Thursday, 24 October 2013

Guest post - Consequences of a US Budget Balance Improvement

"Logical consequences are the scarecrows of fools and the beacons of wise men." - Thomas Huxley 

Please find below a great guest post from our good friends at Rcube Global Macro Asset Management. In this post our friends go through the consequences of a US Budget Balance Improvement.

The US budget deficit which has already shrunk at a pace never seen over the last 50 years is likely to shrink even more going forward given the ongoing republican fight for more spending cuts. This trend is likely to have some consequences on financial markets. We have selected 4 investment themes that we think, should materialize as a consequence.
  • Rising volatility
  • Consumer discretionary stocks underperformance
  • EM assets underperformance
  • Widening US long end swap spreads

The dollar is the reserve currency of the world, hence when the US runs a budget deficit it increases the amount of dollars in circulation, and provides the world with liquidity. When its financing needs shrink like it has been the case since 2010, global liquidity is reduced. This has ALWAYS created or exacerbated some kind of crisis around the world when it happened (Lat Am in the mid 80s, Asia in the late 90s followed by the tech bubble in 2000, the great recession in 2007).

Will it be different this time? QE has provided a necessary buffer to the liquidity shock that the sharp budget balance improvement has created. When QE ends, and if in the meantime spending cuts have intensified (budget ceiling debate) the pain will start being felt.

  • Equity volatility has probably bottomed.

The pace of the deficit reduction is historical. it has shrunk by more than 6% of GDP over the last 3 years. In the past, this has pushed equity volatility upward systematically. Less liquidity means higher volatility, it is as simple as that as the chart below shows.

In previous cycles the trigger for the volatility to spike was bank lending behavior. So far no signs of the cycle being less supportive but there are hints that banks could become less accommodative going forward. Nevertheless this time, the trigger should be around the time investors will price the end of QE.

Another way to look at it is through the strong historical link between the fiscal cycle and corporate profit margins. As the chart below shows, corporate profits have followed the budget deficit momentum closely (with a lag) over the last 40 years. Fiscal gifts have in a way subsidized non]financial corporate profits. It is thus illusory and naive to believe that the ongoing war in Washington over spending cuts wonft have any impact on profits over time.

Earnings growth has also logically been correlated to the budget balance cycle.

The IMF just released global financial stability report highlights the recent rise in corporate leverage which on many counts now exceeds 2007 extremes.

As a result, the IMF baseline scenario for US HY default is to rise to about 10% by 2015. Clearly not priced in by investors at the moment...

Thus it will be particularly interesting to watch the Senior Loan Officer Survey Q3 results early November for clues about bank lending behavior. Both the rise in the financing gap and corporate leverage hint that banks could become slightly less accommodative going forward.

Our US Lending Standard model based on both the financing gap and non-financial corporate leverage suggests so.

  • Consumer discretionary stocks should underperform.

The sector has been the main beneficiary of the fiscal cycle. Now that it has clearly turn, and that republicans will fight for more fiscal austerity, headwinds for the sector are clearly rising. Fiscal largeness or austerity impacts logically ones propensity to spend on discretionary items. As a consequence the relative performance of the sector can be explained by the fiscal cycle.

The urgency of its implementation came from another explanatory driver: interest rates. The spike in
mortgages and short term forward rates, creates further headwinds to an over loved, over owned, and overpriced sector.

Interestingly the same story holds in Europe. The luxury sector has underperformed its benchmark recently by more than 12%. LVMH earnings miss is we think another clear signal that developed markets consumer discretionary equities are set to underperform going forward. Fiscal tightening in developed countries combined with lower growth in Emerging markets are strong headwinds.

  • Emerging market assets will underperform.

Emerging market assets have shown a remarkable negative correlation with the US financing needs. Since proper data began for EM equities, their relative performance versus developed markets has been strongly explained by the US budget balance.

The US budget went from 0 in early 1980 down to a deficit of 5% of GDP in the early 1990s, EM equities enjoyed simultaneously a powerful relative bull market. During the Clinton years, and the US boom, the deficit turned into a surplus of 2.6% in 2000, EM stocks crashed on a relative basis. From 2000 until early 2010 the budget balance nose-dived, and turned into a deficit of 10% of GDP. EM equities which were in the early 2000s extremely cheap on top, outperformed DM equities by close to 300%. Since then, the 6% shrinkage of the deficit has left EM equities underperforming by 35%. During that phase the underperformance was realized with a flat equity market. The MSCI EM is at the same level it was trading at in late 2009. We fear the next phase will see EM equities underperforming in a bear market.

Additionally, as we have mentioned more recently, we believe that China’s massive investment and property bubble is also at risk of rolling over. Private sector credit can’t rise at 40% of GDP every year for ever.

So, emerging markets could be hit from both sides. First by the liquidity withdrawal that the budget deficit reduction and the end of QE imply, second by the coming weakening investment cycle in China. Countries running a budget and current account deficit, together with a large export (to China) GDP ratio are at a particular risk here.

IBM results were we think very interesting; their sales in China were down 20% yoy. 20% is a big number. LVMH painted a similar message the day before. Caterpillar earnings next week will be another interesting read.

  • US Long end swap spreads will widen

Long end swap spreads are a function of relative financing needs between the private and the public 
sector. At this time, the private sector is re-leveraging through increased shares buybacks, dividend 
payments and Capex spendings, while the public sector deleverages. This classic inverse relationship 
implies just like it did in the late 1990s that long end US swap spreads will widen from current levels.

"The consequences of an act affect the probability of its occurring again." -
B. F. Skinner 

Stay tuned!

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