Back from the brink


A record deficit 10 years into an expansion would leave Keynes flabbergasted, but it is likely just a taste of what is to come.

While the US is ‘back from the brink’ and markets have returned to positive territory in 2019, this cycle is well into its late innings. As discussed in this article from GSFM’s investment partner, Epoch Investment Partners, written by CEO and co-CIO Bill Priest, there are three reasons to maintain a cautious investment stance.

The biggest event for markets in the first quarter of 2019 was the “Powell Pivot.” Toward the end of last year, the Fed chair communicated to markets that quantitative tightening (QT) was on autopilot and that the Fed planned multiple rate hikes in 2019. Fears of tighter financial conditions spooked investors, resulting in significant market volatility, with US and global equity markets falling almost 15% in the fourth quarter of 2018.

Fearing a bear market with its negative spillovers for the real economy, Powell executed a swift 180 degree turn, adopting a neutral bias and promising to end QT this September. The pivot brought the market back from the brink, with first quarter gains wiping out most of the losses suffered in the previous quarter.

A second positive development was the moderation of trade tensions with China, with the White House reporting we are now quite close to a signed deal. Trade negotiations have proved much more complex than most investors anticipated a year or two ago. Quite rightly the key outstanding issue is enforcement, something that previous administrations paid far too little attention to. Luckily, US Trade Representative Robert Lighthizer is exactly the right person for this task, although his relentless and mind-numbing attention to detail is likely testing the patience of political bosses on both sides of the Pacific.

Additionally, toward the end of 2018 China began implementing its own policy pivot, hitting both the monetary and fiscal thrusters. This has resulted in an almost immediate improvement in economic momentum, as shown by the dramatic recovery in its composite PMI.

These three developments resulted in early-2019 looking like the mirror image of late-2018. The good news is that markets have moved back from the brink, and we anticipate a relatively benign mid-to high-single-digit return to stocks for the remainder of the year. That said, this cycle is well into its late innings and we now outline three reasons to maintain a cautious investment stance.

Soon to be the longest expansion in US history

The last US recession officially ended in June 2009 and the current expansion has just celebrated its 10th birthday (Figure 1). However, all good things must come to an end as suggested by a host of indicators, including the (almost) inverted yield curve and weak consumer expectations. Precisely when, though, is anyone’s guess, as the record of failure to predict recessions is virtually unblemished.



The approaching Minsky moment: stability breeds instability

The second reason concerns the risks arising from the high and rising level of debt throughout the US economy. While corporate leverage might not be the direct cause of the next recession, it is certain to act as an amplifier making the repercussions considerably more damaging for both the real economy and the equity market. Policymakers agree, with this point emphasized in February by Fed Chair Powell and in early April by the IMF.

One major risk factor follows from the investment grade index now being dominated by BBBs, which means the next downturn may witness a tsunami of “fallen angels,” which could overwhelm high yield liquidity and result in severe market dislocations.

Additionally, about US$1 trillion of this debt is accounted for by firms with debts greater than four times EBITDA and interest bills that consume over half of their EBIT. Such debts, which may be first to default during the next downturn, are now roughly the same size as subprime mortgage debt was in 2007.

Moreover, the stock of “leveraged loans” has grown sharply in recent years, with many policymakers issuing warnings about its risks. Their worries are based on three characteristics leveraged loans share with the subprime-mortgage boom: securitisation, deteriorating quality and insufficient regulatory oversight.

Collateralized loan obligations (CLO) in particular soak up more than half of the issuance of leveraged loans in America and 85% of new issuance consists of “covenant-light” loans.

We have similar concerns about the booming private equity markets, where assets under management have reached over US$3.4 trillion and valuations are just shy of the excesses reached in 2007. We firmly believe that the corporate debt market will be at the epicentre of the next financial crisis. Just as distinguished economist Hyman Minsky would have predicted, a decade characterised by record low interest rates and a flood of central bank liquidity has produced an accident just waiting to happen.

Manufacturing margins have peaked

Four factors explain why manufacturers’ margins have more than doubled over the last two decades: (i) the reduction in effective tax rates; (ii) the decline in interest rates; (iii) wage savings from offshoring; and (iv) the reduced wage bill resulting from more efficient domestic plants. The first two of these factors are likely fully played out, with the third starting to reverse over the last two years, and the last continuing to plod along, but not moving the needle very much. With opportunities for labour cost arbitrage largely behind us, and global supply chains under threat from trade tensions (especially pertaining to tech hardware), the likelihood of further margin expansion is quite low in our view (Figure 2).



Consensus expects S&P500 EPS growth of only 3% this year, down markedly from 20% in 2018 (due in large part to the EPS sugar high that resulted from the end-2017 tax reform). However, consensus expects EPS growth to bounce back to 12% in 2020, an outcome that assumes significant margin expansion. As mentioned, we are thoroughly sceptical regarding the possibility of double-digit earnings growth at this stage of the cycle.

MMT: why now?

Modern monetary theory (MMT) has received a great deal of media attention lately. Its proponents have been encouraged by the benign inflation backdrop and the lack of any discernible relationship between sovereign debt/deficit levels and interest rates. A growing minority of politicians believe this disconnect provides them with a green light to promise aggressive fiscal policies.

In fact, even if uncredited, MMT is probably a good framework for understanding fiscal policy since the early 2000s, and maybe as far back as Reagan. Moreover, MMT will likely be used to justify further fiscal expansion regardless of the outcome in November 2020.

MMT proposes that a country with its own currency, such as the US, doesn’t have to worry about accumulating too much debt because it cannot go broke — it can always print more money to pay interest. So, the only true constraint on spending is inflation, which should accelerate if the output gap is positive (that is, GDP is above potential). However, if the output gap is negative, MMT implies the government can spend whatever it deems appropriate to maintain full employment (and achieve other goals, such as halting climate change). After all, in the modern era of “fiat” currency, governments no longer need to worry about having enough gold to back their paper money.

Crucially, MMT aspires to swap the roles of monetary and fiscal policy. The former relies on tweaking short-term interest rates and occasionally implementing unconventional policies like QE. However, while most acknowledge QE’s crucial role in repairing temporary illiquidity from 2008 to 2010, a majority of commentators question the efficacy of subsequent QE experiments.

The roughly $10 trillion in negative yielding bonds globally attests to monetary policy’s inability to vanquish secular stagnation. This is a major reason for the sudden interest in unconventional policies and approaches. MMT proponents believe fiscal policy should drive monetary policy (with the nation’s central bank mandated to carry out the bidding of its treasury).

MMT challenges a core principle of conventional economics, which is that an increase in public debt and budget deficits will tend to raise interest rates, all else equal. While we are not fans of MMT, we must admit that they do have a point here (Figure 3). Thus, we believe fiscal policy will likely become an even more active policy tool, with an even more expansionary bias, over coming years.



In spite of the concerns described above, our outlook is for relatively benign markets during the remainder of 2019 but followed by a rockier path in 2020 and 2021. Epoch has always favoured companies that consistently and sustainably generate free cash flow, and possess superior managements with a proven track record of allocating that cash flow wisely between return of capital options and reinvestment/acquisition opportunities. We believe such companies are the most probable winners and the ones most likely to provide investors with the best returns. In today’s challenging, late-cycle investment environment we believe these principles are ever more important.

A record deficit 10 years into an expansion would leave Keynes flabbergasted, but it is likely just a taste of what is to come. The current US deficit is the largest it has ever been outside of wartime and recession. Moreover, it is occurring toward the end of what seems destined to be the longest recovery in the history of the US. Note that at the same point in the 1991 to 2001 recovery, we enjoyed a budget surplus of over 2%. In our view, the current budget deficit is indefensible and suggests we may already be living in an MMT world.


The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2019 Epoch Investment Partners, Inc.


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