By Jeremy Lang
Sometimes investors get gripped by a new idea. They can be tempted to buy, or sell, stocks based on a prediction of how the idea might play out. They can be willing to ignore stock specific news and instead speculate on how news might change, if…?
Judging by the behaviour of some areas of stock markets since February, and by the headlines appearing on newswires, we are in one of those periods. The new idea is: ‘what if fiscal policy is coming back?’
It is almost a decade since the crisis and it seems like all the tools of monetary policy have been thrown at the economy. The debate has moved from ‘how do we fix an economy broken by fiscal policy’ in the early 1980s – to ‘how do we fix an economy broken by monetary policy’ in 2016. Instead of reaching for a new theory, we seem to be groping for an old one.
Stock markets have noticed. The noisy news is now about a ‘steepening yield curve’ and what it means. Top down investors have been placing bets on a shift to fiscal policy.
Which types of companies might benefit? This boils down to what form ‘deficit spending’ could take. It is seductive to think government spending means large scale public works. In reality, expansionist fiscal policy is far more complex. Fiscal stimulus can be applied through tax cuts rather than more spending, and the perceived relative efficacy marks a sharp political divide. Also, governments can increase spending in many different ways. Increasing public employee’s wages can be at least as effective as building more roads or bridges.
Clearly the makeup of a 2016 economy is very different to an economy of the 1920s or even the 1960s. One of the issues of fiscal policy’s demand management in the 1960s-70s was its speed of impact. The stop-go cycles of quick fire booms and recessions have often been blamed on the lagged, difficult to predict impacts of fiscal stimulus. Even if the market is right and fiscal stimulus is coming, and it has the perspicacity to spot the stock winners, the impact is unlikely to be seen quickly. In the meantime, who knows what new idea may have gripped investors’ attention.
Fiscal stimulus probably means more supply of long dated government debt. This is why the yield curve has steepened, sending bank shares up and wobbling bond-proxies. Banks face many problems, such as the legacy of credit explosion, as Deutsche Bank has recently reminded us. They also are struggling with low, or in some cases, negative interest rates. Banking is a ‘spread’ business and investors like banks more if they think the yield curve will steepen.
There is a perception some stock prices move in sympathy with long bonds. They are usually stocks which offer little prospect of growth, but pay steady dividends – like Utilities. When bond yields rise, investors can be tempted to sell. In 1999, the yield on US 10yr treasury went from 4.5% to 6.5% and the S&P Utilities Index fell about 10%. However, when yields went from 1.7% to 3% in 2013, Utilities climbed about 8%. But if fiscal policy is coming back, we want to see how Utilities performed from 1963-70, when bond yields jumped from about 3% to 8%. While data is thin, it appears Utilities went nowhere.
However, the ‘bond proxy’ perception snares more than just Utilities. Utilities have higher than average dividend yields, but also little or no growth and low volatility. Consumer Staples can also be viewed as bond proxies, with generally above average dividend yields, but many are still able to generate modest growth. In the two more recent periods of yield spikes, Staples have performed similarly to Utilities, but the ability to generate some growth made quite a difference from 1963-70. Staples saw similar gains to the S&P, at circa 40%. Staples also did better than Financials. Hence ‘simple’ bond proxies like Utilities may struggle if we are in for a 1960s-like period, but ‘safe’ modest growth companies probably will not.
Where does this leave us? Some stocks have started to behave as though investors believe a policy change is coming. Such moves look speculative right now. The last time fiscal policy stimulation was used in earnest was back in the very different 1960s economy, but if we use this as a guide, the outlook for Utilities does not look great – the same for Financials.
From experience, knowing when not to have an opinion can be just as important as trying to form one. Forming an opinion is deceptively easy, but forming an opinion on such a particularly slippery topic is dangerous: it is easy to be wrong. On the topic of fiscal vs. monetary policy shifts, having no view is probably the right view for the moment.
Jeremy Lang is partner and fund manager at Ardevora Asset Management
