We have discussed previously that the Federal Reserve has taken extraordinary steps in response to the Covid-19 pandemic. The Fed has increased its year on year growth in the money supply from under 2% to over 30%. The Fed has flooded the market with trillions of dollars that did not exist previously in an attempt to prop up the economy. All of this frenetic activity serves to artificially lower the interest rate, so that it is easier for businesses to obtain credit that can keep them afloat. This is in addition to all of the other “stimulus” programs the government has instituted. The idea behind all of this is that by extending easy credit terms and increasing the “liquidity” in the market the government can mitigate the extreme effects of the pandemic response. Obviously, this will have an impact on investing.
The Ideology of Easy Credit & Investing
The notion behind all of this credit is that the extension of credit on easy terms will encourage business and overcome an inadequate credit and investing environment. This is a fallacy. All credit is actually debt, that must the borrower must pay back. If the business does not pay back the debt, then the burden fall on the taxpayers. The purpose of this current round of debt expansion is to meet payroll and other day to day expenses while the economy is in lockdown or suffering from reduced demand due to pandemic concerns. Now it looks as if this easy credit is very helpful in that it gives current employees an income and business owners money to pay the rent, etc.
There is an element to all of this that we need to keep in mind. Private lenders will be more careful about who they lend to. If the government were as careful in enforcing lending standards, then they would not need to loan anyone money. This is why losses are always greater on government and/or government guaranteed loans. These losses are not offset by increased economic activity of the recipients of the loans. This focus on keeping existing businesses afloat only makes sense if we ignore the businesses who are not getting loans. These include those businesses who do not meet the qualifications set by the government. They also include businesses that are entrepreneurs do not start because they have no access to capital. The fact is, the government is loaning out real wealth (we will ignore inflation for purposes of this discussion). Whatever wealth the government is loaning to one enterprise another business cannot borrow.
Business Creation & Investing
A business can startup or survive in today’s environment on its own merits by being nimble enough to adapt to the changing consumer demand. They may do this by being credit worthy or possessing enough capital to not need a loan. If a business cannot survive on its own merits, then the government is using lower standards which will cause more losses or the creation of “zombie” companies that exist only because of the easy credit. These lower standards will create more losses and squander more scarce resources. All of this will lead to the creation of less wealth than would have otherwise been the case. Business “A” will get to stay afloat, but Business “B” will either close or perhaps never get started. The upshot is that the government has placed real capital in the hands of less efficient producers thereby lowering the wealth of society, as well as making the economy more rigid and inflexible.
The other reality is that the government will use a political calculation to determine who gets loans and who does not. Businesses will use political favoritism and possibly even under the table payments to secure the loans it desires. Meanwhile startups and unformed businesses without any effective lobby will not get the capital they would have in the absence of government involvement. Of course, there are those that are ok with all of this and in fact want to take it further into outright socialism. Investors have nothing to worry about if that happens because there will be no more investments to make (there is a great deal socially and economically to worry about, of course). All of this contributes to a massive waste of capital and makes investors and the rest of society poorer.
How to Navigate this Reality
The large problem for investors is how to differentiate a well-managed company that can survive on its own from companies that are only in existence because of government provided easy credit. This is certainly a problem but not an insurmountable one. It is more of a problem for the economy and society at large than individual investors. The individual investor can either research the basis of a single company or companies and build a portfolio accordingly or avoid single company risk altogether and invest in a broad market tracking index. The Cake Investment Group recommends the latter plan. It is important to be aware of the broad economic risks, but it is equally important to stick to a solid rules-based investment plan, such as we offer. The Cake Bubble Barometer and the Cake Recession Indicator will give you insight into these economy-wide risks. Meanwhile the best plan is to follow the Cake Trend Identification Line and use the monthly signals it generates to help you make you act rationally as an investor.