by Asset Allocation Committee | PDF

When discussing the fiscal deficit in a meeting with then-President Bill Clinton and his Council of Economic Advisors, Chief Strategist James Carville was quoted as saying, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” As Carville suggested, rising 10-year T-note yields are currently shaking investor confidence in global stocks, particularly in the Technology sector. The primary concern for investors is that the next stimulus package could spark inflation over the next couple of years. In this report, we discuss why some of those fears may be misplaced.

The 10-year T-note yield has tripled from 0.51% last August to a little over 1.54% today. The surge in yields can be partly attributed to fears of accelerated inflation due to the federal government’s growing deficit. The new COVID-19 relief plan has drawn the ire of bondholders because they suspect it was bigger than necessary. The prospect of higher borrowing costs hurts equities because it lowers valuations. In other words, higher yields tend to depress P/E multiples.

In general, the relationship between fiscal deficits and inflation is not all that strong. Over the last 20 years, the U.S. budget deficit relative to GDP has been the largest during any period of peacetime. Throughout this period, however, inflation has never reached the levels seen in the 1970s and 1980s. In fact, core CPI for the last 20 years has grown around the Fed’s 2% target. The two primary drivers of the Consumer Price Index (CPI) have come from healthcare and shelter. Composing nearly 40% of the index, prices in these two sectors have consistently outpaced the overall index.

Inflation has been relatively muted over recent years because the conditions that allowed it to thrive in the 70s and 80s no longer exist today. Deregulation, globalization, and lower taxes have made it easier to cut costs, while making it difficult for firms to raise prices. Deregulation and globalization have made it easier for firms to outsource labor and remove costly regulations, while lower taxes incentivized firms to adopt cost-saving technologies. Additionally, increased competition meant that only companies with differentiated or specialized goods had any real pricing power. As a result, the prices for goods such as apparel and vehicles have been roughly unchanged over the last 20 years.

Instead of seeing inflation in goods and services, we suspect that deficit spending will likely find its way into financial assets. Government spending is paid for through the private sector (which includes businesses and households) and foreign savings. Much of those savings so far have come from households as higher levels of unemployment have deterred spending. These savings have been used to pay down debt and invest in equities (cue the Reddit army). Foreign savings will likely also pick up in the coming months as consumers begin to spend more. This should be supportive of financial assets as a rise in imports is generally funded by an increase of flows into the capital account.

Nearly every president since Nixon has governed with an eye on the bond market. That is because bondholders overestimate the impact that new presidents will typically have on the economy. The chart above shows the 10-year T-note yield along with the first quarter forecast for the next six quarters from the Philadelphia FRB’s survey of professional economists. When the forecast is generally correct, we mark it with dots; when in error, we use open boxes. In 12 of the past 20 years, the expectation has been for rising rates and has been incorrect. Thus, investors should be aware that expectations lean toward higher rates but are wrong more than half the time. Another way of thinking about the recent rise in rates is that most of the time, the consensus is that long-duration interest rates will rise. That being said, we suspect the rise in current rates probably won’t exceed 2% on the 10-year T-note and equity markets will be able to manage this level of increase.

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by Asset Allocation Committee | PDF

With the U.S. dollar apparently poised for what could be a long phase of depreciation, investors are naturally looking more closely at foreign stocks for future growth.  Japan has been a prime focus, not only because it sports the world’s third-largest economy and the third-largest equity market, but also because Japanese stocks have recently performed well.  Over the last six months, for example, the MSCI Japan Index provided a total return of 17.3% (in dollar terms), almost double the return on the U.S. index.  But are Japanese stocks set for further gains over the long term?  Have Japanese stocks really overcome their long period of underperformance since the country’s “bubble economy” burst more than 30 years ago?  A close look at the Japanese economy and financial markets shows Japan has certain cyclical advantages that investors could currently take advantage of, but it is also facing longer-term headwinds that are likely to weigh on returns over time.

Countries that go through an investment bubble like Japan did in the 1980s are left with the challenge of adjustment once the bubble bursts.  Among the many possible strategies to deal with the excess investment and resulting overcapacity, the government can simply step back and allow asset prices to quickly adjust downward, putting lots of people out of work and leaving creditors empty-handed.  After the pain of the Great Depression, governments these days more often try to slow the process and spread the costs broadly.  Our analysis suggests Japan completed the slow process of repricing its assets and working through its excess investment in the early part of this century.  In the chart below, which shows the inflation-adjusted growth rate for each major category of Japan’s gross domestic product (GDP) by period, the red columns show how fixed investment swung dramatically from an average annual increase of 5.5% in the 1980s to average annual declines of 0.4% through the 1990s and 2.1% in the first decade of the 2000s.  However, the chart shows that Japanese investment finally started to grow again in about 2010 (we’ve excluded the data for 2020, since it is distorted by the coronavirus pandemic).

Besides the rebound in investment, Japan has also recently shown other improvements in economic policy and dynamics.  For example, the country has deepened its economic ties to China, helping boost its exports.  It has improved its corporate governance rules and brought more people into the workforce.  All the same, the chart above suggests why its stock market performance remained weak until recently.  As is typical for highly developed countries, personal consumption spending is the biggest driver of Japan’s economy, but the chart shows that this type of spending has been growing ever more slowly, even after investment rebounded and labor force participation increased.  This critical slowdown in consumer spending almost certainly reflects Japan’s major problem with low birth rates, a shrinking population, and population aging.  Taking a “glass half full” approach, you could say that the rebound in Japanese investment has come just in time to offset some of the country’s poor demographics.  From a “glass half empty” perspective, you could also argue that the positive impact of Japan’s investment rebound is being offset by worsening consumer spending trends.

The back-to-back problems of asset price adjustments and demographics have presented a continuing challenge for Japanese companies.  In addition, government policymakers have been unable to come up with ways to address the situation.  In some ways, they’ve even exacerbated it (especially by raising the national value-added levy, a type of sales tax).  As shown in the chart below, Japanese corporate profits have trended upward since the bursting of the bubble economy, but the average rate of increase has been anemic at about 2.5% per year, versus 7.5% per year in the U.S.

Because of its enormous economy and financial markets, Japan can’t be ignored by investors, but this analysis shows that the country continues to face big challenges to its economic growth and corporate profitability.  In the short term, we do think Japanese stocks could continue their recent short-term cyclical rebound because of factors like its corporate governance improvements, investors’ shift toward the “value” stocks that make up so much of the market, or the post-pandemic economic rebound around the world, which is boosting Japanese exports.  In the long term, however, it’s important to remember that Japanese stocks will probably continue to face continuing secular challenges from its poor demographics.

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