Americas CIO View

Bond buyers beware of a stimulus-industrial complex

Biden fiscal policy: spending now, taxing later or not until the bond market objects

The U.S. federal deficit for fiscal year 2020 was 3.3 trillion U.S. dollars or 16% of gross domestic product (GDP). We expect another over 3 trillion U.S. dollars deficit in fiscal 2021. The deficit in 2022 will depend on the economy and what are likely to be new tax policies and spending programs. We think the current tax and spending proposals could cause a continued rapid climb in U.S. debt to GDP. This is a key interest-rate risk and threat to bond buyers without matched liabilities to fund such assets. Congressional Budget Office provides estimates for proposals put to Congress, but we suggest further analysis.

Proposed tax hikes likely pay for only a small part of proposed spending hikes

If tax hikes are limited to corporate profits, investment returns and household income over 400,000 U.S. dollars as being advertised, this will likely make a small dent in paying for all the additional spending in the developing American Jobs and American Family plans. This is because those sources of tax revenue are a small portion of the total and where the most flexibility exists for tax management. We think additional taxes will be required to fund these grand spending plans or deficits could be double-digit percentages of GDP beyond 2021.
It makes more sense to fund government investment initiatives with taxes on consumption, such as fossil fuel taxes to fund clean energy, than on firms efficient at deploying capital. In our view, taxes kept low on enterprises with targeted public investment, in partnership with privates or local government, on transportation, digital infrastructure, advanced computing and biotechnology have the best chance at self-funding from stronger growth.

The Fed can direct the burden of high deficits from real interest rates to inflation

In post war periods of high deficits relative to GDP, such as late 1960s and late 1980s, real interest rates climbed as deficits drew on the savings pool and crowded out private investment. In the 1970s, the U.S. Federal Reserve (Fed) allowed inflation to accelerate, arguably inadvertently or in an attempt to relieve the debt burden. This policy provided no actual relief as inflation badly damaged the economy and left the bond market demanding very high inflation risk premiums into the 1980s. The debt burdens of the 1980s, exacerbated by high real interest rates from the high inflation risk premiums, were finally relieved by an improving economy, after inflation was smothered by rate hikes, and the Deficit Reduction Act of 1993. If there is a lesson to learn, it's that trying to pay for deficits with inflation or rapid money supply growth can be the most expensive and dangerous approach. It's better to let real rates rise.

The bond market is the better disciplinarian: Fed likely waits for bonds to object

Today's long-term bond holders will suffer if a rising debt burden is shouldered by higher inflation or higher real interest rates or a combination of both. While we believe the Fed is likely to act to contain inflation if it trends above 2.5% in the coming years, we see risk of the Fed being late to act or unwilling to risk damaging the economy short-term to contain inflation longer-term. For a long and prosperous cycle, the bond market must guard against inflation risk and be the disciplinarian for these fiscal and monetary policies. If the bond market is dad, the currency market is mom. If the dollar slides, long-term interest rates will rise. While a steeper curve might attract foreign investors, they can hedge dollar risk by borrowing in dollars at zero overnight rates and exchanging borrowings out of the dollar.

How to protect against duration risk? Protecting against inflation vs. real rates

To protect against higher inflation and real yields, consider isolating credit spreads and TIPS break-evens from Treasury yields. To protect against higher inflation, consider real income producing assets, including equities and foreign equities. Banks are equities that can provide protection against both higher inflation and higher real interest rates because banks are short duration assets. We view banks as real assets that are intermediaries of nominal assets. Banks are short duration assets owing to their relatively rapid repricing of asset earnings power and liability costs upon interest rates changes. And higher rates and steeper curves tend to boost bank earnings. Highly competitive, short lived underlying asset business tend to have low duration risk and regulated businesses. At non-financials, we’re selective in seeking inflation protection, as intangible businesses could have better pricing power than commodity and basic goods producers in this digital era. But we are mindful of real interest rate risk, which affects fair P/Es. Thus, we seek growth stocks with sustainable growth to reduce the risk of today's price too dependent on a low cost of capital. Businesses without growth or in decline will be challenged to maintain today's lofty P/Es if real rates rise. We think this is an overlooked risk at many non-financial cyclical value stocks, but also a risk at some popular cause growth stocks with erratic capital costs.

EPS reporting week two: Bottom-up now 42.34 U.S. dollars, we expect 44 U.S. dollars and 180-185 U.S. dollars for 2021

First quarter S&P 500 EPS likely finishes at 44 U.S. dollars, suggesting our 175 U.S. dollars 2021 estimated EPS has 5-10 U.S. dollar upside.



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