Sid Ruttala fleshes out a number of the points that Robert Swift has been talking about in his weekly Ausbiz appearances. Heading into the pointy end of the US presidential election, there is always heightened uncertainty in investment markets and (as much as we might want to given 2020 so far) this is not the time to bury one’s head in the sand and hope for the best.
This week we revert back to the macroeconomy, taking stock of what the markets may look like in the final stretch of this year and heading into 2021. The fundamental question on everyone's mind is what things look like going forward given the continued instability in the geopolitical space and upcoming US elections on November 3. This uncertainty always has an impact on investment markets. Longer-term, we may have finally crossed the debt rubicon - where we may never actually pay back the incredible amount of both household and fiscal debt. If this is the case, what does this mean for financial markets and asset classes going forward? Quite a chunky, and one might say ambitious, project to sum up in a few paragraphs, but let me try in any case.
Firstly, let me begin by saying I gave up on watching the first presidential debate after spending all of ten minutes fending off a migraine. Suffice it to say, the markets didn’t react all that well either. As though the uncertainty surrounding the current policy environment wasn’t enough, the rhetoric was positively vitriolic. But, never fear, investors can take reprieve in the fact that election cycles have short-term implications (volatility) but never in the long-run. At worst, as is shown below, we may have to worry about a democratic sweep (even here history is on the investor’s side). For the long-term investors, think back to the Bush election that was decided by the court as well. I say “as well” because this one is in all likelihood going there too, hence Trump’s urgency with a supreme court nomination. We certainly didn’t flinch then and this time is not likely to be any different. Same with every doomsday scenario that we faced in recent history, Watergate, First Gulf War, 9/11, Iraq War, the list goes on and on. So what do we care about?
What Does Matter?
So now that I’ve told you that it’s the liquidity and monetary policy that matters more for financial markets than questions of underlying GDP growth (if that were the case then we should all be growing at 1.5% p.a. as opposed to the double digits that we have become used to), let us look at the biggest risk of them all: The probability of a reversal in monetary policy. One that is only possible should we see surprises in headline inflation. If so, when and how is this likely to happen?
Let us begin with some basic figures around debt. As can be seen in the figure below, current gross debt to GDP in percentage terms stands at close to 400% of GDP. As of this year, US Federal Government debt stands at close to 107% of GDP, a sum vast enough that the natural impulse from any central bank is to keep a lid on rates to keep up serviceability. In Australia, this figure stands at a more “manageable” 45% of GDP, but household debt is second highest amongst OECD countries which presents an altogether different but perhaps more severe headache. Why is this a problem?
It’s not a problem immediately since it does naturally keep a lid on yields. However, the cost comes in other forms, typically income inequality and asset price inflation. Since subsequent increases to liquidity end up flowing towards asset price inflation and yield suppression.
For investors, the bigger problem is that even slight increases to CPI inflation can have amplified flow-on effects for asset prices. As I have mentioned in previous articles, the discount rate for valuations is typically the risk-free rate of return, which is the cash rate, and even a slight change from a true 0 to a nominal positive can have vast implications, especially across the high growth segment that is trading at historically high PE’s. With regards to Australia, have a look at the below graph of asset prices plotted against the (inverted) cash rate.
Coincidence? Methinks not.
So Where to Next?
What has been immediately evident when pouring over past comments from central banks across not only Australia but Jackson Hole in the US and the ECB is that there is a slow realisation that rates are unlikely to be normalised in the short-run. The only way out of this pickle is to actively have headline inflation shoot above the cash rate, with the outcome, of course, being that you inflate away the real value of the debt over time (positive). Effectively a write-off but not called as such. The fall guys, if Japan and Europe are anything to go by, are the financials who 1) have to hold a certain proportion of their balance sheets in government bonds; and 2) are forced, via the cash rate and ES transactions, to take the pain should inflation come back into the picture and real rates stay put.
As such, the biggest risk is not necessarily political but an impetus for change in central bank policy. This is not the markets as we know them and it is for this reason that the yield curve no longer predicts the future as was typically the case (i.e. predicting the likelihood of monetary tightening and recessionary scenarios) and the 10-year barely budges despite increased volatility or sell-offs (another way of saying, if necessary, they will control the slope). In any case, we still can’t grapple with the notion of taking 10-year duration treasuries for a paltry 0.63% yield. It doesn’t make sense when you consider that this becomes significantly negative in real terms after taking into consideration the Fed's target inflation of 2%. That is unless you have conviction that yields will go further into nominally negative territory, which we won’t rule out yet even if Powell has. We all know how long Lowe lasted in his vehement ruling out of QE closer to home.
How to Allocate?
This is where the political policy side does come back into the equation, albeit indirectly. Fiscal policy can change the inflation expectations and headline CPI quite drastically. This happened to be the reason why most direct stimulus measures advocated by the Chancellor of the Exchequer in the UK, Rishi Sunak, and the $600 USD a week jobless benefit advocated by the Democrats are good short-term measures. Since they feed through directly into spending as opposed to tax cuts or cash rates, which feed through to asset price inflation. Direct demand targeting measures that come through these types of spending programs, even infrastructure-related, have a two-fold impact: 1) they squeeze out the corporate sector as a percentage of GDP (i.e. assuming finite capital) and 2) increase consumption.
The allocation in this instance should depend on whether the higher inflation warrants a change in monetary policy, in which case the allocation would then be towards lower growth but higher correlated and higher-yielding materials and commodities (e.g. copper) sectors as well as, TIPS (Treasury Inflation Protected-Securities) and infrastructure. If inflation is low enough to not warrant any overarching changes to monetary policy (which is more likely) then the idea is to sequentially revert back to value and gold. By the way, this is where I disagree with Robert, I continue to believe that gold is not the best hedge against inflation but is one against uncertainty.
Finally, remember that even if we have a different administration in the US, good luck reversing the corporate tax cuts in the Senate. Probability-wise, we will have more fiscal stimulus and this time around there will not be much opposition to spending as was the case in the past. Trying to oppose big-ticket spending programs with rhetoric about prudence, as was the case under the Obama administration, won’t fly when your own party threw caution to the wind and blew it out (Federal government debt) by $8.3tn USD in the space of four years and tax cuts in the middle of uninterrupted economic expansion.
Whoever wins and however much uncertainty there is, the two rules to assess these markets by, just like Buffett’s two rules of investing, are 1) liquidity; and 2) remember rule one.
Markets & Commentary
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