Credit Suisse: Diversify to survive stock risks

Via the excellent Damien Boey at Credit Suisse:

Infrastructure stimulus package in the wings? Numerous press reports are emerging that US President Trump is mulling over a USD 1 trillion infrastructure stimulus package to shore up the recovery. The reports follow recent Fed announcements (or more precisely, reiterations with more detail) on corporate bond purchasing and “Main Street” lending programs. In response to the newsflow, equities are rallying, while bonds are weakening. The optimism is understandable. After all, infrastructure spending has long been touted as a way forward for the US economy, with bipartisan support. And if the Fed put is alive and well, perhaps we can get the best of monetary and fiscal stimulus at the same time.

More fiscal stimulus should mean more private sector saving. It is a national accounting identity that the sum of saving across all sectors in the economy must equal zero. For every lender there is a borrower. Re-arranging the identity, private sector saving—the sum of corporate and household saving—must equal the sum of the trade balance and fiscal deficit. Going a few steps further, corporate saving should equal the sum of the trade balance and fiscal deficit minus household saving, and corporate profits should equal this sub-total plus business investment. More fiscal stimulus should support corporate saving and profits, provided that it is not completely saved by households, or whittled away by larger trade deficits. The positive about infrastructure speding is that it bypasses households’ decision to save or spend, and directly injects cash into the economy. It should directly flow through to corporate saving and profits.

The trouble with fiscal stimulus. Government debt is a stock, while fiscal deficits and GDP are flows. Constant fiscal deficits will cause government debt to rise at a steady pace. But constant fiscal deficits do not mathematically contribute to GDP growth, because once the initial deficit is spent, it becomes embedded into the base level of GDP. Indeed, from this inflated position, reductions in fiscal deficits can outright detract from GDP growth, even as they cause government debt to rise at a slower pace. This arithmetic matters in the current context, because the US government plans to spend USD 9 trillion of stimulus over the next year or so, worth 42% of current annualized GDP. It will be very difficult to sustain this level of stimulus going forward, and indeed, the proposed USD 1 trillion infrastructure stimulus would seem like a “drop in the ocean” next to what is currently being spent. To be sure, the US government is not even halfway through its $9 trillion stimulus package, and so there is much more support for the economy and corporate profits to still look forward to. But our point is that peak stimulus is already upon us. In April alone, the budget deficit was equivalent to 53% of monthly GDP, and in May, this figure has shrunk to “only” 18% of monthly GDP. There will be large deficit spending numbers, and volatility in these numbers to come over the next year. Government debt will continue to rise sharply. But the peak impact on GDP growth is already being experienced. Arguably, the peak impact on corporate cashflow is not too far away either. We estimate that with fiscal deficits so large and overshadowing the rise in household saving, that the mathematical boost to corporate free cashflow (as per the national accounting identity) is the most positive in recorded history. Consistent with this finding, we also note that corporate buybacks are resuming after a brief hiatus. Everything looks like it is getting back to normal. But the reality is that if the government does not repeat its current dosage of emergency stimulus, there will be a large fiscal drag to contend with in 2021-22. And with this in mind, policy makers are really hoping that the private sector recovery is so independently strong that no-one will really notice the medium-term fiscal drag in the pipeline.

Inflation is still a risk to monitor. As flagged in recent missives, a fiscally driven boost to corporate saving and profits expressed as shares of GDP implies margin expansion, and can be equivalent to an uplift in corporate pricing power. Alternatively, it could equally be a reflection of weakness in employee wage bargaining power because of high unemployment driving the stimulus in the first place. But interestingly, the latest data reveal that wages are rising at a 3.5% annualized pace after stripping out compositional shifts, and despite high unemployment. Also, trend productivity growth is rather soft, partly reflecting supply chain disruptions and permanent business clossures. Therefore, unit labour costs are rising rather than falling, especially relative to CPI. Real unit labour costs, and the labour share of GDP are threatening to rise rather than fall at the expense of the profit share and profit margins. There is unusual cost pressure in the pipeline. CPI inflation is the balancing, or reconciling item. If firms can pass on cost increases to end consumers via higher CPI inflation, then it is possible to reconcile rising nominal unit labour costs with a mathematical rise in profit margins from fiscal stimulus and a corresponding fall in the labour share of GDP (or real unit labour costs). With this in mind, we think that firms are indeed facing a rare window of opportunity to pass on cost pressures on to end consumers in a high stimulus environment. In our view, these developments are potentially quite inflationary, and help to explain why we are not yet seeing outright deflation despite the sharpest downturn in the economy in a generation. But we also need to account for the temporary nature of fiscal stimulus, and weigh this up against various supply shocks that could persist longer term, in forming a longer term view about inflation. Moreover, we need to think about how inflation could feedback into current asset pricing, shaping current financial conditions and recovery dynamics. Complex indeed!

Equities stopped being about earnings and valuations ages ago. We are fascinated by the debates about how fiscal stimulus could re-shape the corporate earnings and inflation outlooks. But as interesting as these debates are, the reality is that the equity market rally has stopped being about earnings a little while ago. Indeed, it has probably even stopped being about multiples some time ago, even if we value the market on a 2-year forward Consensus basis, as opposed to a through-the-cycle basis on the belief that fiscal stimulus will stall longer-term mean reversion in profit margins. Almost everything has started to hang on low risk free rates and low volatility. While the jury is still out on how high bond yields can rise in this sort of environment, especially with the Fed capping yields through quantitative easing (QE), what we can see is more volatility in growth, inflation and bond yields. Dramatic shifts in fiscal policy necessarily create waves and cycles in their own right, and it is hard to engineer seamless transition to the private sector, and seamless coordination with monetary policy makers. Our view is that for as long as equity market volatility (VIX) is above break-even levels (currently 27%), investors will be inclined to short volatility on stronger growth, fiscal stimulus or the Fed’s put, supporting equities further. But once the VIX undershoots, investors are likely to become more pre-occupied with the unpriced risks and uncertainties in the world. Given that the VIX at time of writing is at 32%, sitting not too far away from break-even levels, this is an incredibly uncomfortable situation for investors. We recommend that investors without a clear crystal ball take a diversified asset allocation and factor approach. We suggest hedging against reflation risks through resources stocks. We also suggest taking on short momentum, short value and long quality factor exposures to navigate this tricky period with volatility. Short momentum positions help to capture what limited cyclical upside there is from further VIX compression. Short value and long quality positions help to protect against de-leveraging risks in the event that bubble valuations correct in asset allocation land for whatever reason. The good news is that our factor screens favour resources exposures within the ASX 100, consistent with our asset allocation views.


David Llewellyn-Smith
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