically viable than ever before

So 10 years ago, it looked like you're going have to subsidize these things enormously to make it work. Now it looks like the economics are a lot more favorable. So I think we can actually make pretty good progress on the climate change agenda, given that the economics of generating electricity from wind and solar have improved so substantially.

Tony:

It's really great to see the economic improvement because, as business analysts, we've been talking about this for some time, that battery costs are coming down every year and that the efficiency of solar and wind is going up every year. And so these are going to become economically viable on their own. And I think you're right. We're at or near that tipping point. And there are, certainly from an equity investment point of view, some clear beneficiaries, whether that's in the industrial space, the auto space, the utility space. So some very clear beneficiaries. And we've got to ferret those out on a company-by-company basis to see what's discounted in versus what's not.
I think the energy sector is interesting to me because, certainly long term, there are some real going to be real challenges as oil demand declines, although, based on our work, it's going to take longer for the actual demand to decline than many think. Plus, I could foresee a situation in the interim, in the medium term, where oil demand is still quite robust, particularly with this recovery that we've talked about being a very fast, sharp recovery, so being a V-shaped recovery in oil demand. But if you think about oil supply being constrained actually, being much more of an extended U-shape recovery in terms of oil supply, particularly as the writings on the wall-- large companies are going to be just more and more hesitant to invest.
So I think that's interesting. I'd like to get your thoughts on that. And then I'd also like to get your thoughts on the financial sector here because there's risks of stranded assets where they lend to companies that aren't going to be around forever. So what are you thinking on that side?

Bill:
Well, you're absolutely right about the process. This transition is decades, not years. So even if electric cars reach the point where they're completely competitive with gasoline cars, it's going to take a long time to actually ramp up production, to mine the lithium to have the battery capacity in place.

CAPTION: Oil prices to remain underpinned by strong demand for some time

So the tipping point in terms of economics is going to be followed by several decades of transition. And so you're right. The demand for energy is going to be pretty-- for oil-- is going to be still very high for many years. And I think you're also right.
The fact that investment in shale got really disrupted by the drop in energy prices and oil prices that we saw last year means that you could have demand outstrip supply. You could actually see some upward pressure on energy prices. Now, the wildcard here, of course, is what does Saudi Arabia and Russia do in terms-- they have excess capacity that they can bring back on stream. And the question is, how high will they let energy prices get before they actually respond to that increase?

CAPTION: Climate change can have real investment implications

In terms of the stranded assets issue, I think that's really important because climate change can make it so that the things that you have invested in turn out to be in the wrong places. So you worry about all the investment that we've made along the coast of the United States. And if the climate evolves in a very bad way and sea levels rise very quickly, some of these assets may not really be saleable. And so people who have leant against those assets, which are oftentimes very long lived, may find that their performance is not as good as they have anticipated.
I know the Federal Reserve, in terms of their supervision processes, is now really looking closely at banks and asking themselves the question of, what kind of exposures do you have that would turn out to be bad if the climate change were to evolve in a way much more rapidly than what people potentially think is the most likely scenario?

Tony:
Yeah. So I think the nice, positive irony there is, this is another example, potentially, where regulation can actually be beneficial to the banks, not just the broader financial system, but also to individual banks.

Bill:
And it's the safety and soundness issue. Basically, if a bank continues to lend into areas that are at risk and the risks manifest themselves more quickly, then that bank could get into difficulty. So it's a real safety and soundness issue. And that's why bank supervision is relevant to this issue.

Tony:
Well, Bill, I want to thank you. This is this has been a pleasure connecting today. There's so much you've given us as investors to think about. I look forward to speaking in a year's time or a year and a half's time, and we can see how all this actually plays out.

Bill:
No, it's going to be a very interesting period because we've just never gone through anything like this, so. We're all making our prognostications, but you should be humble in that process because the uncertainty level is extraordinarily high.

Tony:
I agree. We're in uncharted waters. And it's going to be really important to be forward-thinking and active. So I want to thank you again, Bill. It's been a total pleasure.

Bill:
Thank you.

Carrie:
Investors certainly have a lot to think about today. And Tony and Bill provided some compelling context and insight. For investors, I would offer this key takeaway. Bill and Tony were definitely in agreement that the economy will come roaring back in the second half of 2021 and into 2022. But longer term, there are really no structural changes to the US economy. So as active, fundamental investors, a cyclical early cycle positioning is appropriate in the near term. But investors will need to be nimble in when to pull out the late cycle playbook.
I learned a lot today, and I hope you did too. Thank you for tuning in. And we hope you'll explore future episodes of Expert to Expert.

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