Sometimes the equity research guys nail the bigger-issue: good news and bad news. At least that’s my attitude when they bring up a topic I’ve been talking about for eight years. As a precursor to what they have to say in the following paragraph, economies go through boom and bust cycles. The world’s central banks try to stop the destructive force of boom-and-bust cycles by using monetary and fiscal policy strategies. When the U.S. Federal Reserve Board raises rates, the increased cost of money slows borrowing, profit margins and the larger economy. To stimulate the economy, the Federal Reserve Board lowers interest rates, making big-ticket items such as houses and cars more affordable. However, what happens if, after years of lowering interest rates, the economy still slows?
When this happens, it’s time to engage in another type of stimulus strategy called fiscal policy. President Franklin Delano Roosevelt first engaged in fiscal policy years ago by spending large sums of money on the Works Progress Administration and the Civilian Conservation Corps in order to employ millions of unskilled workers. Tax cuts also make up fiscal policy. Fiscal policy initiatives are voted on by Congress, suggesting that if it takes an act of Congress to get something done it must be obvious and important. If deflationary trends worldwide continue to hamper U.S. economic growth, one can expect the next president of the United States to press Congress for fiscal spending initiatives and tax cuts.
According to Credit Suisse’s analyst, Garthwaite, markets are underestimating the probability of fiscal QE: In the opinion of Credit Suisse analysts, the likelihood of some form of fiscal QE by one of the G4 central banks over the next three to five years is high and for the following reasons: 1) Given the age of the U.S. cycle, history suggests there is a 60% chance of a U.S. recession within the next three years; this would require real rates to fall by 5%, which is very hard to imagine or achieve. 2) Conventional monetary QE is having increasingly unwelcome side effects (e.g. the net interest margins from banks is falling, creating zombie capitalism, and potential housing bubbles). 3) Fiscal QE is effective in that for every dollar the government spends it can expect to get back 1.8 times that sum in economic growth. 4) Fiscal policy is more acceptable politically, as it can target the median households via construction jobs and tax cuts/incentives. 5) Lastly, analysts believe that strong structural disinflationary forces from technology and low Chinese wages will continue to make it hard for central banks to hit their inflation targets. That is, we’re still fighting deflation, not inflation. Ultimately, the holdings of central banks in domestic government debt could be swapped into very long-dated, zero-coupon bonds, meaning increased government spending has little financing impact.
Credit Suisse global economic analysts rank the likelihood of fiscal QE by region based upon (1) the shortage of existing infrastructure, (2) need for stimulus, (3) how constrained monetary tools are in the country and (4) the capacity for policy flexibility. Given these parameters Credit Suisse thinks Japan is most likely to conduct some form of fiscal QE, followed by the UK, the US and lastly the Euro area.
Economic analysts identify five types of fiscal QE: The most likely of these is implicit government spending while central banks print money in order to fund profitable infrastructure projects. Analysts think Japan is most likely to move first but will probably resort to tax cuts rather than spending, given Japan’s existing high-quality infrastructure. Within the UK, analysts believe infrastructure QE is most likely to occur within three to five years. While political hurdles to undertaking infrastructure QE are greater in the Eurozone, analysts describe a form of European fiscal stimulus plan that might work legally, practically and logically but would need a crisis and time to organize.
Equity and sector implications: Credit Suisse analysts are now focused on stocks that would benefit from infrastructure QE and look attractive regardless. FYI, your’s truly has over weighted these kinds of stocks for some time. According to Credit Suisse, the outlook for US non-residential construction looks attractive, with a compelling need to upgrade infrastructure throughout the United States. Moreover, analysts project that a 5% increase in construction and defense spending for such companies could re-rate their multiples leading to higher multiples for infrastructure and defense-based firms. Multiples could rise to 18 times earnings. This strategy would also support low real interest rates and, therefore, support the price of gold, leading to a potential for a six fold increase in gold demand.
Vaughn Woods, CFP, MBA
Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0215