Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 243

US fiscal stimulus may prove reckless

We are in uncharted waters. Prices for sovereign, corporate and high-yield bonds and equities are at, or near, record levels thanks to the ultra-low policy interest rates and the massive quantitative-easing programs of the G3 central banks (the US Federal Reserve, the European Central Bank and the Bank of Japan) over the past decade. But now two of those central banks are winding back. In response to the strengthening economic environment, the Federal Reserve is raising the cash rate and has commenced an automatic program to shrink its balance sheet while the European Central Bank has halved its asset-buying program.

Potential for reckless and explosive consequences

While the major central banks would like to engineer a ‘soft landing’ with gradual increases in interest rates, there is a material risk that they could be forced to tighten monetary policy faster than expected. In our view, the US administration’s tax cuts and recent budget measures have elevated the risks. The tax cuts and additional spending will make a fiscal injection into the US economy of nearly 2% of GDP per annum for the next two years. The timing of such a large fiscal stimulus at, or near, the top of an economic cycle when central banks are trying to exit the largest monetary expansion in modern history may prove to be reckless. The US unemployment rate at 4.1% is at a 17-year low and the US economy has added jobs over the past 88 months, which is the longest such consecutive stretch on record. While there appear to be powerful longer-term secular forces at work that are likely to result in low inflation over the longer term, there is a significant risk that the size and timing of the US fiscal stimulus could trigger a jump in US inflation, in particular from stronger wages growth, over the next year or two. This may be highly problematic for the Federal Reserve and complicate its efforts to engineer a gradual tightening with a soft landing. We cannot think of a similar combination of circumstances in modern history. The cocktail could be explosive. The best hope for investors is that either the US tax cuts and extra spending have limited effects on growth and inflation in coming years or the secular forces that have kept inflation low accelerate to offset any inflationary pressures from the fiscal stimulus.

Those hopes may well prevail, but the risks for investors over the next 12 months or so are asymmetrical to the downside. There is a meaningful probability that US inflation and wages growth will accelerate and the Federal Reserve will be forced to tighten monetary policy faster and by more than expected. On 27 February 2018 the Chairman of the Federal Reserve, Jerome Powell, responding to questions before Congress, suggested that they may need to tighten monetary policy more quickly when he said:

“At the December meeting, the median participant called for three rate increases in 2018. Since then, what we've seen is incoming data that suggests a strengthening in the economy and continuing strength in the labour market. We've seen some data that in my case will add some confidence to my view that inflation is moving up to target. We've also seen continued strength around the globe. And we've seen fiscal policy become more stimulative.”

Was it a 'canary in the coal mine'? 

If the Federal Reserve is forced to act more swiftly and forcefully than expected, it is reasonable to assume that US longer-term bond yields could jump meaningfully (above 4% compared with about 2.90% for the US 10-year Treasury bond today), which could trigger the biggest slump on world share markets since the global financial crisis. In our view, a 20% to 30% global stock market correction is within the range of outcomes in these circumstances.

What happened on 2 February 2018 may prove to be the ‘canary in the coal mine’ warning for investors. On that day, the US Department of Labor disclosed that average hourly earnings for private sector workers rose 2.9% in January from a year ago. This was the fastest rate of wages growth since 2009. The news triggered a jump in longer-term US bond yields to four-year highs and nearly a 10% correction in the US stock market.

In light of the risks, we have increased the defensiveness of the Global Equity portfolio. Over the past three months, we have increased the cash weighting of the portfolio to about 13.5% today. The increased cash weighting should enhance the defensive characteristics of our portfolio and act as a partial hedge against a potential market correction and higher interest rates in general.

It may turn out that we are wrong or premature to be so cautious. But we have no desire to remain at the party, nor be the last to leave, when we judge that risks are elevated. Investors in this environment could well take some sage advice from Warren Buffett in Berkshire Hathaway’s annual report for 2000:

“The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball … but they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”

 

Hamish Douglass is Chief Executive Officer and Chief Investment Officer at Magellan Asset Management, a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any investor.

 

7 Comments
Steve
March 08, 2018

A great article Hamish, thank you. The risks are building and it seems to me that the debt levels in Australia and in the US and other western countries is where the catalyst for a the tidal wave of problems will come. One risk I never seen discussed anywhere is the risk of an increase in the wholesale costs of funds to Aust banks and corporates. We constantly see two facts being restated - Australian official interest rates are on hold and US interest rates are on the rise. One would have thought if the US interest rates are going up and our dollar is falling, the banks cost of funds must be rising. The constant restatement that official interest rates are on hold is giving great comfort to those borrowing money in Australia; many of whom incorrectly equate official interest rates with mortgage rates. An interest rate increase by the banks in Oz will have to have a flow on effect for bad debts in the banking system, a crunch on consumer spending (till now a strong part of our economic story), as well as a reduction of demand and an increase in supply in the housing market. And just as we try to come to terms with the increasingly fragile state of the world economy we have Donald Trump lighting matches....

Frank Gomez
March 08, 2018

A contrarian view may be that the stimulus from the tax cuts will offset the risk of over-tightening monetary policy. I find it hard to believe that a 2% of GDP fiscal stimulus will cause inflation to go from being under-target to over-target when the growth of the Fed Balance Sheet of around 20% of GDP in recent years had little effect.

Any future administration/Congress is likely to wind back spending and tax concessions to start to bring the fiscal situation in the US back into balance so the 2% stimulus is unlikely to be permament and will eventually be wound back from future growth.

Frankie
March 04, 2018

Thanks for the warning, Hamish, but even if rates rose from the current 2.9% to say 4%, it's not earth-shattering compared with what we would once have considered normal. Might even give a few more investors a half-decent return on their cash and bonds and give them more money to spend. It's be different if we were talking 8-10%.

Steve
March 08, 2018

An increase from 2.9% to 4% represents a 138% increase in the cost of borrowed money - I think that's pretty significant.

Peter Smits
March 08, 2018

make that a 38% increase

Steve
March 08, 2018

I stand corrected :-)

Peter
March 12, 2018

Don't forget that the total amount of debt outstanding is significantly greater than when interest rates were at 4% in the past.

The last time the US 10 year rate was over 4% was back in July 2008. Back then the US federal government had about $9.5 Trillion of debt. That's an interest burden of about $380 Billion.

Currently the US federal government debt is about $21 Trillion. Therefore an interest rate of 4% would result in an interest burden of $840,000,000,000 p.a.!!

That's a huge difference.

 

Leave a Comment:

RELATED ARTICLES

The 1970s offer a helpful framework for today's markets

Five factors driving the great Australian recovery

Four themes to set your portfolio for economic recovery

banner

Most viewed in recent weeks

How much do you need to retire comfortably?

Two commonly asked questions are: 'How much do I need to retire' and 'How much can I afford to spend in retirement'? This is a guide to help you come up with your own numbers to suit your goals and needs.

Meg on SMSFs: Clearing up confusion on the $3 million super tax

There seems to be more confusion than clarity about the mechanics of how the new $3 million super tax is supposed to work. Here is an attempt to answer some of the questions from my previous work on the issue. 

The secrets of Australia’s Berkshire Hathaway

Washington H. Soul Pattinson is an ASX top 50 stock with one of the best investment track records this country has seen. Yet, most Australians haven’t heard of it, and the company seems to prefer it that way.

How long will you live?

We are often quoted life expectancy at birth but what matters most is how long we should live as we grow older. It is surprising how short this can be for people born last century, so make the most of it.

Australian housing is twice as expensive as the US

A new report suggests Australian housing is twice as expensive as that of the US and UK on a price-to-income basis. It also reveals that it’s cheaper to live in New York than most of our capital cities.

Welcome to Firstlinks Edition 566 with weekend update

Here are 10 rules for staying happy and sharp as we age, including socialise a lot, never retire, learn a demanding skill, practice gratitude, play video games (specific ones), and be sure to reminisce.

  • 27 June 2024

Latest Updates

Investment strategies

The iron law of building wealth

The best way to lose money in markets is to chase the latest stock fad. Conversely, the best way to build wealth is by pursuing a timeless investment strategy that won’t be swayed by short-term market gyrations.

Economy

A pullback in Australian consumer spending could last years

Australian consumers have held up remarkably well amid rising interest rates and inflation. Yet, there are increasing signs that this is turning, and the weakness in consumer spending may last years, not months.

Investment strategies

The 9 most important things I've learned about investing over 40 years

The nine lessons include there is always a cycle, the crowd gets it wrong at extremes, what you pay for an investment matters a lot, markets don’t learn, and you need to know yourself to be a good investor.

Shares

Tax-loss selling creates opportunities in these 3 ASX stocks

It's that time of year when investors sell underperforming stocks at a loss to offset capital gains from profitable investments. This tax-loss selling is creating opportunities in three quality ASX stocks.

Economy

The global baby bust

Across the globe, leaders are concerned about the fallout from declining birth rates and shrinking populations. Australia, though attractive to migrants, mirrors global birth rate declines, and faces its own challenges.

Economy

Hidden card fees and why cash should make a comeback

Australians are paying almost two billion dollars in credit and debit card fees each year and the RBA wil now probe the whole payment system. What changes are needed to ensure the system is fair and transparent?

Investment strategies

Investment bonds should be considered for retirement planning

Many Australians neglect key retirement planning tools. Investment bonds are increasingly valuable as they facilitate intergenerational wealth transfer and offer strategic tax advantages, thereby enhancing financial security.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.