Unbridled capitalism has its limits. This has been confirmed by football (soccer). Customers (fans) have been deprived of fully enjoying the product for the last year and the suggestion that it would become even more distant from the paying public was met with universal condemnation. Maybe the pandemic has made people just that little bit less willing to tolerate greed. There’s an important lesson for politicians there too. What’s important now for the universal good is continuing to deal with the pandemic, supporting the recession and aligning business and macro strategy with the needs of the carbon transition. None of this leads to a conclusion that the happy marriage between monetary and fiscal policy is about to be dissolved. Big central bank and government balance sheets are here to stay. Bond investors, relax.
Build it and they will...revolt
It became public last week that the owners of twelve European football (soccer) clubs had badly interpreted a piece of classical economics known as Say’s Law. The “law” is popularly known to suggest that supply creates its own demand. What it was never meant to mean was that if you produce something then someone will always buy it. It was originally an argument that the act of production itself creates income which then generates demand in the broader economy. Anyway, the Super League 12 thought that the idea of creating a new competition that modelled itself on the American sporting franchise model would be met with enthusiasm on this side of the Atlantic. I’m sure they had in mind an end of season final climax to give the Superbowl a run for its money – Lady Gaga singing Ode to Joy as Juventus took on Real Madrid for the 18th time that season! The whole episode was bizarre. It’s hard to think of an example in business when leading players collectively suggested a new operating model that was firmly rejected by employees (coaches and players), customers (fans), business partners (sponsors) and the regulators (UEFA and FIFA). The idea took the notions of it being the taking part that mattered and that no-one would be losers to a degree never seen before in professional sport. The whole point of sport is to have winners and losers and to have a competitive environment that ensures that it is not always the same winners and losers. The unpredictability, the drama of last minute goals, underdogs beating giants and games being the focus of communities at all levels is what keeps the fans turning up to games and paying their television subscriptions. Thankfully, the idea sank quickly (though I doubt not without trace) as supply failed to find a demand curve at all.
Wait and see
Meanwhile, in financial markets things have been relatively calm. A phrase I have heard a lot over the last couple of weeks is that the market is in a “wait and see” mode. The consensus is clear, and we are waiting for the data to confirm that the global economy is at the beginning of a long expansion. The big movers have been equities this month. I pointed out that April tends to be a good month for stocks, and we are seeing new highs in several indices. In the US, the Q1 earnings season is in full swing and so far, with about a fifth of companies having released results, earnings are running 34% above expectations. Bottom-up consensus earnings-per-share forecasts for S&P500 companies remain bullish with 2021 expected to see a 24% increase over the 2020 outcome (and of course 2020 got better from the second quarter onwards) and another 16% increase expected in 2022. It still means the market looks expensive on a traditional price-earnings measure (25.5x this year’s earnings at the current level of the market) but we are in period of unprecedented liquidity and low real interest rates. A 4% earnings yield still looks a whole lot better than a 1.6% risk-free yield. Until there is a new twist in the macro-outlook or another period of bond volatility, then the wait-and-see approach supports a fully invested strategy.
For the moment the bond market is saying “100bps and done”. By that I mean, yields have risen by a full 1% at the 10-year benchmark level since last summer and now seem to be settling into a 1.55% - 1.65% range. The consolidation of yields might reflect some caution amongst investors about the macro-outlook – a caution that has not yet dislodged the consensual bullish outlook but, nevertheless, bears watching. It comes from a number of sources. First the pandemic. Globally, the number of new cases is still increasing, and many countries are not showing the benefits yet of vaccinations either because of issues with distribution, access, and efficacy. I commented a couple of weeks ago that better case numbers and vaccination levels in developed countries might still mean that international travel and fully open borders remains some way off because of the uneven situation globally and particularly in countries like India and Brazil. Second, there is the potential for tax increases in the US. They are unlikely to be a full reversal of the Trump cuts, but markets just don’t like tax increases and the way they might impact certain sectors. At some point markets might like the fact that the US deficit is ballooning to record levels. But as long as the Fed is still mopping up a lot of Treasury bonds, then it’s taxes that investors really don’t like. Third, there are the flat-earthers that think everything is built on air and that speculative bubble activity will eventually pop the whole financial circus. Actually, I am not really sure that any of this explains why bond yields retreated from their recent highs – a lot of it is just sentiment on the airwaves. It might just be supply and demand. It might be that collectively bond investors don’t really think the Fed will need to tighten before it has said is likely. Investors should just enjoy this period of relative calm.
Don't worry (but do research)
All the major debates in the markets – whether inflation is going to persist beyond Q2, whether the Fed needs to taper this year, whether the stock market is in the mother of all bubbles – are not going to be resolved anytime soon. Indeed, are they ever resolved? Bubble talk is inevitable when prices hit cyclical highs and returns have been strong for a long period of time. Inflation has gone up and down over the last twenty years without being a real economic problem. The Fed will change its stance when it sees fit but recent history suggests that it won’t be the kind of draconian monetary tightening that we’ve seen in the distant past. My personal view is not to worry too much about things I can’t control, invest in those assets you are comfortable with and try to be balanced enough to have some growth and some capital stability if things wobble a bit. For now, equities are providing steady returns, bonds are generating a little more income and there’s enough confidence in the developed world about breaking the back of COVID to keep things ticking over nicely for a bit longer.
I mentioned the US budget deficit above. Government borrowing has risen everywhere. The EU’s statistical agency, Eurostat, said that the euro area government debt to GDP ratio reached 98% in 2020 with a combined budget deficit equivalent to 7.2% of GDP. The UK government had net borrowing of £303bn in the fiscal year ended March 31st. This was equivalent to almost 14% of GDP. It’s net debt to GDP ratio rose to 97.7% from 84.4% in the previous fiscal year. The most recent Congressional Budget Office projections in the US estimate a 2020 deficit of 14.9% of GDP and a public debt to GDP ratio of 100.1%. These are staggering numbers for peace time. The pandemic has clearly pushed up these numbers over the last year given the impact on jobs and incomes and the need for governments to borrow to support the economy. In many countries, deficit and debt numbers were already high even before COVID and have been since the global financial crisis, despite attempts at austerity in the mid-2010s. The reality is that developed economies have structurally low rates of economic growth and are vulnerable to recessions as a result. Monetary policy has been increasingly used to its full and fiscal policy is now being used aggressively. The link between them is central bank purchases of government debt – a necessary part of how the official sector supports economic growth. This is not going away. It means low interest rates for a long-time and it means that there will be a lot of misplaced worries about government debt levels. As long as central banks keep buying – and they can – then no government is going to not be able to finance itself. While unpalatable to some, it keeps the system working and allows private capital to be directed to the real economy rather than to financing deficits.
Macro policy and carbon transition
And that brings me to my final point. The US organised Climate Summit this week re-introduced the US into the global fight against climate change. It was a taster to the fuller discussions and more concrete pledges that will be made at the COP26 meeting later this year. In order to meet technological requirements of achieving a net zero economy in the decades ahead, there is a huge demand for investment. Government will need to be part of that, increasing the share of public spending on infrastructure. Central banks will need to keep oiling the wheels of the bond markets, perhaps providing the reserves to financing business as usual borrowing. At the same time there will be more green bonds to finance the carbon transition and governments will need to ramp up their programmes in the years ahead. Macroeconomic policy crossed the Rubicon after the global financial crisis and it is not going back – saving the planet is much more important than saving the banks. Hopefully, COVID related spending can be reined in quickly as economies recover, but there is still going to be a lot of debt. Fixed income investors just need to put the right price on it.
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