Guns and Butter 2.0

Quick read:

• Downbeat forecasts for global growth appear to underestimate the amount of fiscal stimulus set to flow into the economy in 2023. Rising government spending on both national defense and domestic investment should bolster global growth and offset the drag of 2022 monetary tightening.
• In our tactical multi-asset portfolios, we are positioned for resilient global growth. We expect higher neutral interest rates in both the US and Europe. We are also positioned long in cyclical equity markets like Japan, Australia, and Canada, which stand to benefit from investment-oriented government spending.

The “Guns or Butter” model is a simple economics concept that describes the tradeoff governments face in spending on national defense or on domestic programs. The model is meant to highlight the spending constraints faced by governments – they must choose between the two. The phrase was also used as the title of Irving Bernstein’s history of the Lyndon Johnson presidency in which he described LBJ’s failure to manage the tradeoff and his excessive spending on both Guns (Vietnam War) and Butter (Great Society).¹ The current trajectory of fiscal policy across developed markets appears set to again test the limits of government spending growth – with rising government outlays on both Guns (related to the war in Ukraine and Taiwan tensions) and Butter (industrial policy investing in re-onshoring & energy infrastructure). In our view, the potential economic implications appear to be underappreciated by both central banks and market pricing.

The Russian invasion of Ukraine shined a light on a couple of existential fragilities faced by developed market economies. First, it showcased the underinvestment in defense spending in Europe – only the US was able to supply adequate weaponry for Ukrainian self-defense. Second, it reemphasized the COVID experience of fragile global supply chains – most notably European dependence of Russian natural gas, but also the US dependence on key Russian and Ukrainian exports. As we approach the one-year anniversary of the invasion, we expect the announced government spending responses – both national defense and industrial policy – in the US and Europe to upend the economic and market regime of the preceding decades. Active and procyclical fiscal spending in both the US and Europe (as well as Japan) should prevent a recession in 2023, raise neutral interest rates (i.e., the rate at which monetary policy is neither stimulatory or restrictive), and benefit investment-focused industries and countries.

Historical and forecasted budget deficits across developed markets

US fiscal primes the 2023 economic pump

The US passed three large fiscal bills in 2021 and 2022: the Infrastructure Investment and Jobs Act, the Inflation Reduction Act, and the CHIPS Act. Together, these bills authorize over $1.6 trillion in new federal spending that will begin to flow materially into the economy starting in 2023. The legislation also has large incentives to catalze tens of billions of dollars in additional investments from the private sector; for example, the three largest global semiconductor firms have recently announced plans to construct new/larger US factories. As shown below, between these recent bills and COVID-related legislation like Operation Warp Speed, government R&D spending growth is accelerating strongly and poised to eclipse the pace of the previous decades.

US government investment spending

Germany forced to rebuild its military and energy infrastructure simultaneously

Much of the increase in global arms spending can be directly attributed to the situation in Europe and the invasion of Ukraine. Decoupling from and defending against Russia neccessitated massive expenditures across Europe in 2022, particularly in Germany. The status quo in Germany of low levels of military spending, persistent underinvestment in infrastructure, and government budget surpluses were all upended. German Chancellor Scholz recognized the war as a watershed moment and committed to large spending growth to upgrade an outdated military and transform the energy sector. The consequences of all of this additional spending can be seen below in the forecasted 2023 Eurozone government bond supply, where the largest swings come from additional German debt issuance.

Eurozone net supply of government bonds

What do these views mean for portfolio positioning?

In our tactical multi-asset portfolios, we seek to deliver diversifying returns that are lowly correlated with stock and bond markets. We do so primarily by seeking out relative value opportunities across different countries in both stock and government bond markets.

Our insights on fiscal policy mitigate our concerns about a recession in either the US or Europe. As a result, we continue to be short Eurozone government bonds and have added to long positions in global equity markets like Japan, Australia, and Canada that stand to benefit from a continued investment-focused and commodity-intensive global expansion.