The Fiscal Dance

Lyn Alden Schwartzer


Summary

- Household equity allocations (as a % of household assets) are near the high end of their historical range.

- An analysis of corporate capital structures in terms of equity and debt, and how it changed over time.

- Why fiscal policy is a key variable to consider within any tactical investment framework, at this particularly juncture.




This article focuses on the Federal Reserve's Sep 21, 2020 Z.1 Financial Accounts release.

The Z.1. release is a quarterly report by the Fed that accounts for the assets and liabilities for entities throughout the United States, including households, businesses, and governments. It comes out with a bit of a lag, but the abundance of information makes it a great data set for monitoring long-term trends.

Record Net Worth

U.S. household net worth reached an all-time high in Q2 2020, both in nominal dollar terms (red line below) and in CPI-adjusted terms (in blue):

      Chart Source: St. Louis Fed


Total household wealth reached nearly $119 trillion in nominal dollar terms by the end of the quarter. This new high in net worth is due to the sharp rebound in equity prices that occurred through Q2, the continued increase in housing prices, and the rapid growth of the broad money supply.

Some people are confused at why markets and overall net worth could have done so well this year so far, despite such a bad environment for employment and GDP.

The reason, of course, largely has to do with trillions of dollars of government transfer payments from April through July of this year. Due to record levels of stimulus checks, unemployment benefits, PPP loans for businesses that largely turn into grants, and corporate bailouts, personal income on a nationwide scale went up rather than down in this recession so far:


Chart Source: St. Louis Fed


More important than absolute household net worth, and a key ratio to be aware of, is household net worth as a percentage of GDP. This ratio is shown in blue on the left axis of the chart below, with short-term interest rates in red on the right axis for context:


Chart Source: St. Louis Fed


This ratio of household net worth as a percentage of GDP shot up to new record highs of over 6x or 600% this quarter (largely due to a sharp decline in GDP), after already being at record highs of nearly 550% in recent years.

All else being equal, low interest rates put upward pressure on real estate and equity valuations, which puffs up net worth relative to income and relative to GDP. As we've reached lower and lower interest rates over time, asset valuations have pushed upward. 

However, momentum and other factors tend to exaggerate this move in certain asset classes over time.

During the 2000 peak, real estate was reasonably priced compared to historical norms, but equities briefly shot up to record high valuations, which pushed up household net worth to about 450% of GDP.

During the 2007 peak, it was the opposite, with equities at historically reasonable valuations while real estate briefly soared to record high valuations, which pushed up household net worth even more to nearly 500% of GDP.

In recent years, both equities and real estate have been historically highly-valued together, as interest rates have hit lower lows, and that combination of high equity valuations and high real estate valuations has allowed household net worth to break out to record highs as a percentage of GDP, even compared to 2001 and 2007. 

We were getting close to 550% household net worth to GDP in recent years, and the decline in GDP in Q2 as asset prices went up, has briefly taken that ratio to over 600%.

Normally, a big economic shock would dislodge that and start to deflate asset valuations to some extent, but so far in this recession, record amounts of stimulus have been able to keep personal incomes and asset prices levitating through this year. And the four-decade trend of lower interest rates has been beneficial to asset price valuations.

Since August, fiscal stimulus hasn't been in effect, so uncertainty and volatility have returned to equity markets.

Equity-Heavy Household Allocations

The majority of household net worth consists of financial assets like cash, bonds, real estate, and stocks.

We all know by now that by most metrics, equity valuations are historically high. For example, based on the S&P 500 average price-to-sales ratio, or the cyclically-adjusted price-to-earnings ratio, or market capitalization as a percentage of GDP, the stock market is more expensive than most times in history. 

By some of those metrics, like the price-to-sales ratio, it is the highest in history, while in other metrics, like the cyclically-adjusted price-to-earnings ratio, it is the second-highest after the 2000 dotcom bubble peak.

On the other hand, the one key metric for which stocks are not particularly expensive, is the equity risk premium, meaning the earnings yield or dividend yield of the S&P 500 compared to an interest rate benchmark, like the 10-year Treasury rate. By that metric, the valuation advantage actually still leans a bit towards the stock market, especially if you filter out a handful of particularly bubbly stocks.

And that's what makes this environment so hard for investors. Back during the dotcom bubble 20 years ago, 10-year Treasury notes were yielding a very attractive 6%. Not only were stock valuations extremely high, but the equity risk premium was also at a record low compared to those high-yielding nominally risk-free bonds, so Treasuries were a no-brainer better alternative to stocks that smart investors could shift into.

With interest rates around the developed world all near-zero currently (or even nominally negative in some cases), and thus sovereign bonds set to produce extraordinarily low returns over the next decade, many investors are left scrambling for assets, including equities and real estate even at rather high prices.

In other words, many investors accept the prospect of long-term low returns that stock indices are likely to offer at such high valuations, because those returns could still be comparable to, or better than, the return they'll get from Treasuries over the next decade, in exchange for more volatility. Both will likely be low-returning areas, especially in inflation-adjusted terms, but which will be better is an open question.

I prefer good-quality stocks from a long-term perspective, including some foreign stocks that are generally cheaper at this time, but I do use Treasuries for some counter-cyclical defense, to buy dips and sell rips in equities and other asset classes via tactical rebalancing.

However, we have to be cautious, because equities are very popular among investors at this time. Besides the traditional stock and bond valuation metrics, one ratio we can look at is the percentage of U.S. household assets that consist of equities, from the Fed's Z.1. report.

As of Q2, 23.5% of household assets consist of equities (in red below), which is near the high end of the multi-decade historical range. I also included household real estate as a percentage of assets on this chart as well, which is currently at a more historically average allocation:

Chart Source: St. Louis Fed


If I plot the year-end household equity allocation percentage along with the forward ten-year percent annualized S&P 500 returns from the end of that year, it shows that periods of high household allocation to equities tend to be followed by a decade of poor annualized equity returns, and vice versa:

Data Sources: Federal Reserve, Aswath Damodaran (NYU)


When equities were over 20% of household assets in the late 1960's, the result over the next 10 years was about 2-3% annualized returns, which is not even adjusted for inflation. Then, when equities fell to cheap levels in the 1970's and 1980's, down to well below 10% of household assets, the annualized forward returns were over 15%, which even after adjusting for inflation were great.

The dotcom bubble, where equities briefly reached 25% of household assets was the worst time in modern history to buy equities, as they produced slightly negative 10-year annualized returns from there. The 2008-2010 period was a great buying opportunity, and now from 2017-2020, equities have been back up to around 25% of household assets.

This inverse correlation between household equity allocation and forward equity returns is roughly what we would expect to happen from a rather crowded trade.

To summarize here, U.S. household assets and net worth are at a record-high percentage of GDP and earned income, and equities currently represent a historically high portion of those highly-valued household assets. This combination historically doesn't bode particularly well for ten-year forward returns, especially if we adjust for inflation. As a long-term trend, however, it's not a trading signal, but rather just a "big picture" observation.

Equity-Heavy Capital Structures

Despite being highly indebted based on various metrics, such as corporate debt as a percentage of GDP, corporate capital structures are actually tilted more towards equity than average, as of Q2 2020. That's because, as previously described, equities are so highly-valued.

Specifically, at the end of Q2, total corporate equity (excluding banks) was worth $33.5 trillion, while total corporate debt (excluding banks) was worth just under $11 trillion. In other words, total corporate debt was worth about 1/3rd as much as total corporate equity shares at market value.

If we add corporate equity and debt together, the total is about $44.5 trillion, with equity accounting for about 75% of that total, and debt accounting for the other 25%. That's the current capital structure of U.S. nonfinancial corporations in aggregate: three quarters equity and one quarter debt.

Compared to history, this ratio is currently on the high end, meaning that equity value outweighs debt value by more than average. This chart shows market-value equity as a percentage of the total sum of equity and debt since 1945:

     Chart Source: St. Louis Fed


During the booming 1960's, corporate equity remained in a 70-75% band for capital structures for most of that period, with debt representing the other 25-30%.

Then, during the inflationary 1970's and 1980's, equity valuations were much cheaper, and so equities made up just 50-60% of corporate capital structures. Corporate debt was relatively low as a percentage of GDP, but corporate equity was also unusually cheap.

The 1980's began a disinflationary trend and a mega stock boom into the 1990's, with corporate equities reaching a record 78% of the total capital structure at the peak of the dotcom bubble by the end of the 1990's decade.

Then, this ratio went down and chopped along for a while after the dotcom bubble burst, and then during the 2009 market bottom, equities were very briefly back to just 60% of the corporate capital structure before quickly shooting back up.

For the past several years, since around 2014, corporate equities have once again been hovering at around 75% of the corporate capital structure, which is near the top end of the historical range.

The big caveat for this comparison of corporate capital structures, is that it's currently more top-heavy than usual. The handful of mega-cap tech and internet stocks, like Amazon (AMZN), Microsoft (MSFT), Apple (AAPL), Facebook (FB) and Alphabet (GOOGL) represent several trillions of dollars in equity market capitalization, but have comparatively very little debt. The vast majority of their combined capital structure consists of equity.

As we move down into medium and smaller companies, however, their tilting towards debt becomes a lot bigger, with lower equity valuations and higher debt loads.

Both corporate debt levels and equity valuations have been sharply rising, so corporate debt and corporate equity have both grown faster than GDP. This chart shows nonfinancial corporate equities (in blue) and debt (in red) separately, each as a percentage of GDP:


                         Chart Source: St. Louis Fed


Equity value peaked in the 1960's at around 90% of GDP, bottomed at below 40% of GDP in the 1970's and 1980's, soared to 160% of GDP during 2000, bottomed at around 70% of GDP in 2009, and now is at a record high of over 170%.

Meanwhile, corporate debt used to be as low as 20-25% of GDP, but has since nearly tripled to the 55-60% range.

Partially this trend increase is from globalization, especially if we compare the 2010's to the late 1960's. The S&P 500 is a lot more global today than it was 50 years ago, both in terms of earning revenue from abroad, and cutting expenses by building things in cheaper countries.

However, it's not all (or even mostly) from globalization. The S&P 500 used to earn a bigger percentage of its revenue from overseas ten years ago than it does lately, for example, even though the stock market capitalization to GDP ratio doubled during that time due to increases in equity valuation.

                       Table Source: S&P Global


In fact, globalization as measured by global trade as a percentage of global GDP, peaked in 2008 according to World Bank. 

This mirrors what we see from the S&P 500 foreign revenue percent table above that also peaked in 2008.

So, changes in valuation play the key role for the value of the stock market as a percentage of GDP, especially over a given decade, but that can be amplified by structural trend shifts like corporate tax cuts, globalization, and large publicly-traded companies taking market share from non-public small businesses.

Final Thoughts: The Fiscal Dance

A theme I've been framing for a while now, is that with the economy in the state that it's currently in, whenever fiscal stimulus is shut off, rising insolvency and normal recession characteristics could begin playing out.

In my previous article from August, for example, I described it like this:

However, with Congress currently in a gridlock and on recess, the economy rode off the fiscal cliff a couple weeks ago. Nearly 30 million people are no longer receiving those extra federal unemployment checks that they have been receiving for the past four months, and instead are receiving the normal level of state unemployment aid. Plus those one-time stimulus checks that both employed and unemployed people received are long-since spent.

Left unaddressed, this will eventually translate into more insolvency, such as a greater percentage of missed housing payments and a decline in overall consumer spending, and thus a possibility of W-shaped economic data, another deflationary shock, and more traditional recession effects being felt by more people.

If we look at the S&P 500, which has a lot of factors contributing to price movements, we can see how stimulus fits into the big picture as a variable.



S&P 500 Technical

If we zoom in on the 1-year chart for small caps, which are more economically sensitive and were less influenced by momentum and unusual options activity in August, it’s more clear:



Russell 2000 Technicals

The reason this current economic environment is tied to fiscal stimulus in an unusually tight way, is because of where we are at in the long-term debt cycle.

The amount of leverage and wealth concentration in the economy are both historically high, so any disruptions to broad personal income can more easily lead to systemically poor outcomes both in terms of civil unrest and broad insolvency than those disruptions could cause in a normal, healthier environment.

That will likely make the 2020’s into a particularly “macro heavy” decade, because this could very well continue to play out differently than a normal business cycle depending on how fiscal stimulus or lack thereof impacts the economy. My long-term base case is for very heavy fiscal spending, but the timing is tied to politics.

My overall process continues to be to focus on good individual stocks and ETF allocations, with a side order of precious metals. I’m using fiscal stimulus as one of my tactical risk-on and risk-off indicators, but the underlying theme is to focus on quality businesses. Unfortunately, we have to factor stimulus or lack thereof into fundamental business earnings estimates, especially for the more cyclical industries.

Personal incomes and many risk asset prices have so far defied the recession due to fiscal stimulus. But whenever stimulus goes offline, the natural tendency for an economy so indebted and impaired, is to sink into a period of disinflation and a weakening recovery. Whenever stimulus goes online (which at this point is significantly funded by permanent central bank monetization of the Treasury’s bond issuance), nominal GDP growth can be improved and risk assets have a better shot at pushing up, at the cost of higher inflation expectations and currency devaluation.

Most asset classes these days are correlated to one big theme: rising or falling inflation expectations. And these expectations are tightly tied to fiscal policy.

So, depending on their time frames, investors have that dance to play, of being more tactically aggressive or defensive based in part on fiscal stimulus being on or off, combined with whatever other indicators they prefer to use, such as fundamental valuations, oversold/overbought conditions, and technical indicators.

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