Robert Swift takes a look at the shift in language coming from central bankers and finance ministers and, more importantly, the implications for equities and bonds.
Author: Robert Swift
Confirmation bias is a common problem for portfolio managers. You have a thesis and then look only for news flow and data that confirms that thesis.
Since there always lots of news and data available, this bias is commonplace. However sometimes, you’re right and the news flow is supportive because it is meaningful.
One such example now is a subtle shift in language coming from central bankers and finance ministers, representative of a shift in macro policy from monetary to fiscal. For a number of reasons they will never say the last twenty + years of continued monetary incontinence has a) been a mistake and b) a mistake that has gone on too long in the face of evidence that illustrated its shortcomings, but at least we are seeing a shift? We think so at least and have positioned the portfolios accordingly. This has implications for the kind of risks that should be in your portfolios.
Here’s where we think the language has shifted and how it points to more fiscal; and the flip side, a continued steepening of the US yield curve with that of certain other countries to follow.
This is the start of a global paradigm shift or pivot.
John Williams the President of the Federal Reserve Bank of New York, one of the 12 Banks in the Reserve System effectively stated recently – we may have had interest rate policy that unduly benefitted wealthy people.
Janet Yellen, the Treasury Secretary in charge of spending and budgets, stated in selling the $1.9 trillion package to Congress, that with this fiscal package we now have a chance to come out of this recession strongly rather than the anaemic recovery we had from the GFC in 2008. In other words monetary easing alone did ‘naff all’ but raise debts.
And the dog in the night that still doesn’t bark – there was no mention of Yield Curve Control by Jerome Powell in his latest testimony to the House Financial Services Committee in February.
USA Banks’ Supplementary Leverage Ratio or the ability to use Treasuries, was NOT renewed by the Fed, and will end on March 31st. This ability was conferred as part of the Covid response and shows the confidence in the economic recovery. It may also see the banks sell Treasuries.
With economic growth at 4, 5, maybe 6% annualised, the 10 year note has no business being at 1.6%. Typically nominal long term bond rates mirror nominal GDP. So, we should be approaching at least 3%?…assuming we revert back to long term trend growth after the easy comparisons are over?
See the chart below from our colleagues at GCIO in Singapore, with whom we run an Asset Allocation service.
Source: GCIO
Japan may be following – we also know that central bankers talk to each other and was it a coincidence that the Bank of Japan, announced recently that it is now pulling back from asset purchase programmes (monetary injections) by removing guidance on ETF buying AND it widens the band for long bond yields albeit by a very small amount
The ECB won’t and so we fully expect the Euro to weaken from here as interest rate spreads widen. This also makes the financing of the 20% US budget deficit (yes that’s right) easier since yield spread will attract foreign buyers of US government paper.
See the chart below for the spread between US and German backed Euro bonds.
Source: Bloomberg
Powell is a genius tight rope walker here. He can’t abuse the notion of fiat money much more than it has been in the last 20+ years. Greenspan, Bernanke and Yellen did that to excess during their tenures, leaving with him with a nasty condrum – the markets need the opium of easy money and a free put option; this dependency is not good for their long term health; weaning them off it may cause a tantrum.
However at 100% debt to GDP he can’t really let rates get too high as he administers ‘cold turkey’ since debt service costs will be usurious as a drain on the budget. By using calming language now and talking UP the economy, he is tempering the inflation threat early; calming the markets about his attitude to fiat money and their elevated prices, and yet letting some element of doubt or risk back in. If you are calmed by his thoughts on inflation and how it isn’t present (oh yeah?), then remember that NO asset price crash has occurred without the CPI or PCE being ‘under control’. Essentially they have to deflate this bubble WHILE stating that the economy is on a sound footing AND prepare us for a shift in macro policy away from what has clearly not worked. We hope we can be talked down calmly.
(If you want an apology about the horrible policy errors conferred on us all, forget it).
(The inflation statistic is a horror show once you try to understand what is in there and frankly horribly adulterated. So if you don’t look out for ASSET bubbles then you will miss the danger signs. I think it was Bismarck who said that the 2 things you should never see being made are sausages and the law. I think we can add ‘inflation statistics” to that?)
So how much higher do rates go?
We are nearer the end of the long rate rise vs short rates than the beginning but they ain’t going down below 1.5% again.Charts from ‘FRED’ or the St Louis Federal Reserve Bank, show the average 10s vs 2s spread is about 1.2% over the last 50 years…we are just above average now.
Now maybe we should be using the ratio rather than the arithmetic difference since the steepness is relevant, and if so then we are certainly closer to the above average point.
Source: FRED
So, while fully cognisant of the difficulty in predicting long rates, we guess at 2.5% as the new average on the 10 year with maybe an overshoot if the recently announced additional $3 trillion package is passed. Yes $3 TR
ILLION. It was only about 20 years ago, by the way, that government debt to GDP was at about 50%. And to think that doubling that debt while having nothing to show for it; except more wealth inequality and a fail grade in Infrastructure, is not deserving of an apology!!
Source: American Society of Civil Engineers
Implications for equities and bonds are (we think) clear:
The SHAPE of the yield curve will benefit dividend paying companies
More fiscal spending will benefit industrial companies and smaller companies
More regulation and higher taxation may take away some of the tailwind to equities of the last few years
The targeted fiscal programme will benefit US Infrastructure stocks (a theme we have been boring everyone on for a few years now) and it will be more than Utilities that benefit – we own Quanta, Johnson Controls, and others whose products will be essential as the grid and capital stock are upgraded.
Add in the geopolitical shifts with the Quad alliance and Japan becoming a key partner, then Japan continues to look very good – here we have long argued that Japanese technology is ludicrously overlooked especially in the area of Semiconductor Production Equipment – here we have owned Advantest, Tokyo Electron, Ibiden etc for a while. It’s not too late. While ‘Technology’ may be vulnerable to this shift in macro policy, not all Technology companies will be. Valuation spreads are wide, business models different, and balance sheets and cashflows too.
In short Technology is a sector in which stock specific risk will be rewarded – if your manager has skill. If you have a manager who buys all of it regardless, we show the chart below. You have been warned!
Do not be greedy about equity returns. Profitability is above average, wages relative to profits must rise, companies have underinvested and need to catch up, taxes should go up, and the world is becoming less price efficient as trading blocs are fragmented by political alliances.
This week we would like to revisit the topic of asset prices. More specifically, in reference to the latest RBA meetings and the IMF World Economic Outlook. A topic that is particularly important to us in perhaps elucidating whether we are in the beginning of (another?) bull market or in the final stretches of irrational exuberance. Most importantly, what does this mean for your investing going forward?
O Bubble, Bubble, wherefore art thou Bubble?
Deny thy consequences and refuse thy name.
Author: Sid Ruttala
Anyone that has seen the hot property market, including the recent “best month in 32-years”, might feel a little uncomfortable and scratching their heads at what has been happening. You wouldn’t be alone. The RBA minutes have shown that the board has been watching this particular area quite closely. The case is not isolated either, the S&P500 Stateside has hit all-time highs, the Asian markets continue to roar ahead and Vancouver now has the distinction of being the second-least affordable housing market on the planet (that particular example is apt given the Canadian economy’s similarity to Australia, both being commodities driven). Anything with scarcity value, from crypto to artwork or even pokemon/sports cards, have seen their owners gain immense fortunes. All this, at a time when the market is still recovering from a global pandemic. Policy and geopolitical uncertainty continues to haunt the peripheries but we continue to seemingly ignore it. All this might suggest that we are in the midst of a bubble and you would be partly right. The problem might be in how we investors assess a particular thing and what we are assessing it against.
Let me elaborate. It is true that equity market valuations have hit all-time highs and asset valuations continue to skyrocket, but against what? That is where the question becomes more nuanced. Since the beginning of the covid pandemic, money supply indicators, including broad money, have shown double digit growth, 20% USD, 11% AUD, 10% in the Yen and the numbers continue across most of the world.
Going back to a view that I have previously touched upon, is it valuations going up or money (in this instance the commodity that those valuations are measured against) being devalued? It was Friedman who said that inflation everywhere is a monetary phenomenon, he forgot to mention that also translates to asset price inflation. Is it any wonder that Bitcoin, which has a finite supply of 21 million, remains a scramble. Even if you don’t agree that it has any intrinsic value, you must accept the premise of the argument. By the way, I continue to believe that the argument of intrinsic value in this instance is a fallacy and I say so despite my reluctance to trade that particular asset class. Gold’s valuation far outstrips its actual useful or practical value, a large chunk of the valuation is simply in its role as a store of value. By an extension of that logic, a luxury good, say a Rolex, should have no more value than any other watch assuming the same quality. You are just paying a premium for a belief and a mental programming that says said product makes a statement.
So that is the first point, for the much older investors, the markets may not be as irrational as they may appear. Coming back to the RBA and IMF. There were two things that the board addressed and the IMF corroborated. The first, you get the feeling that they feel asset valuations are a cause of concern though the Governor didn’t go that far as to explicitly state it (and neither should he) but even if this were the case that should not necessitate a normalisation of rates. Rates being the most important factor when it comes to asset prices.
Even pertaining to equity markets, take a look at the below graph. It showcases that US investors had borrowed close to $814bn USD against their portfolios as of late February (the biggest monthly increase since 2007).
Coming then to the second point both seemed to agree upon, addressing the problem will have to be through non-interest-rate regulatory tools. What are those regulatory tools? Typically, think about credit checks or buffer requirements. Think about minimum deposit requirements or interest only loans. To see how this might have a direct impact upon asset prices a quick example might be Hong Kong. When then CEO Carrie Lam, fighting declining approval ratings, lowered the minimum deposit requirements to 10% for properties up to $8m HKD (as opposed to the previous $4m HKD). While this did undoubtedly help many people afford their own properties, especially first home buyers, it had a secondary impact of putting a boost on property prices when the policy was brought in (Q4 2019, though they subsequently cooled off after, well, we all know what happened).
For a further walk down history lane, it was precisely these requirements apart from the Fed Funds Rate that enabled one of the largest expansions in the US real estate market pre-GFC. This time we are likely to see the opposite happen. Lending standards and capital requirements are likely to see tightening as the economy recovers with the implicit hope of cooling off credit growth. From an allocation perspective, we are unlikely to see any changes to the headline cash rates globally. This however, despite what has been said, is not a choice but necessity. As we have elaborated upon previously, covid has brought about fiscal deficits across most of the western world that we have not seen since the World Wars and the case is similar across most emerging markets. Even slight increases in headline rates will have immense implications upon the debt-servicing requirements and consequent tax burden. To give you a context of the magnitude, the central bank balance sheets of the US, BoJ, RBA and ECB expanded more in the year 2020 than the five years following the GFC.
Stateside this will likely continue under the new administration, an additional $2tn earmarked already. At home, don’t forget an upcoming election down under. If the recent trends regarding longer-term yields are anything to go by, we are probably going to see most of the new spending and debt-issuance end up on central banks’ balance sheets given little appetite from alternative investors.
So, what does this mean for us investors? The first is simple, the outstanding returns of the past year across asset classes may be just that, an outlier recovery fuelled by loose monetary policy. We have probably seen the easy returns made. As policy makers change tack and work toward trying to taper off some of the risks associated with ever increasing asset prices, investors might need to be a little nuanced in how they allocate. This is necessary, given that the ramifications have broader implications than just from an investment perspective. Take income inequality for example, one of the unintended consequences of covid policy has been a record number of billionaires added to the Forbes list, about one new one every 17 hours. For the investor, expect the asset classes that you have become used to seeing incredible growth in see tightening, including property and the higher growth segments of equities markets.
As for the question of a bubble? Maybe we are in one, but it is potentially the wrong question all together. The more apt question is, given the incentives for policy makers, government and the amount of liquidity that is driving this, what are the likely outcomes? Take the example of income inequality, one might then ask themselves the question, what does this mean for luxury goods? Or within property, what does this mean for high-end vs. low-end properties? If the cash rates stay low and regulatory tightening occurs on the lending side, what does this mean for my bank shares? This core part of so many Australian portfolios is an interesting one. Anecdotally, a home loan specialist at one of the big banks recently told one of our team that they have rarely been busier than in recent months. Many Aussies have taken advantage of the current situation to lock in low rates. What happens when the banks’ NIMs get squeezed further though? And their loan book growth if lending standards are tightened? This might not happen any time soon (maybe when those locked in rates roll off and become variable in five or so years though?) but it is definitely a consideration for many of Australia’s retiree population. The Australian retiree that has the vast majority of their wealth in a “diverse” selection of property and bank shares is placing a lot of faith in what is essentially one big bet. If the property market finally takes a dive, it will take the banks along for the ride. Given the Australian index’s reliance on and weighting toward the Big Banks, a dive from the property market (and the accompanying problems for the banks) could trigger a much broader sell off across Australian equities. This is perhaps the best argument for ensuring you are also diversifying into international equities.
From the fiscal side of the equation, if we are likely to see increased government spending, what might this mean for infrastructure? This has been one of the big thematics for our global equities manager Robert Swift for a number of years now, a theme kicked into overdrive by covid stimulus. Or what about the effect of direct stimulus upon consumer discretionary spending? A segment that our Australian equities manager Ron Shamgar has been very much on top of this past year.
So going back to the original questions, in this particular author’s humble opinion. Bubble? Possibly by historical standards but there is a little more nuance to this than first meets the eye. Irrational exuberance? No, when you consider the nuances mentioned above. Are we at the beginning of a bull market? Probably, might be a lame one though.
By now most of the readership, we assume, has heard about the Archegos Capital fiasco. A situation that, last Friday, shook global equity markets. A series of events wiping out close to 50% of the market capitalisation of Discovery, more than 50% of Viacom, 20% off Baidu to name a few, not to mention the fact that it has led to an increased level of volatility in global markets. But, just in case you haven’t and you are an investor who has been scratching his/her head at what has been happening in terms of price action, read on.
A Little Context
Author: Sid Ruttala
Before we explore the current situation further, a little history into Archegos. Archegos Capital Management, is an outfit run by Bill Hwang, an interesting character who would in any other situation deserve a full article for himself in my opinion. Mr. Hwang made his mark in the finance world close to two decades ago as the protege of Julian Robertson, part of a club now referred to as the Tiger Cubs (i.e. the alumni of Tiger Management who went on to form their own hedge funds once the mother firm folded in 2001). This particular cub was originally inducted into Tiger in the 90s after he had managed to be particularly lucrative for the firm as a broker at Hyundai securities. Following the roll up of Tiger in 2001, Mr Hwang branched out on his own, investing for himself and starting his own outfit in Asia.
That particular outfit, rather creatively named Tiger Asia, was not only bankrolled by Robertson himself but became one of the largest investors in Asia, managing billions at its peak. However, having shown stellar returns through much of the decade, Mr Hwang decided to leave another kind mark on the industry, this time making him rather infamous. Underlying the stellar returns Mr Hwang had been showing, it seemed that there were certain irregularities. These particular irregularities included insider trading and market manipulation, which eventually resulted in a ban from trading on the Honk Kong exchange and penalties by the SEC to the tune of $40m USD.
So that should’ve been the end of it right? Wrong.
Twelve months after the collapse of Tiger Asia, Hwang launched a second firm, Archegos Capital Management in 2013. This time he had converted the firm into a family office, a setup that managed to rid him of the pesky headache of regulatory requirements (family offices are exempt from the SEC’s reporting requirements for investment firms). The firm grew by leaps and bounds, not only in size and scope but also risk appetite. The initial principal of $200m grew steadily over the years to about $10bn (as recently as last week).
This brings the second question, how did a family office grow big enough to make a global impact? The key here is that the fund had, it seems, been using previously unheard of levels of leverage, often borrowing close to seven times principal in order to amplify returns. A scenario that allowed it to grow by leaps and bounds over a close to decade-long bull market. The music was playing, so to speak, and everyone was dancing; institutions as well as prime brokers were bending over backwards to extend lines of credit for lucrative commissions. Aside from being a prime example of what excesses and low interest rate environments can create in terms of dislocations, this particular situation also brings to the forefront another example of the risk management practices (or lack thereof) at global institutions. After all, we have seen this play out before, though many have forgotten about it, in a little blip called the GFC and, for those of you that wish to go back further in history, LTCM (Long-Term Capital Management) that in many ways exacerbated the Asian Financial Crisis.
But who do we kid? There is no protection against human nature, after all. If the upside is lucrative enough, we are all prone to bite the bullet and play along. So much so it seems that most of the brokerage teams had been lobbying the risk departments to turn a blind-eye to Mr. Hwang’s rather chequered past. Hwang was, after all, seen as a “money-making genius” and maybe this time would be different. The fees would certainly make up for it and hopefully they wouldn’t be the last one standing in the room if it went wrong.
Unfortunately, it did go wrong when shares in some of Archegos’s biggest positions started to decline and warranted a margin call. By Friday of last week two of his biggest lenders, Goldman and Morgan Stanley, initiated the sale of some of his biggest positions, $20bn USD worth of it to be exact. On Friday alone, Goldman and Morgan Stanley managed to sell off $19bn USD at seemingly garage sale prices, wiping out close to $33bn USD in the market capitalisation for the companies involved and potentially more to come. Unfortunately in situations like this, there is a domino effect whereby the sale triggers broader sell-offs and panic starts to set in.
It seems that Archegos has exposure via more institutions, including Credit Suisse and Nomura to name a couple. That particular information led the market to sell off Credit Suisse, which lost close to 15%, and though the impact upon Nomura was more muted, it might still have the potential to wipe out the firms second half profits. Credit Suisse and Nomura have to unwind another $20bn USD, potentially more pain to come?
What does this mean for investors and what can we take away?
All these events are going to bring increasing levels of scrutiny by regulators and the extent of leverage within the broader markets. All things equal, we are at the very least likely to see a lowering off the risk-appetite and de-leveraging within the broader markets. As firms ask their clients to taper off some of their risk exposures.
As for the regulators, the only thing done so far has been to ensure that brokers aren’t coordinating the sale and breaching antitrust regulations, apparently we’ve at least moved on from the 80s. But, as the world continues to stay at lower rates for longer, the quest for returns will continue to drive risk appetite and leverage (for lack of a better option). And while we might see some turbulence as financial institutions at least pretend to tighten credit lending requirements, somehow we doubt this will be the end of it.
For the discerning investor with a longer time horizon, hold in there. After all, you could’ve bought Discovery 40% cheaper with no news flow and no changes to what the underlying metrics were pre-selloff. And add in our tendency to have the collective memories of goldfish, as soon as the markets and media find another hot topic, it will be business as usual. The fact that most of the financial institutions globally have been showing some of the best capital markets returns in years should tell you that, depending on how quickly the world moves on, the siren call will be too hard to resist. Market participants are creatures of habit after all, insisting like a chronic gambler that this will either be the last time or this time will be different. Clue: it never is. For yourself, at least understand what is driving moves like this and have a longer time horizon, these types of markets also present immense opportunities.
There is a novel idea in finance, the two main drivers of human behaviour in markets are fear and greed, understand them and learn to use them to your advantage.
Some of the best opportunities on the ASX in recent times have been microcaps. Companies where the business models are scalable, management have a track record of execution, and, more importantly, companies that are well funded. Altium and EML, as best-case examples, were sub-$50m microcaps just 7-8 years ago and are multibillion dollar businesses today.
Authors: Ron Shamgar
8common (8CO.ASX) is a software business in expense management, specialising in the government and not for profit sector. The software allows employees to claim work related expenses. It has 10% market share of the Australian market and an even larger share of the government sector. 8CO will be a beneficiary of the recommencement of travel and it has recently added over forty government departments to the platform. 8CO also recently launched a new card payments solution called CardHero, being utilised for segments of the $4.8bn National Disability Insurance Scheme (NDIS) program, as an integrated fund disbursement and spend management option. CardHero is designed to help prevent fraud by instantaneously accepting or rejecting transactions as they are made. CardHero is exciting for investors because the ARPU is 6x higher and the addressable market is significant. A broker recently initiated coverage on 8CO at a valuation of 50 cents.
Source: 8CO company filings
AF Legal (AFL.ASX) is a family law roll up story. In a defensive and highly fragmented industry, the company is aspiring to become the largest family law firm in Australia. AFL is growing laterally by both adding new recruits and through the acquisition of existing firms. The recent deal to acquire NSW based Watts Mcray adds scale with $6m revenues and we estimate $2m of EBIT post-synergies. We estimate that AFL is on track for EBIT of $5m in FY22. The company is very cash generative and capital light. On a decidedly somber note, there is little doubt that AFL has benefitted from the spike in divorce rates due to Covid hardships. On the lighter side, some investors regard AFL as a hedge against their own future potential divorce bill! If they can execute in line with our assumptions, we value AFL at $1.50.
RPM Group (RPM.ASX) is an automotive group similar to ASX listed Bapcor. RPM business includes the selling of tyres, motorsport apparel and has mechanical repair shops. Similar to AFL, RPM is an acquisitive roll up story. Guidance this year is for revenue of $55m and EBITDA of $5m. The management has signaled three acquisitions currently in the pipeline that should take the group to $100m in revenue once completed. In the medium term, group aspirations are for $150m business and 10%+ EBITDA margin. RPM is a Covid beneficiary too. The domestic travel thematic, elevated due to national border closures, and the reduced public transport usage working in their favour. The founders of RPM have a track record of previously building a similar business and selling it for $35m (to Bapcor) in 2015. We believe their current ambitions are significantly greater than last time around. If RPM can achieve $100m revenue then we value the group at approximately 3x the current share price, putting it around the 90c mark.
Source: RPM company filings
Disclaimer: All three stocks are held in TAMIM portfolios.
We wrote about the need for a U-turn in macro policy thinking recently. It looks like we are getting one; or just as important for market psychology, other investors think we are getting one – a shift that is. Read on to learn what investors should consider in this context.
Author: Robert Swift
Don’t expect a ‘mea culpa’ from policy makers for 20+ years of ‘monetary policy for rich people’ but we are getting a shift in thinking and so off we go to the next experiment (or paradigm if you are in academia). This has implications for the kinds of stocks and sectors and countries in which you should invest. Incidentally, it’s not exactly the shift to a policy we expected, but it is probably better than repeating what has been done for the last 20 years, which always prompts the definition of madness.
We wanted and anticipated a shift from ZIRP to something a little more fiscal and supply side to encourage investment and jobs growth.
The fiscal stimulus we are getting ($4tn+ and counting) is pro cyclical not counter cyclical. This looks like a big increase in government spending and borrowing in conjunction with low short term interest rates, at a time when the economy is growing quite well. That’s quite a heady and unusual combination.
In the US economy ‘animal spirits’ seem to be stirring. Vaccinations are running ahead of other countries’ programmes (as Churchill said, the USA always invariably does the right thing but only after exhausting all other possibilities) and the tech embargo has produced a large planned increase in onshore SPE capital investment. Interestingly too, the Biden Administration has not (yet?) removed Trump’s ‘unnecessary and damaging’ tariffs on Chinese exports. We are thus in a ‘full on’ return to National Industrial Policy which will boost aggregate domestic demand and inflation expectations. [Build Back Better – Buy American]
Since ZIRP or Zero Interest Rate Policy hasn’t worked other than for those on Wall Street, or with lots of moolah to start with, we had expected a shift to fiscal policy and a normalisation of monetary policy which would potentially benefit Main Street – i.e. higher interest rates at the long end as the Fed began to reduce its interventions/QE, and letting bad financial decisions have their consequences rather than free put options and bail outs for Wall Street. This would be orthodoxy or certainly post 1980 Reagan orthodoxy from when large scale government intervention was deemed to be part of the problem, and private enterprise was less concerned about share buy backs and more concerned about sustainable growth through re-investment.
There really is no need for a large pro cyclical fiscal AND monetary stimulus other than if you think it’s time to throw out the old post 1980s playbook and try something new? Essentially the Reagan era orthodoxy looks to be out the window, and so off we go into what for many people will be the unknown. At this juncture let’s just say that quite a few global investors have careers that only encompass ZIRP….we are all about to be tested.
There really has never been any deflation as this chart from the Cleveland Fed shows. So, continued ZIRP with a big fiscal boost is inflationary.
US Inflation – What deflation?!?
Source: Bloomberg
Let’s have a quick summary of what we see in the $4+ trillion package:
Infrastructure but a huge clean energy expansion with credits for Electric Vehicle purchases
Incentives to return technology supply chains to USA soil
Unionisation of the workforce to drive up wages relative to profits (not necessarily a bad thing given where they are now relative to history)
Higher headline taxes (will the likes of AMZN actually pay them?) including a multi-national tax proposal which we view as essentially ‘soft form’ capital controls if it passes through globally.
So it’s a return to big government and centrally directed capital allocation or essentially the 1950s. We have christened this SPLURGE or Spending Public money Like URGiving it Everything. The USA is a first world country with 3rd world infrastructure, so we view this spending on the national capital stock as an essential part of the US’ rebuilding process, and do like infrastructure companies as investments, but this has to be paid for AND inflation expectations can’t be let loose or we’re not back to the 1950s but back to the 1970s.
We see the USA as on a tightrope. One side is uncontrolled inflation as ZIRP + SPURGE are implemented but the productivity boost never happens, and the other side is bad or compromised legislation and no real fiscal boost but only more ZIRP which continues to fail Main Street. Rebuilding and recalibrating wages vs profits is essential for social cohesion so we like the fiscal plans – assuming SOME of it actually gets to where it should go. However, if inflation becomes even more visible than it is now and the Fed can’t ‘jawbone’ and persuade people to relax about the ‘temporary’ spike in inflation (eh? Ed), then treasury auctions become difficult. It was a poor treasury auction of 7-year notes that created the sell-off in Q1 and there are quite a few auctions coming up! If the long bond sells off too aggressively, we have the topic of yield curve suppression back again which is essentially capital controls.
Why?
At 100% debt to GDP, a 10-year note at 3% costs 3% of GDP just to service the debt. So that possibly won’t be allowed to happen? (For those of who think years and years of ZIRP and QE was a good idea, USA debt to GDP was about 50% in 2008. In other words you haven’t got a lot for your money.) Chairman Powell has subtly so far NOT mentioned YCC but if that long bond rises to the same percentage as nominal GDP, as it typically does, then watch out.
US Inflation will be a ‘shock’ based on this disconnect
Source: Bloomberg, Delft estimates
If the $4tn+ investment doesn’t happen, then ZIRP on its own will continue to fail Main Street and we have louder grumblings and more left wing populism. In Albany, the New York State government recently passed tax increases which take NY taxes above those of California. There are rumblings about imposing a state exit tax as folks continue to move South and East to lower tax states. This cry for a re-set has just started.
So, how to pay for it?
The USA budget deficit this year could be anything from 10-17% of GDP and it is highly likely that foreigners will have to buy some bonds since the US domestic savings pool is not big enough. To that end the rise in longer US rates relative to foreign rates is very helpful and a master stroke by the Fed.
Source: Bloomberg
Corporate tax rates are going up too and fiscal drag will also be used to raise taxes on the individual. We have loved the rallying cry to pay more tax at the higher rates, by the CEOs whose last few years have been spent aggressively minimising their global tax burden! Chutzpah.
Nonetheless, deficits will increase and you won’t be repaid as a debt holder in 2021 dollars when you redeem your bonds in a few years. Inflation has been mandated.
Here is what we are considering as investors:
Cash is expensive. You will lose more by timing the markets in and out of cash, than by being diversified in risk assets
Long term bonds will probably come under more pressure but if they hit 3% then they are attractive
Corporate credit will do well as growth is run hot – we especially like Asian credit where the Chinese have begun to tighten, allow property loan defaults and generally restrained the potential consumer speculations they mistakenly allowed in the past. E.g. Ant Financial being regulated.
Infrastructure equities – there is a LOT of technology in building a nation’s capital stock and connecting renewable energy to the grid, for example, is not straightforward but a speciality of companies like Quanta (PWR.NYSE) which we have owned for a while. Not as cheap as it was but as cheap as Facebook and it performs a (more?) useful service, so good on the ESG dimension.
Clean energy companies like AES (AES.NYSE), NextEra Energy (NEE.ASX), TransAlta Renewables (RNW.TSE) and Johnson Controls (JCI.NYSE) which specialises in reducing ambient heat generated by the built environment.
Industrials such as Schneider (SU.EPA), Cummins (CMI.NYSE), ABB (ABBN.SWX), Emerson Electric (EMR.NYSE), Eaton (ETN.NYSE), Ebara (6361.TYO)
Materials companies – BHP (BHP.ASX), Rio Tinto (RIO.ASX), CRH (CRH.LON), Heidelberg Cement (HEI.ETR), Anhui Conch Cement (600585.SHA), China Lesso (2128.HKG)
True technology especially in the SPE space such as Advantest (6857.TYO), NXP Semiconductors (NXPI.NASDAQ), KLA (KLAC.NASDAQ)
Smaller Asia companies are particularly attractive relative to elsewhere – cheap, growing and with better governance. We have an Asia Small Companies strategy which has been running for over three years now
