Is the Fed Fueling Inequality?
In case you hadn't noticed (and chances are you haven't... with the warm summer weather, beach books have probably been at the top of most peoples' reading lists), a debate has been raging in the financial press about whether the Federal Reserve and its monetary policies have exacerbated societal inequality in the U.S.
The leading voice in the "Yes, it has," camp is Karen Petrou, who published a book earlier this year titled Engine of Inequality: The Fed and the Future of Wealth in America. She then followed up with a July op-ed in The New York Times, "Only the Rich Could Love This Economic Recovery."
On the other side of the argument is Martin Wolf, chief economics commentator at the Financial Times, whose recent op-ed entitled "Monetary policy is not the solution to inequality," riffed off a report by the Bank for International Settlements that concluded, "Monetary policy is neither the main cause of inequality nor a cause of it."
Petrou's argument, at its core, is that the Fed's decade-long, post-financial crisis, pandemic-times policy of keeping interest rates ultra-low (negative, in fact, when inflation is taken into account) has inflated the value of financial assets and real estate without stimulating broad economic growth.
Stocks and bonds are disproportionally owned by the wealthy. According to data from the Fed itself, in the U.S. 54% of equities are owned by the top 1%. And since the 2008 downturn (and the Fed's subsequent stimulus efforts), the increase in the value of financial assets has been 10 times the growth of GDP – which until recently had languished at levels not seen since the end of World War II. The well-being of most people outside the 1% is tied more to economic growth. The math, Petrou writes, is pretty simple: "When financial rates of return are above that of broader economic growth, inequality speeds up in a cumulative way."
As a result, Petrou said in a June Financial Times op-ed of her own, "The U.S. central bank has played a direct, if wholly unintended, role in driving income and wealth inequality to astonishing heights."
("Unintended" is an important word here. There is no indication the Fed is a knowingly malevolent actor. Fed Chairman Jerome Powell has spoken publicly about the Fed's commitment to principles of inclusion and diversity.)
There are a couple of other ways in which Fed policy affects rich people and disadvantaged populations inequitably. Those at the lower end of the wealth ladder tend to put what money they accumulate in savings accounts, where the interest they have received for the past decade has been close to zero in nominal terms, and negative in real terms. It's those at the upper end who tend to invest in higher-yielding assets.
Also, to the extent the Fed's easy money policies – low rates and aggressive bond buying, known as quantitative easing – end up spiking inflation, the effect will be more pronounced on the poor, who tend to spend a greater proportion of their income and wealth on consuming goods and services, which rise in price in inflationary environments.
"Inflation is already a painful tax on low, moderate and middle-income households," Petrou wrote in the Financial Times.
The counter argument essentially asks: What should the Fed have done differently in the wake of the two seismic shocks we suffered through in the past 10 years – the global financial crisis and the Covid-19 pandemic?
Martin Wolf put it this way in the Financial Times.
"It would have made no sense to adopt a deliberately more restrictive monetary policy solely in order to lower asset prices. This would have reduced activity and unemployment. That is the worst thing that could happen to people who are dependent on their wages for their livelihoods."
"How would the majority of people, who own almost no assets, be better off because billionaires were a bit poorer? It would be mad for central banks to cause slumps in order to lower asset prices."
I tend to agree with Wolf. But I worry that widening disparities in wealth and income could pressure political leaders to adopt fiscal (tax and spending) policies and impose regulations that slow growth and end up reducing overall well-being.
The White Hat/Black Hat debate over monetary policy is only one aspect of an ongoing conversation about whether (and if so, to what extent and in what ways) the financial system that powers our capitalist economy is an agent of, or a purveyor of, systemic inequality.
Related examples include claims by Emery University law professor Dorothy A. Brown in her book, The Whiteness of Wealth, that the tax system impoverishes Black Americans. Or by Destin Jenkins, University of Chicago assistant professor and author of The Bonds of Inequality, which claims the municipal bond market represents "infrastructural investment in whiteness" and that "the history of inequality in twentieth-century America is, in part, the history of municipal debt."
The debate over whether the financial system is driving inequality to new heights is, I believe, a distraction from what needs to be our singular focus: on shared prosperity and on how the financial system can help support that outcome.
Here we are again: The United States has once again hit the debt ceiling, and the government can no longer issue any new debt unless and until Congress acts to raise the ceiling.
A number of years ago I wrote an Op-Ed for The New York Times, excoriating Texas Senator Ted Cruz for reading Dr. Seuss's Green Eggs and Ham for 21 hours on the floor of the U.S. Senate holding the debt ceiling hostage to his unrelated cause du jour... rolling back Obamacare.
This fall, as the U.S. Treasury runs out of tricks to keep our federal fiscal machinery running, we will no doubt see Congress once again play chicken with our country's full faith credit.
As my colleague, Strategas' Dan Clifton recently wrote, "Republicans have little appetite to raise the debt ceiling... making it clear they are not willing to vote for a straight debt ceiling increase given the Democrats are moving $6 trillion of spending under the budget reconciliation process."
Warren Buffett has aptly termed the debt ceiling a "political weapon of mass destruction." A default by the United States on its outstanding public indebtedness would have incalculable consequences for the global financial system and would permanently impair the dollar's status as the world's reserve currency. Treasury Secretary Janet Yellen warned of "irreparable harm to the U.S. economy and the livelihoods of all Americans" if Congress does not act on the debt limit.
Yet, ironically, voting not to increase the debt ceiling is one of the few levers members of Congress have, be they Republicans or moderate Democrats, to prevent an equally serious act of fiscal irresponsibility – namely, spending another $4 trillion on childcare, eldercare, housing, education, paid leave, pre-Kindergarten programs, health insurance, nutrition and other social priorities. Which, if enacted, would come on top of the following spending bills:
- $550 billion in new spending in the much-discussed bipartisan infrastructure bill which was just passed by the Senate and is awaiting consideration by the House of Representatives.
- the $1.9 trillion American Rescue Plan passed earlier this year;
- the $2 trillion COVID-19 relief CARES Act and the $500 billion Paycheck Protection Program.
All of which piles onto outstanding debt (both that held by the public and intergovernmental holdings) of over $28 trillion. The United States now owes others more than 126% of its gross domestic product. 100% is considered the threshold for avoiding a "debt spiral."
What will it take before our elected officials recognize there is, in fact, a limit to what we as a society can afford to spend – and that we are way, way past that point? Are we even capable of navigating between the Scylla of default and the Charybdis of excessive spending?
In my 2012 book Stewardship, I wrote about the Great Financial crisis as a preview – a case study in what happens when we fail to live up to our stewardship responsibilities. I warned that similar stewardship failures were showing up in our failure to responsibly manage the finances of our country.
The sequel to that frightening film is playing out now. As I said in 2012, the consequences could well make the last financial crisis look like child's play.
Pressing On: From Marriage Equality to Financial Equality
June 26 isn't just any other early summer day – it's an historic day for LGBTQ equality.
It's the anniversary of numerous milestone moments in the gay rights movement. On June 26, 2003, the U.S. Supreme Court ruled on Lawrence v. Texas, voting to invalidate sodomy laws across the U.S. Ten years later, the Supreme Court overturned a key section of the Defense of Marriage Act (DOMA), a federal law that defined marriage as a union between one man and one woman.
And on June 26, 2015, the Court ruled on Obergefell v. Hodges – a landmark ruling that gave same-sex couples the right to marry in all U.S. states and made marriage equality the law of our land. Obergefell v. Hodges also removed some of the most significant of the inequities same-sex couples had historically faced – namely the inability to participate in the benefits available to married heterosexual couples, such as filing joint tax returns, access to a spouse's Social Security or health benefits, and gift and estate tax marital deductions, to name just a few.
The day symbolizes a lot for me and my family. I am a father and stepfather of two LGBTQ women. When my home state, Minnesota, proposed an amendment to make same-sex marriage unconstitutional in 2012, I campaigned publicly to encourage business leaders to oppose the amendment. It didn't pass. Remarkably, just a few months later, Minnesota legalized same-sex marriage.
Lately, a lot of attention and energy has been focused on the extent to which our financial system may or may not contribute to systemic racial inequality. Versions of this narrative are presented in several recently published books, including Karen Petrou's Engine of Inequality, Dorothy A. Brown's The Whiteness of Wealth, and Destin Jenkins' The Bonds of Inequality. All focus on the relationship between the financial system and economic inequality.
But in the same way financial inequality is all too real for all communities that exist outside mainstream culture – that continues to be true for the LGBTQ community.
In addition to complexities around retirement, estate and financial planning, the LGBTQ community faces its own particular share of financial headwinds. To name just a few: Numerous studies have found LGBTQ professionals face a pay gap in their careers, and the disparity can be especially wide for transgender individuals who transition at work – one study found female transgender workers saw their earnings drop by a third after their transition. When buying homes, LGBTQ individuals and families may face discrimination from agents or sellers – as well as being 73% more likely to be denied when applying for a mortgage. And nearly one-third of bisexual women and transgender individuals live in poverty.
That said, there is promising energy behind a push for financial equality for the LGBTQ community. In March, the Consumer Financial Protection Bureau issued a rule affirming it is illegal for lenders to discriminate on the basis of sexual orientation or gender identity. And the Call Me By My Name campaign is calling on U.S. financial institutions to increase support of the transgender and nonbinary communities by allowing consumers to select the name they'd like to be called by – and honoring that decision on each touchpoint, from the individual's bank card to statements to phone calls.
Important legislation is also in the works. In Congress, the House-passed Equality Act would amend existing civil rights laws to establish sexual orientation and gender identity as protected characteristics, as well as establish explicit nondiscrimination protections for LGBTQ people. It awaits action by the Senate.
While these advances are steps in the right direction, there is still more to do. We must continue to press for financial equality for the LGBTQ community and all communities that face financial roadblocks – and, working together, help to eliminate the challenges they face.
Here Come the ESG Boo Birds
Call it what you will – ESG, socially responsible, sustainable – values-based investing has become as polarizing as seemingly every other topic in American society.
On the one hand, the current administration seems intent on incorporating it into every nook and cranny of financial, monetary and regulatory policy. On the other, ESG "boo birds" have recently come out in force, pushing back on the rush to invest in investment strategies that stake a claim to being socially responsible.
A recent Wall Street Journal op-ed titled "Who Really Pays for ESG Investing?" claims, "If ESG investing truly maximized returns, fund managers wouldn't fake a commitment to it while quietly doing their job – investing in companies that focus on shareholder returns and profits."
A recently published study by Scientific Beta, "Honey I Shrunk the ESG Alpha," argues there is no positive ESG alpha and states, "ESG strategies perform like simple quality strategies mechanistically constructed from accounting ratios."
Blackrock's former sustainability investing CIO accused financial services firms in a USA Today op-ed of greenwashing in the name of profits.
Even my Baird colleague Jason Trennert at Strategas (et tu, Jason?), pointing to a 98% correlation between the risk/return profile of the leading ESG ETF and that of the S&P 500 Index (with almost identical sector weights), writes, "Products being sold to achieve these social goals are little different from the Broader Index itself, merely more expensive."
It's no surprise that as socially responsible investing enters adolescence here in the United States, it is coming under increased scrutiny and losing some of its youthful luster. Some of the criticism is deserved. This is yet another area where the financial services industry has taken a good idea and pushed it to commercial excess. There is a lack of consistency around metrics. Product sponsors have made unsupportable performance claims based on short-term one-year results post-COVID. Not to mention that the language of socially responsible investing is enough to confuse even experienced investors.
However, what underlies much of the criticism of ESG is a failure to acknowledge a sea change in what it means to be a fiduciary.
Fiduciary traditionalists believe that the sole responsibility of individuals, firms and committees managing and overseeing portfolios is investment return – more specifically, risk-adjusted returns over full market cycles. I can remember being chastised by committee elders on one of my first committee assignments 35 years ago for failing to hew to the investment management equivalent of Milton Friedman's pronouncement that the only responsibility of corporate executives is to grow shareholder value.
Friedman's shareholder-centric formulation has been since been replaced by the Business Roundtable's 2019 statement about stakeholder value, which declared that corporate executives are accountable to multiple consistencies – shareholders, yes, but also employees, customers and clients, suppliers and the communities in which they all live and work.
In the same way, the orthodox view of fiduciary duty is being replaced by a more holistic vision of what it means to be a fiduciary: one in which fiduciaries are responsible not just for investment returns, but for the overall well-being of the ultimate beneficiaries of the funds they are overseeing.
It doesn't do any good to beat one's benchmark or generate a superior Sharpe ratio if, in the process, the planet can't support life or social order devolves in the face of economic inequality.
Or, as an "Other Voices" column in Barron's recently suggested, it is penny-wise and pound-foolish to focus on portfolio diversification while ignoring "real-world root causes of systemic risk" that can't be diversified away but determine more than 75% of your return.
No less a traditionalist organization than the CFA Institute – known for ethical integrity and analytical rigor in support of the investment profession – has embraced "purposeful capitalism." The Institute's 2021 report, entitled "Future of Sustainability in Investment Management," embraces "a mindset change" that calls on investment organizations to "be proactive, rather than reactive, in helping solve the world's problems."
"Financial organizations must ... combine their financial views with some exposure to wider stakeholders," the report states, and must consider "total system-wide returns on capital."
Which, one might agree, is a dramatically broader mandate than mere investment returns alone – and one ESG boo birds may want to consider before decrying socially responsible investing strategies.
The information reflected on this page are Baird expert opinions today and are subject to change. The information provided here has not taken into consideration the investment goals or needs of any specific investor and investors should not make any investment decisions based solely on this information. Past performances is not a guarantee of future results. All investments have some level of risk, and investors have different time horizons, goals and risk tolerances, so speak to your Baird Financial Advisor before taking action.
A Better Way to Democratize Finance?
You've probably never heard of Aaron Shapiro.
Unlike the founders of other higher profile FinTech startups, Shapiro hasn't been on the front page of any major business publication. He hasn't testified before Congress. Yet Shapiro is an innovator committed to "democratizing" finance. And he and his company, Carver Edison, arguably are doing as much to make wealth accumulation possible for people "left behind" by the wealth gap over the past few decades than online trading platforms or digital currencies.
What business is he in? The decidedly unsexy business of employee stock purchase plans.
Known as ESPPs, employee stock purchase plans were created in 1964 as part of President Lyndon Johnson's "war on poverty," 14 years before 401(k) plans were born. The idea was to give people who work for public corporations (there are 35 million of them today) the opportunity to grow their wealth by investing a portion of their pay (up to $25,000 a year) in the stock of their employers at a discount (usually 15%) – with favorable tax treatment.
About three-quarters of the public companies in America offer ESPPs, but participation is low. According to current survey data, 62% of companies with an ESPP reported participation rates of 40% or less of eligible employees.
One reason for this is that employees who might benefit the most feel they can't afford to do so. Which is what happened to Shapiro's mother, who worked at UnitedHealthcare for a time and couldn't afford payroll deductions to participate in the company's ESPP. She missed out on the stock's skyrocketing ascent over the recent two decades. Motivated by his mother's misfortune, Shapiro set out to reimagine and retool ESPPs.
Shapiro pioneered a unique program called "Cashless Participation" that, in essence, lends money short-term to employees at no interest cost (though in some cases with a small fee) to enable them to buy more stock in their company's ESPP than they could otherwise afford.
Here's how it works:
An employee signs up for their ESPP. They select how much of their income they want or can afford to contribute. That contribution comes out of their paychecks every pay period.
So far, that's no different from traditional ESPPs.
The innovative part is this: On or before the date on which stock is purchased, Carver Edison sends the company an additional amount equal to the difference between what the employee has contributed and the maximum purchase permitted by the company. On average, employees can own 50% to 150% more than what they had deducted from their paychecks.
What makes this all possible is a private letter ruling Carver Edison applied for and received from the Internal Revenue Service that affirmed, " ... a participant's ability to obtain a loan from its employer or a third party to purchase shares under a plan does not prevent the plan from qualifying as an employee stock purchase plan."
Importantly, Carver Edison offers education materials to companies who sponsor ESPPs because, like any investment vehicle, ESPPs are subject to risks like concentration in a single stock and price declines. Purchasing stock at a discount both increases the potential for return and cushions the risk of downside volatility. But leveraging stock purchases through cashless loans dials up the risk and return in opposite directions.
Concerns about America's growing wealth gap and about income inequality have increased interest in financial services tools and strategies that expand market access to non-traditional participants – those who haven't been able to participate in the rising value of financial assets since the Great Financial Crisis.
The most famous of these, of course, is Robinhood's commission-free online brokerage platform. But Walmart just hired two senior Goldman Sachs executives to help deliver financial services through their more than 4,700 stores. And a little-noticed proposal in former U.S. presidential candidate Michael Bloomberg's policy platform was using the U.S. Postal Service to deliver basic financial services.
As is always the case, there can be a downside to financial innovation. A classic example was the recent short-term trading in GameStop stock on online trading platforms, which had very little to do with constructively "democratizing finance" or building long-term wealth for investors.
Which begs the question: What might the ESPP equivalent of GameStop be? Possibly employees flipping out of their plans and selling their leveraged positions for quick gains.
"Cashless Participation" certainly demonstrates the potential inherent in reengineering old-school, low-tech programs like ESPPs to overcome barriers to broader and more financially meaningful employee stock ownership. The key, as always, is to make sure this and other innovations remain true to their original purpose and achieve their intended outcomes.
It's Time to Take Action on Climate Finance
Anyone who questions the essential and salutary role the financial system plays in society need only look at the way participants in financial markets are responding to the planet's single most pressing existential imperative – transitioning to a low-carbon economy.
There is an enormous amount of activity these days on the part of governments and NGOs, regulators, philanthropists, investors, and financial services providers around gearing up to support emerging climate-aligned finance initiatives.
In the first week of March alone:
- The U.S. Securities and Exchange Commission (SEC) announced the formation of a Climate and ESG Task Force and said its 2021 examination priorities will "reflect the complicated, diverse and evolving nature of risks to investors and the markets, including climate and ESG."
- The Securities Industry and Financial Markets Association (SIFMA), a trade group, announced its support for "mandatory disclosure of corporate-specific, financially material, decision-relevant data relating to climate risks and opportunities."
- The House Financial Services Committee Capital Markets Subcommittee held hearings on "Climate Change and Social Responsibility: Helping Corporate Boards and Investors Make Decisions for a Sustainable World."
- Federal Reserve Bank Governor Lael Brainard delivered a speech at the Institute for International Finance 2021 U.S. Climate Finance Summit on "The Role of Financial Institutions in Tackling the Challenge of Climate Change."
Despite this extraordinary energy around the topic, the scale of the climate finance challenge is massive. According to a December 2020 report by Boston Consulting Group (BCG) and the Global Financial Markets Association (GFMA), the aggregate investment required to keep global temperatures from rising more than 2 degrees centigrade from pre-industrial levels (the ambition contained in the Paris Agreement) is $100-150 trillion, or $3-5 trillion annually. This compares to an estimated current investment of $600 billion annually. It also dwarfs the $4 trillion in aggregate spending President Biden is signaling he will propose later this year for "Build Back Better" investments in infrastructure and strategic industries, with only a portion targeted at climate-related business sectors like renewable energy and electric vehicles.
This will require nothing short of an overhaul of financial markets structure to accommodate an unprecedented increase in financing that enables decarbonization and other forms of climate change mitigation.
The following chart (courtesy, again of BCG and GFMA) affords a picture of who and what will need to be involved to make this happen.
Source: Climate Finance Markets and the Real Economy: Sizing the Global Need and Defining the Market Structure to Mobilize Capital. Published by Boston Consulting Group (BCG) and Global Financial Markets Association (GFMA) in December 2020. Used with permission.
This goes far beyond earlier efforts, like so-called "green bonds," which seem quaint by comparison. Mobilizing capital to prevent a species-threatening environmental crisis will involve a broad range of asset classes – including not just equity, bonds and bank loans, but also structured financings and sustainability-linked instruments.
Old-school instruments like municipal bonds should not be overlooked. Commentator Chris Hamel points out in a recent Bond Buyer article that municipal market in any given year is responsible for about 75% of the new money spend on infrastructure and calls for allowing private activity bonds to be used to finance things like a national system of charging stations for electric vehicles.
What will also be necessary are innovations in financial products that help reduce and allocate the risk inherent in replacing fossil fuel-based power with renewable power, particularly in areas of the world (namely Asia) where the need is greatest and political and currency risks elevated. This kind of risk mitigation will require new derivative tools and strategies (yes, the same derivatives Warren Buffett once called "financial weapons of mass destruction"). This effort will also require a lot of blended public/private/not-for-profit financial partnerships. Public and philanthropic capital – also known as "concessionary capital" – will be needed to entice much more significant amounts of capital from private investors out along the risk continuum.
Critically important will be identifying and deploying patient capital, so-called "green equity." "We need to reenergize financing for all of this," Microsoft founder Bill Gates, recently told the Harvard Business Review. "We need to tap... capital for the super-long-term nature of the products we need." In that same interview and others, Gates has said that if we are able to successfully mitigate the disastrous impact of climate change, it will be the most amazing thing humanity has ever done. Finance has an important role to play in that effort.
For more on climate finance, its evolution and related news, I suggest exploring SIFMA's suite of videos and articles on the topic.
A Bubble's a' Brewin' – But Not the One You Think
With market participants focused on whether we are in a stock market bubble, another bubble is developing and commanding relatively less attention: a bubble in the public indebtedness of the U.S. The situation is remarkably similar to the one that followed the Great Financial Crisis, only several times larger – a massive increase in budget deficits and a concurrent swelling of the balance sheet of the U.S. Federal Reserve Bank, all with support from policymakers as being "the right response" to a crisis (financial then, pandemic now), seemingly without any thought about how we're going to work our way out of this.
U.S. Treasury Secretary Janet Yellen acknowledged in her recent confirmation hearing "an appreciation for the country's debt burden," but went on to express the consensus view that "right now, with interest rates at historic lows, the smartest thing we can do is act big."
Meaning spend big and borrow big.
A little more than 10 years after Simpson-Bowles Commission's report ("The Moment of Truth") and its chairs' premature declaration that "the era of debt denial ... is over," we will have spent:
- $2.0 trillion last March to replace income destroyed by the coronavirus, followed by another ...
- $900 billion in December, which turns out was a mere appetizer ahead of President Biden's proposal for another ...
- $1.9 trillion early this year.
Even if the Biden plan gets cut back (as my colleague Dan Clifton at Strategas predicts), that still could amount to almost $4 trillion in new federal spending in the most current 12-month period alone – all of which, 100%, was and will be deficit-funded.
It's no surprise, then, that the debt owed by the U.S. government to the public is estimated to increase to nearly $22 trillion by the end of fiscal year 2021 – up from $16.8 trillion in 2019 (not including entitlement liabilities from Medicaid, Medicare and Social Security). Such an uptick will equate to more than 100% of GDP for the first time since World War II.
And we're not done. In the second half of this year, we are likely to see proposals for $2 trillion in spending on infrastructure, $600 billion on affordable housing and $2 trillion of climate change initiatives, offset to some degree by yet-to-be determined by tax increases.
The questions posed by this spending binge are the same one I asked in my 2015 book A Force for Good:
"Is the US on a glide path to fiscal disaster? Or can we pull off what one commentator termed 'the miracle of immaculate monetary exit?' Are we about to enter into what economist Gary Shilling calls 'the age of deleveraging?' If so, will policy makers be able to effect what Bridgewater hedge funds manager Ray Dalio calls 'a beautiful deleveraging,' or will it be ugly? How long will our government engage in what economists Carmen Reinhart and Kenneth Rogoff have termed 'financial repression' – keeping interest rates artificially low (as they are now) to hold down the costs of financing debt, to the benefit of borrowers like the U.S. government over savers, the general population? Will our government eventually try to inflate their way out of America's debt burdens?"
Today, as was the cases following the financial crisis, there are several ways to resolve this problem, but the two of them mentioned above – financial repression and inflation – represent a Sophie's choice of unacceptably painful outcomes. The only truly viable path is to grow our way out of the sinkhole of public debt, as we did following World War II and, frankly, as we were on the path to doing before COVID-19 struck.
Today's growth challenge is made more difficult by the fact that growth for growth's sake is out of favor under the current Democratic-controlled government. Many policymakers today want "equitable" or "inclusive" growth and "sustainable" or "green" growth that doesn't degrade the environment.
All fine, up to a point. But they would be well-advised not to place too many constraints on growth. Our nation's debt burden will only begin to be manageable if the expansion of our economy is greater than the interest rate on our debt. Or, as Thomas Piketty expresses it in his book, Capital in the Twenty-First Century, g > r, where g is the economic growth rate and r the rate of return on wealth.
"If interest rates are 2 percent and the economy is growing at 3 percent ... then all a country has to do is sit back and wait," explains the Financial Times in a recent article. "As long as it does not borrow more, then debt will gradually dwindle to nothing compared with the size of the economy." On the other hand, "If interest rates rise above economic growth ... even small debts can get out of hand."
The Carnegie Endowment puts it in even simpler terms: "If I have a lot of debt, and if my income is rising relative to my cost of debt, it becomes easier for me to service the debt over time."
Growth for growth's sake may be out of favor, but the fact is, the only way out of this is to grow the economy. We need to collectively solve a multivariable equation with only one optimal answer: g > r. Anything else simply isn't an option. Or, at least, not a very attractive one.
Charting a Course for the Future of Finance
I've never been a fan of sitting on the sidelines. In my life and work, I very much want to be part of a team – working together to develop ideas, make decisions and see them through.
To effect change, though, you need to take action.
That's one reason why I was pleased to rejoin the board of directors of the Securities Industry and Financial Markets Association (widely known as SIFMA) this fall. The premier trade association for the U.S. securities industry, SIFMA advocates on regulation, policy and legislation that impacts individual and institutional investors.
It's great to be back on the board and working alongside my industry peers, having previously served as a director for more than 10 years and as chairman in 2011. It is particularly gratifying to rejoin this year, as my colleague and fellow Baird Vice Chairman, Jim Allen, served as chairman of SIFMA's board of directors in 2019. He's now following his passion for community service by joining the board of the SIFMA Foundation, which champions financial education and literacy, particularly among kids.
Jim and I are proud to carry on Baird's long tradition of financial services industry leadership. That legacy begins with our firm's founder and namesake, Robert W. Baird, who believed so passionately in the need for our industry's self-regulation that he crisscrossed the country by train to convince his peers of its necessity and its advantages.
His efforts culminated in 1939 with the founding of the National Association of Securities Dealers (NASD), a self-regulating organization. Three Baird leaders would serve as the organization's chair, including Baird himself; Clarence Bickel, our third president, who also served two terms as governor of the New York Stock Exchange; and Robert Haack, a Baird stockbroker who went on to become president of the New York Stock Exchange for 10 years. After creating NASDAQ in 1971, the organization was eventually succeeded by the Financial Industry Regulatory Authority (FINRA) in 2007.
Over our 100-plus-year history, numerous Baird leaders have served in leadership roles across the industry, carrying out our commitment to integrity, fairness and honesty in our business. To name just one, our former chairman and visionary leader, Paul Purcell, served multiple terms on the SIFMA board and also sat on the board of its predecessor organization, the Securities Industry Association.
I'm thankful to have the opportunity to carry on this tradition and to join my colleagues in leaving the proverbial sidelines and working to advocate for effective, efficient markets that benefit all investors.
How to Hedge a Swan's Tail
Nassim Nicolas Taleb, author of a book about the inevitability of unpredictable events, told Bloomberg Television last spring he gets irritated every time he hears the coronavirus pandemic referred to as a "Black Swan" – an event of enormous impact and consequence that couldn't have been predicted.
For Taleb, the pandemic is more like a "White Swan", long hiding in plain sight and wholly predictable – something he, Bill Gates and others had been pointing at for years.
Whatever color swan it is, the pandemic (and the ensuing global economic lockdown that macro research firm Strategas argues is the true Black Swan) is only one of several potential society-threatening extreme events identified in the book 7 Deadly Scenarios, written by Andrew Krepinevich. (Don't read it at bedtime.) Like a nuclear attack or a naval altercation with China in the South Pacific, the COVID-19 public health crisis is one of innumerable scenarios, seen and unseen, that could easily trigger a precipitous 35% drop in global market values like the one we experienced in March. And, as Taleb argues, in a complex, globally interconnected and increasingly fragile world the likelihood of such extreme events is increasing.
All this has renewed interest from institutional and individual investors alike in hedging against so called "tail risk."
Tail risk is usually defined as the chance of loss due to rare events. It is often quantified as a price movement three standard deviations outside the norm.
The case for protecting against tail risk in portfolio holdings is fairly straightforward and compelling. It's similar to the rationale for buying insurance on your house.
Where it gets interesting is around execution: how best to hedge against downside risk.
The traditional "keep it simple" time-tested advice from financial advisors has been to diversify across asset classes. For example, to allocate your portfolio 60% to stocks, 30% to bonds and 10% to cash. Which historically has worked pretty well. In his book, Wealth, War and Wisdom, the late investment strategist Barton Biggs looked at the performance of different asset classes during World War II, one of the most globally disruptive events in history, and concluded a 60%-40% stock bond allocation maintained value as well as any other allocation. (Though he also recommended buying farmland as extra protection.)
Many institutional investors adopt a similar approach but diversify less to bonds and cash and more to hedge funds or real assets, strategies that are harder to access for smaller investors.
Few would argue traditional diversification smooths out portfolio returns, moderating peaks and troughs in performance. The problem today is that (a) with bonds and cash yielding close to nothing, cash has a bigger impact on what a portfolio can earn than in a higher interest rate environment. (Assuming a 7% nominal long-term return on equities, allocating 40% to bonds and cash would reduce those returns to slightly more than 4%.) Also, (b) with bonds fully valued, their ability to provide non-correlated positive returns in a stock market sell off is diminished.
Enter the "tail risk" specialists. Among them Taleb, who advises the firm Universa's tail risk hedging program, which was famously terminated by the California Public Employees Retirement System (CalPERS) pension last fall and winter, only months before it would have earned the fund an estimated $1 billion in gains during the March drawdown.
Tail risk insurance comes in many flavors. But the idea is to allocate a small portion of a portfolio say to strategies that pay off when the world seems like it's coming to an end, allocating the rest of the portfolio to stocks. Depending on where the insurance kicks in (down 15%, down 20%, etc.), the price of volatility and an investor's willingness to sell off upside, the overall cost of the insurance can be managed to less than .50% annually. At least by institutional investors and/or family offices with the expertise to construct custom hedges.
For individual investors there are a few hedging strategies offered by specialists like Parametric, including various forms of put buying or collaring. A zero cost collar, for example, has no upfront costs but may limit your upside in strong equity markets. Without a budget, buying puts can be costly. Depending on current levels of volatility, investors may have to spend 3%-5% or more annually to receive the downside protection they desire. These strategies aren’t for everyone, as they typically have higher minimums of $1mm or more.
So, what's an individual investor to do?
One of my favorite ideas is to arrange for as much in lines of credit as your bank, wealth management firm or other reputable financial institution will lend you.
Financial markets are nothing if not resilient. They have recovered following every major crisis in our lifetimes. But as Warren Buffet, the most famous advocate of a fortress approach to liquidity management, puts it, "to finish first, you must first finish". You must have enough in reserves to stay invested during a crisis, enough to survive without having to sell your assets on the way down, at the bottom, or on the way up, before they have fully recovered their value.
Liquidity is the key to making it to the other side of a market crisis. Credit facilities are an underappreciated way to create liquidity. And unlike cash, many lines of credit don't cost anything... until you draw them down.
Which is (sort of) like not having to pay for insurance before you file a claim.
Past performance is not indicative of future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk, including loss of principal.
Small Business Capital Lifelines are Fraying
During a time of unprecedented societal disruption, providers for capital of small- and minority-owned businesses are at risk
The COVID-19 pandemic has highlighted more than any event in our lifetimes the importance to the "real" U.S. economy of small businesses, which generate more than half of GDP.
It's highlighted the hanging-by-a-thread fragility of enterprises owned by minorities or located in disadvantaged communities.
And it's also created existential challenges for the mission-oriented financial partners who serve that community.
Even in the best of times, businesses like Karibu Grocery and Deli, located in St. Paul, Minnesota, struggle to get access to capital and to the basic financial services they need to survive and grow.
Opened by the Ali family in summer 2018, Karibu sells groceries and serves Somali food in east St. Paul. The family faced a number of challenges before they were even able to open Karibu's doors. While siblings Abdiwali, Ikram and Mohamed had a promising location, a business plan and some start-up capital lined up, they struggled to secure additional financing for Karibu because of their limited credit histories.
Karibu's story is anything but unique. During the Coronavirus pandemic and social unrest roiling low-income communities, traditional lenders have pulled back from making smaller, more service-intensive loans in what they perceive as high-risk communities.
According to Forbes.com, only 12% of Black and Latino business owners who applied through mainstream banks or credit unions for forgivable loans under the Paycheck Protection Program (PPP) received what they applied for.
Deprived of access to credit, and with an average of less than 30 days of cash on their balance sheets, nearly half of the 500 minority businesses responding to a survey by Global Strategy Group predicted they will be forced to shutter their doors permanently.
If there are financial lifelines of any kind for minority entrepreneurs amidst this confluence of crises, they may be community development financial institutions (known as CDFIs") – not-for-profit capital providers making investments aimed at expanding economic opportunity in low-income communities.
It was through a CDFI that the Ali siblings and Karibu Grocery & Deli found their capital lifeline. In addition to support provided by the City of St. Paul, the African Development Center and other funding sources, the 30-year old, Minneapolis-based Community Reinvestment Fund USA (CRF) granted the Ali's a loan that enabled them to open Karibu.
Recently, CRF was able to network with more than 40 other CDFIs to help originate over $500 million in PPP loans predominantly for Latino-, Black-, women- and Native American-owned businesses.
Nationally, about 300 CDFIs have approved more than $7 billion in PPP loans. That's out of a total of the more than $520 billion approved for PPP loans.
CRF is one of more than 1,100 community development financial institutions certified by the CDFI Fund, a division of the U.S. Department of the Treasury created in 1994. The CDFI Fund makes approximately $200-300 million in capital infusions to CDFIs each year, which organizations like CRF combine with foundation grants and leverage with various types of loans from commercial banks, who then get regulatory credit for their investments under the Community Reinvestment Act.
Collectively, they have $211 billion in total assets and made more than 750,000 loans to small businesses in 2019 totaling $21.5 billion.
Unfortunately, that's a drop in the ocean relative to overall need.
Many CDFIs are being tested by the same factors threatening the survival of the minority-owned businesses they serve, namely COVID-19, the shutdown of whole sectors of the economy and elevated social unrest.
Because a significant percentage of the businesses they lend to tend to be in the service, hospitality and restaurant sectors – parts of the economy that have been disproportionately affected by the pandemic – the credit quality of CDFI's loan portfolios is even more stressed than that of regulated financial institutions.
"This is definitely a situation where we have to 'put our own masks on first' before we can help others," says CRF's founder and CEO Frank Altman.
The lifeline for CDFIs could be a provision in the HEROES Act – a coronavirus relief bill passed by the U.S. House of Representatives in May. The bill would appropriate $1 billion to make capital injections into CDFIs – four to five times the annual amount the CDFI Fund normally makes available each year. As of late August, the fate of that appropriation was stalled negotiations with the U.S. Senate.
Long term, however, other non-governmental solutions are needed if CDFIs are to continue to serve as the provider of capital for minority businesses.
The growing popularity of impact investing may hold some promise. Over 25 years, Calvert Impact Capital has raised over $2 billion by offering Community Investment Notes to investors in denominations of as little as $20, making the proceeds available to CDFIs and other mission-driven intermediaries. Online technology company CNote's flagship also offers the opportunity to invest directly in CDFIs.
The Ali family and Karibu Grocery & Deli are only one proof point of how critical the access to capital CDFIs provide is to small- and minority-owned businesses and, by extension, to the U.S. economy.