When the US Fiscal Policy Hits Its Limit

Fiscal policy can reach its limit just like monetary policy does. We experienced a taste of this in the aftermath of the Global Financial Crisis, observing what the limit of monetary policy would look like. Now, we are testing the limit of fiscal policy as the US fiscal deficit is projected to run at approximately 6% over the majority of this decade. The implications are profound, akin to when the interest rate hit zero.

What does it mean when fiscal policy hits a limit? In a developing economy, it means high fiscal deficits and rapidly rising government debt, usually accompanied by slow growth and credit rating downgrades. This leads to liquidity crises and currency selloffs, prompting the central bank to raise the interest rate to an elevated level, which then results in fiscal austerity and potentially a recession. However, the implications in the US are much more complicated due to US exceptionalism and dollar hegemony.

Economic Growth Implications

When fiscal policy hits its limit, increased fiscal deficits lead to higher long-term borrowing costs for both the government and the private sector. This crowds out private investment, offsetting the positive growth impact of higher fiscal spending. US economic growth could remain moderate to strong if US exceptionalism endures and investors are willing to continue funding the US government. In contrast, growth could materially weaken if US privilege diminishes.

Inflation Implications

Long-term inflation expectations have been well-anchored despite inflationary periods over the past few years, due to the Fed’s strong credibility. However, we cannot rule out upside surprises in inflation expectations if fiscal policy hits its limit. Financial repression could become the least resistant way to reduce the debt burden.

Inflation-linked bonds and commodities would benefit if such a surprise materializes, while most other assets would suffer.

Equity vs. Bond Implications

Public and private equities have performed well over the past three decades despite slowing US growth potential. The level of interest rates may be more important than the level of economic growth when it comes to equity performance. A low interest rate enables shareholders to leverage the company’s balance sheet and boost ROE, while interest rate declines lead to compression in equity earnings yields. An 80/20 portfolio outperformed a 60/40 portfolio in such an environment.

As long-term real interest rates return to a more normal (higher) level, bonds become more attractive again from a risk premium perspective. Intuitively, higher interest rates favor creditors over debtors (or shareholders who like to take on debt, such as private equity LBOs). Therefore, a 60/40 portfolio becomes more attractive compared to what it was ten years ago.

Both equities and bonds should underperform cash if stagflation occurs. However, that remains a low-risk event barring significant supply shocks.

Dollar Implications

This is probably the most difficult aspect to consider. If the troubles of the US economy due to the limits of US fiscal policy do not spill over to other economies, the dollar should weaken. However, if it leads to financial accidents and de-risking, the dollar should strengthen due to risk-off behavior.

What will it take for the immaculate disinflation to materialise?

In contrast to what I had anticipated, a US recession did not materialise in 2023. And the market prices in the upside scenario of immaculate disinflation, with a soft landing in growth while inflation declining to the 2% target. It forces me to ponder about the following questions: is a US recession being delayed or avoided? What will it take for the avoidance of recession / immaculate disinflation to materialise?  

To answer the question, we need to assess where we are in terms of growth and inflation. To be clear, the economic situation is not rosy at all; it is probably just merely not as gloomy as originally anticipated. Core inflation remains sticky and noticeably above the 2% target in all the major developed countries. Meanwhile, barring the US, GDP growth is either close to zero (Europe and Canada) or declining further away from its growth potential (Japan, Australia and South Korea). Even though the negative shocks caused by Covid and the Russia/Ukraine war are fading – leading to the decline in inflation from very high levels – the stickiness of inflation despite weak growth is striking. That sits in contrast with – and is arguably worse than – the 2010s when both growth and inflation was persistently below desired levels.  

What do the above-target inflation and weak growth tell us about the underlying economic supply and demand? On the supply side, supply shocks are being unwound but not yet finished. Optimists purport that inflation will continue to decelerate while growth will stabilise as the unwinding continues. Pessimists argue that de-globalisation represents a new and persistent source of inflation booster and growth dampener – which means inflation wouldn’t decline to the 2% target without a recession.  

On the demand side, the current growth and inflation dynamics suggest that the Covid-era and post-Covid policy stimulus is not yet fully offset by the recent aggressive monetary tightening. That leads to sticky inflation and growth not falling below zero, even though growth moderated by demand destruction amid Covid and the Russia-Ukraine war. Excess savings are not yet depleted (particularly in the US), and income is supported by fiscal stimulus, for instance.  

In terms of the economic outlook, what will it take for the immaculate disinflation to materialise? The question is most pertinent for the US, as Europe is probably already in a recession and the smaller developed countries are highly geared to the US/China economic cycle. To be clear, I doubt AI alone can help the US avoid a recession before AI is still at its early stage and yet to affects a large number of sectors in the economy. Therefore, we probably need at least three things to happen simultaneously: 

1. The negative supply shocks continue to fade without new shocks emerging. That may manifest itself in the continued growth in the US labour force. 
2. The lack of a further rise in US bond yields as investors are willing to believe in the US government and to fund the ballooning US fiscal debt and deficit at a relatively low yield.  
3. The European and Chinese economies continue to provide disinflationary impetus due to their weak demand.  

None of the three factors is certain. So I am still surprised by the optimism that the market places on immaculate disinflation. I still think a US recession is more likely to be delayed than avoided.  

Rebalance Diary August 2023

60% equities (10% DM small-cap, 30% DM and 20% EM), 30% fixed income (15% US Treasuries, 15% EM bonds) and 10% commodities.

On the asset class level, equity risks are reduced while the portfolio starts investing in long-term US Treasuries due to high interest rates and recessionary risks. The portfolio maintains some exposure to commodities for diversification, though inflation risks have declined from elevated levels.

The portfolio starts investing in small-cap stocks within equities due to its large valuation gap versus large-cap. The outperformance of small-cap stocks in the 1970s represents another reason to invest in small-cap stocks. Meanwhile, I maintain diversified exposure to ex-US stocks, which generally offer 10% long-term expected returns.

For fixed income, the portfolio has a barbell strategy, with half in US Treasuries and the other half in EM bonds. Given the soft-landing optimism in the market, there is an argument that a further switch from EM to US bonds is warranted. Nevertheless, both dollar and local-currency EM bonds offer 7%+ yields, while some LatAm central banks have started monetary easing on the back of decelerating inflation.

The portfolio continues to maintain decent exposure to EM assets with cheap valuations.

Risks to the portfolio:

• Stagflation in the US with a strong US dollar would negatively impact most of the assets in the portfolio.  
• Continued tech rally would lead to underperformance of this portfolio versus a simple global equity index fund.
• A Japanification of the Chinese economy would lead to a further fall in EM and commodity assets.   

Rebalance Diary May 2022

• Significant value is found in the stock markets of the Eurozone, Japan and China.
• If the war morphs into a “frozen conflict” in Eastern Ukraine while the EU continues to allow imports of Russian natural gas and food, then the geopolitical situation may have passed its worst moment for European equities. Investors can then shift the focus to the still-resilient economy bolstered by post-pandemic domestic spending. Increase positions in European value equities.
• Kuroda’s ambition to revive the Japanese economy – before he steps down next year – has led to a consistently accommodative monetary policy and a sharp depreciation in the yen, which in turn boosts Japanese company profits. Japan’s determination to stick with QE and yield curve control contrasts with global synchronized tightening, the latter being a key headwind to global assets. Increase positions in Japanese equities.
• Chinese equities look cheap after a 50% drawdown in the MSCI China Index. Policy stimulus is kicking in while the Zero-COVID policy should fade in due course. Initiate positions in China-only equities.
• Sell UK equities (high stagflation risks), EM equities, EM Asian equities and Oceania equities to fund the above equity purchases.
• Keep (low) US equity exposure via US value equities. Continue to avoid US/European growth equities as the valuation gap between growth and value stocks remains elevated despite the recent underperformance of growth stocks.
• EM bonds provide significant exposure to commodity exporters while offering a 7% yield. Increase positions in both EM $ bonds and EM local bonds. Sell US Treasuries – where a flat yield curve implies little value on the long-end vs the short-end – to partially fund the EM bond purchases.
• Shift gold exposure into broad commodity exposure as global prices may decline further if real bond yields continue to rise from the current level (zero).

From Russia to (the Rest of) the World

It is worth re-assessing the questions raised in the last post (dated 24th Feb):

• Will the West kick Russia out of SWIFT, despite Russia providing 28% of EU imports of crude oil and 41% of EU imports of natural gas?
  • Yes, it happened. the West pledged to kick several important Russian banks out of SWIFT. More importantly, a large chunk of central bank assets are frozen under sanctions, putting Russia straight into sovereign debt and currency crisis.
• Will Russia deliberately default on its USD or rouble debt, despite the huge FX reserves (and no problem to repay)?
  • Highly likely given the various capital controls in place. Foreign holders of a ruble-denominated bond may not receive an interest payment due today as the Russian central bank banned the transfer of the coupon payment. Sovereign CDS pricing also indicates a high likelihood of Russia defaulting on its dollar bonds.
• Will the geopolitical tension trigger systemic crisis (like the GFC or AFC) and subsequent oil price crash?
  • Not yet. It should be unlikely, but is something we watch closely.
  • So far, the market treats the geopolitical event as a supply shock, as evidenced by the sharp rise in commodity prices. Due to the small share of the Russian GDP in global GDP and a low likelihood of a prolonged energy supply suspension from Russia to the EU, the market expects the demand impact to be moderate.
  • However, as lots of cross-border physical trades, capital flows, loans and investments get abruptly suspended between Russia and the West, we need to closely watch any banking or payment failure that might trigger regional credit crunch (or even banking crisis). A silver lining is that European financial claims on Russia are significantly smaller than in 2014 when Russia invaded Crimea.

Questions about Russian Equity Outlook

• Will the West kick Russia out of SWIFT, despite Russia providing 28% of EU imports of crude oil and 41% of EU imports of natural gas?
• Will Russia deliberately default on its USD or rouble debt, despite the huge FX reserves (and no problem to repay)?
• Will the geopolitical tension trigger systemic crisis (like the GFC or AFC) and subsequent oil price crash?

Under a rational baseline, the answers should be “No” for all three questions, which suggests an attractive risk-return profile of Russian equities that fell more than two thirds from its peak in Q4 2021.

Of course, the downside scenario encompasses the unpredictability of Putin’s next moves and its profound ramifications (e.g. follow-up sanctions).  

What the US/Europe and China Can Learn from Each Other’s Experience since the GFC

• The large fiscal and credit stimulus in China in 2008/09 – unprecedented for the country at the time – led to high inflation in 2010-11 and monetary tightening subsequently.
• Chinese experience following the Global Financial Crisis suggests that the unprecedented fiscal and monetary support by the US and Europe since the onset of the pandemic are markedly inflationary. That in turn may force DM central banks to tighten earlier than expected.
• In contrast, the fiscal consolidation in 2010-2013 by governments in the US and Europe represented a disinflationary force the most of the past decade.
• The US and Europe’s experience in that period suggests that the relatively moderate fiscal and credit support to the private sector in China since last year is markedly disinflationary, particularly when periodic outbreaks and local restrictions weigh on consumption.
• Hence we may continue to see monetary policy divergence in 2022 between the West and China.

Which Inflation Risks, and where?

• It is worth dividing various inflation risks into short-term, medium-term and long-term in order to understand which are temporary or persistent.
• Restrictions and disruptions due to factory shutdown or workers isolated at home are temporary in nature. And the world is learning how to impose smarter restrictions with minimum impact on mobility. Hence such kind of short-term inflation risks are temporary and should be looked through by investors and policymakers.
• Policy-driven inflation risks are medium-term in nature, as policy tends to have a lagging and longer lasting-impact on the real economy than supply chain bottlenecks do. Persistently large fiscal stimulus and dovish monetary stance (notably the Fed and the ECB) are potent drivers of medium-term inflation risks. They shouldn’t be overlooked lightly because of the political motives that could make such inflation risks persistent: high fiscal debt and deficit prompt some central banks to foster an environment of “financial repression”/excessively low real interest rates.
• Long-term inflation risks are mostly disinflationary, including technological innovation and ageing. Moore’s Law suggests a fast cost decline in unit computing power, a remarkable disinflation force given the increased relevance of semiconductors in today’s economy.
• How to gauge the significance of the medium-term inflation risks? Wage growth is a vital indicator to monitor. Wage growth in the EU, Japan and China are similar to what they were before the pandemic, whereas the measure in the US has jumped to a multi-decade high. Hence the medium-term inflation risks are arguably higher in the US than in Europe/Asia.

A Major Risk to a Diversified Portfolio?

A rebound in the (US) long-term real yields.

Global equities have done very well this year despite already-strong performance in 2020 as well as higher inflation and bond yields. Notably, the 10-year real yield in the US has been stuck at -1% despite the significantly better economic outlook.

The “culprit” is the Fed – or its dovish monetary stance – as it prefers to under-react than to over-react to inflation.

What if long-term real yields rebound? In that scenario, bonds will almost certainly deliver negative returns as the initial yield cannot compensate for the duration-related loss. Equity valuation will also decline given higher risk-free long-term interest rates. Global ex-US stocks may also underperform US stocks due to a stronger USD. Credit spreads may also widen in such a risk-off scenario. A strong USD should also lead to a fall in commodity prices (including gold).

It seems nowhere to hide. Is holding USD cash the only option?

One idea is to invest in floating-rate notes as monetary tightening may be the force behind the rebound in real yields. And floating-rate notes benefit from rising interest rates.

Negative Market Implications of a Biden Presidency?

A Biden presidency should provide lots of benefits to the world that has just seen four years of a chaotic US administration. A centrist, pro-trade, environmentally friendly and multilateralist agenda benefits the global economy. 

But here is a seemly provocative question: any negative market implications from the Biden presidency?

Surely, economies and markets do not often go hand in hand. Here are my thoughts about potential market implications:

Under a Biden presidency and a split US Congress:

• Additional sanctions on Russia which weigh on Russian assets
• More effective COVID-19 response in the US which boosts the US economy and the USD, which ironically dampens investor enthusiasm about non-US assets. It may also motivate a tapering in the Fed’s asset purchase programs, leading to higher US bond yields and lower tech stock prices (not only in the US but also in EMs)

Under a Biden presidency and a Democrat Sweep:

• All the above
• More substantial fiscal stimulus leads to higher bond yields and lower tech stock prices
• Tax hikes in a later date put pressure on US stocks
• Regulatory headwinds for energy and tech stocks