The Month Ahead Sep 2016: Let’s Get Fiscal, Fiscal

For some of us growing up in the 80s, music videos then were a collection of wishful thinking, elaborate dance moves and unadulterated boy-meets-girl plots in sharp contrast to today’s cacophony of videos that are inundated with sexual innuendos, narcissism and violence. However, there will always be an outliner. Olivia Newton John “Physical” video in 1981 broke new grounds with her salacious undertones and homosexual subtext. It went on to become her most popular single in her career and won her the Grammy award for the best music video of the year while consequently debunking ONJ girl-next-door image. The current economic condition is turning out to be an outliner as well where growth remained sub-par despite years of liberal monetary easing. The world awaits a concerted “Fiscal” response and the calls for it is getting louder. We extend our megilah of discussions centred on the urgent need for fiscal response in the coming quarters. We started this discussion back in May 2016 http://www.covenant-capital.com/wp-content/uploads/2016/07/Money-No-Enough-May-2016.pdf where we commented the money multiplier into the economy has fallen precipitously since 2011 coinciding with fiscal impulses reversing from easing to tightening in the same year. We concluded by providing a timetable of possible fiscal responses in the coming year across the various economic blocs. In last month edition, http://www.covenant-capital.com/wp-content/uploads/2016/08/The-Month-Ahead-Aug-2016-Me-Before-You.pdf, we quantified the economic risk of policy inertia on this front could subtract another 10bps off 2017 GDP growth forecast where Japan is the only major economic bloc stimulating, Europe and US are indifferent and China is contracting. When we juxtaposed this recovery with past six great crises as defined by Reinhart and Rogoff, employment in the US, while has fully recovered, has taken the longest time to recover. Improvement in US GDP initially has trended along with the past crises, but has now trended below the range of past crises at this point of recovery. Of greater concern is productivity has stagnated and in fact year-to-date has declined for the US. The longest Post-war era recovery – US Employment Current recovery is the worst at same point in time

This conscious decoupling of monetary and fiscal policies cannot continue as it risks putting the global economy into recession come late 2017/2018. Markets participants are increasing becoming more militant about the potency of further monetary easing including unintended negative effects such as banks’ declining profitability hampering their propensity to lend, consumer and corporates exhibiting classic Ricardian Equivalence behaviour by tapering their spending and investing for the future. Furthermore, monetary policy easing is perceived to have contributed to rising social inequality by helping to fuel asset price inflation at a time of disinflation in wages. The growing tide of political populism as election looms for US, France and Germany in the coming 12 months is likely to make easier fiscal policy a more attractive policy tool. The topic of fiscal easing has certainly move up in the political agenda in the last few months. Politicians in several developed economies have mentioned the need for infrastructure investments from PM Abe of Japan, PM Renzi of Italy to Premier Xi of China in the recently concluded G20 summit. Even in the midst of US political swashbuckling, both candidates have extolled the need for infrastructure spending.

The need is certainly there. In a recent World Economic Forum report, the institute commented there has been a marked deterioration in the quality of infrastructure in many developed countries compared to ten years ago. The average age of US public capital stock is now the oldest since 1925 with infrastructure like damns/levees already approaching its design life. The American Society of Civil Engineers estimate that USD1.1trn of investment is needed over the next seven years. If such investments were made, they estimated it will translate to USD1.8trn of cost savings to consumer and corporates. Even in Japan, where many of us are accustomed to its superior infrastructure, more than half of Japan’s bridges will be more than 50 years in 15 years’ time. Japan’s current capex on infrastructure is merely covering only depreciated capital and replacing scrapped infrastructure. According to Goldman Sachs, there has been no net increase in social capital investment since 2004 for Japan.

Deterioration of infrastructure in many DM Age of US capital stock is the oldest it has ever been

But is not just about age of capital stock that requires replacement. Obsolescence especially with the advent of new technologies could also warrant replacement. Power grid is one such opportunity. The advent of smart grids technology, alternative power sources and even the prevalence of distributed energy generation all requires significant upgrades for many advanced economies’ archaic grid system that were mostly build post WW2. The Edison Electric Institute forecast USD22bn is needed every year till 2020 to upgrade US transmission grid. Another area is communications infrastructure. According to Goldman Sachs, the migration from 4G to 5G will see speed 100x faster than 4G, 50x lower latency and will enable for the machine-machine communication, virtual reality deployment and full autonomous driving. Opportunities abound to spend the much needed dollar.

Fiscal policy extends beyond building physical infrastructure such as building bridges and damns. In the era of ageing demographics, fiscal levers could also be extended to other areas such as social safety nets, healthcare and community projects. A good example of this enlarged government spending on “soft” infrastructure is in China. Since 2011, the % of GDP spend on social infrastructure in China has increased from less than 9% to 11% by 2015. This could rise to as much as 15% by 2020 according to CICC. China is leading the call on decisive fiscal response to augment monetary policy and is evident since 2011 when they started to run larger fiscal deficits. Last year, for the first time since 1999, China actually ran a larger deficit than it has budgeted. Year to date, the broader measurement of fiscal loosening has so far reached -2.1% of GDP; a pace much faster than last year during the same time where it ran only a 0.1% deficit. We expect the in the last quarter of 2016, China will accelerate its fiscal expenditure so as to match its budgeted -3.0% deficit. Anecdotal evidence such as the pick-up in pace of new order of the contractors, electricity produced and prices of basic materials are collaborating this view of accelerating fiscal levers in the coming months.

China is running larger fiscal deficit Is not just bridges but social and healthcare needs.

The potency of fiscal stimuli in tandem with cheap financing has to be underscored. IMF analysis shows that for every dollar of public spending, GDP is boosted by $2 to $3 dollars in the medium term. When output gap is as large as it is now, a 1 pp increase in public investment could increase output by 3% after four years. Furthermore, a 1 pp increase in GDP that is debt-financed given cost of fund is so low has the impact of a 3% increase in output. In fact, where nominal interest rates are now globally, the impact of government investment versus any cuts in capital or labour tax is far more impactful. Penny for pound impact given slack and interest rates Gov’t investment is more impactful

In recent months, we have started to detect the possibility of an industrial production rebound that has gone amiss over the last 6 consecutive quarters. Emerging markets is leading the charge in this rebound. Excess money, often a 6-month harbinger to turns in industrial production is trending higher since the start of 2016. Despite the overhang of supply, base metals prices are positive for the year. Even China industrial enterprise profits have convincingly turned around.

3Q16 IP forecast to double from 2Q16 Excess money turned positive since start of year

Despite oversupply, metal prices are trending higher China enterprise top and bottom lines improved

We caricature the current state of global economy with respective to the industrial cycle as below. We believe for most countries they are already at bottom of a demand trough with some of them at cusp of a revival, notably in Brazil, China and Euro Area. This nascent recovery in industrial cycle has percolated to earnings revision upwards for the first time in a very long while.

Major economies industrial activity has troughed Finally seeing net upgrades in earnings

Source: Goldman Sachs, Covenant Capital

Asset Allocation Strategy:

Admittedly, our confidence level of a renaissance in industrial activity is still guarded and would require another 2-3 months of data to verify. However, it is the implication to asset prices that we are most attuned to. Consensus positioning is heavy towards bonds and defensive strategies (dividend strategy included) within equity. Should we get a confluence of improving industrial activity along with detailed and targeted fiscal stimulus, position unwinding of these consensus trades will be extremely painful in the ensuing months. What are the implications of a recovery in global IP and restoration of positive fiscal impulses to various financial assets? We numerate the impact in each individual assets classes while detailing the changes we are making in our asset allocation.

Fixed Income: Reduce from Overweight to Underweight. This is a highly anti-consensus trade and reversed our months long view of overweighting fixed income. Given positioning and if we are proven right that we are at the cusp of industrial cycle recovery alongside accommodative fiscal policy, the pain trade of unwinding this extremely expensive asset class can be quite deleterious. Goldman Sachs postulates if global industrial production expands towards 3%, G7 yield curve could steepen as much as 100-150bps implying a drop of 12% in capital value of a UST10 year bond! Market participants have been willing to buy up 2 sigma expensive government bonds because growth outlook has been uncertain. Should this view reverse either via better economic outlook or concomitant recalcitrance by central bankers to ease further, we believe bonds will see significant sell-off complicated by lack of liquidity to exit.

Hence our fixed income allocation is geared towards opportunity for spread compression because of better growth prospects such as emerging market credit, US high yield and an absolute return unconstrained global macro bond fund manager.

Equities: Reverse Underweight to Neutral. We are holding back from overweight equities as we lucubrate our industrial production recovering thesis over the next 2-3 months and mark-to-market further news flow on fiscal policies. We subscribe to the view that a rising bond yield is good for equities even the short term adjustments to rising rates could be acutely adverse. There have been several occasions throughout history that have shown us equities, especially cyclicals can generate positive returns even as rate rises. This is particularly evident during periods when the economy is exiting debt and/or growth deflation crisis. The Dot-com busts and Asia Financial Crisis are two most recent examples. The equities portfolio is still heavy on alternative strategies in US and Asia, small-cap managers in Japan, Europe and Asia but we have started to incorporate cyclical trades in energy and metals and mining sectors.

Japan and German cyclicals have started to outperform defensives and they are extremely cheap

In terms of regional preferences, we prefer Japan, Asia followed by Europe and lastly US. The preference for the rest of the world to US is predicated on valuation of US being relatively more expensive than them and divergent monetary policy paths of US where it is likely to tighten in the next 3 months while the rest will continue its easing mode, albeit at varying degree of easing. Moreover, regions like Asia and Europe are more sensitive to global industrial cycle than the US.

Japan and Europe relatively cheaper than US and will outperform when US yield rises

Commodities: Remain Neutral preferring to play the sanguine view on oil via oil related equities or ETF. We have called for an exit on long Gold due to heavy speculative long position in our 2H16 Investment Strategy ,http://www.covenant-capital.com/wp-content/uploads/2016/09/2H16-Investment-Strategy-Odont-need-toP.pdf. Since then Gold has gone nowhere trading in a tight band. Unless inflation becomes a problem, against the view of a stronger USD, we continue to stay away from Gold. Within basic materials, our preferences are for Steel, Copper and coal. We are also exploring a hedge fund specialising in industrials and resource companies in line with our recovering industrial production thesis. FX: Long even more USD against the JPY especially. GBP decline has troughed as economic data post Brexit has surprised on the upside, while BOE is likely to hold off further monetary easing. Long GBP/EUR at 1.17 exit 1.22. Alternatives Investments: Increasing for non-correlated market returns. We continue to like non-correlated strategies like our quantitative trend follower manager, long/short equities managers in the US and Asia. We have also been very bullish about real estate particularly in Europe and Japan and look to introduce more private equity real estate managers.

Featured Picture/Quote: An endearing spirit.

http://www.channelnewsasia.com/news/sport/paralympics-singapore-s-swimmer-yip-pin-xiu-beats-own-record-to/3115550.html

Edward Lim, CFA

Chief Investment Officer