The Seeds of the Next Financial Crisis Lie in Washington

The greatest threat to the health and stability of our financial markets may just be the United States government. With each passing day, the actions and words of policymakers on both sides of the aisle reinforce this sobering reality.

Investors trying to identify and manage long-term risks would be wise to take note of three of the more troubling developments unfolding this summer. 

Rather than wean markets off of unsustainable fiscal and monetary policies, leaders in Washington, D.C. are once again kicking the can down the road — and in a dangerous direction.  

Most notably, Congress and the Trump Administration have rammed through a budget bill that will raise federal spending caps by approximately $320 billion over the next two years. In addition to this gross increase, the bill omits an extension for the caps established by the Budget Control Act of 2011. If discretionary spending rises at just the rate of inflation over the next 10 years, this legislation will end up costing almost as much as the $1.9 trillion tax cut package passed in 2017.

The sad fact is that federal entitlements and expenditures fuel significant portions of the American economy. If debt service payments remain on track to quadruple over the next decade, however, there will need to be significant cuts across the federal budget. The government’s inability to continue injecting copious amounts of rocket fuel into the economy will weaken the support beams that are keeping asset valuations high.

A key takeaway for investors is that the day of budgetary reckoning is coming. Stocks and bonds are unlikely to avoid the collateral damage of inevitable federal belt-tightening.          

Another confounding development is the Federal Reserve’s decision to lower interest rates last week by 0.25 percent despite no overt signs of froth in the economy. This extremely dovish move comes right before a planned end to balance sheet reductions.

One of the many problems associated with a perpetual easing cycle is that when another recession hits, central bankers will lack the tools to prop up Main Street and Wall Street. The Fed’s swollen balance sheet, which has not been prudently unwound since the global financial crisis, cannot support more asset binging. Moreover, rates can only go so low when they are already hovering in the 2 percent to 2.5 percent range.   

While markets may cheer for a rate cut today, investors will wish the Fed had kept more dry powder on hand when the bear rolls in. 

Finally, the rhetoric surrounding the latest Democratic presidential debates includes some startling policy proposals. It is especially concerning that several candidates, including Sens. Kamala Harris (D-Calif.) and Kirsten Gillibrand (D-N.Y.), have indicated they would seek to pass a financial transaction tax to fund their initiatives.

Levying a steep trading tax on investors — regardless of whether they are an individual or an institution — is not going to hurt Wall Street nearly as much as it will hurt ordinary Americans invested in retirement plans and retail funds. A recent study conducted by the Securities Industry and Financial Markets Association indicates this tax would cost the average retail investor tens of thousands of dollars over a lifetime. This is a dismal approach to funding expanded entitlements, but it may be on the horizon whether we like it or not.

Unfortunately, what is transpiring before our eyes is nothing new. Democrats and Republicans have spent the past 25 years implementing fiscal, economic and monetary policies that have lulled markets into a state of overdependence. The problem today is that many investors have failed to contemplate what happens when the federal government leads them off a cliff without a safety net below.

There is thankfully still time for investors that want to better align their portfolios to today’s realities. A first step in this process is accepting that a portfolio of 60 percent stocks and 40 percent bonds does not provide the type of diversification needed to navigate a crisis or full market cycle.

A world without ultra-accommodative and interventionist government policies will include much more volatility. As a result, savvy investors should be assessing alternative asset classes and hedging strategies that balance market exposure with downside protection. 

The definition of a “modern portfolio” is going to evolve considerably for investors in the years to come.

Randy Swan is the founder and chief investment officer of Swan Global Investments and the creator of the proprietary Defined Risk Strategy (DRS).

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