How dominant is financial dominance?

Good morning. Fed Chairman Jay Powell appeared unfazed on Friday, telling an interviewer: “You won't hear us overreacting to these things.” [past] “Two months” of rising inflation. “We've divided our critics into equal-sized piles at this point,” he added, with a hint of bravado. His cool tone can be forgiven. Powell is tantalizingly close to securing a soft landing and his legacy. Conflicted? Email us: robert. armstrong@ft.com and ethan.wu@ft.com.

Financial motivation

It is widely agreed that US fiscal deficits lift growth and the stock market, a phenomenon known as “fiscal dominance” (we have also heard “fiscal aftershocks” and “fiscal smoothing”). The idea is that the traditional balanced relationships between the market, the Fed, and the economy are overshadowed by financial power. The intellectual appeal is clear – the financial story simultaneously explains why there has been no recession, why inflation has remained somewhat flat, why long yields are still high, and why stocks don't care about such high yields.

The economic intuition of this view derives from Levy-Kalecki's identity, which holds that larger government deficits must translate into higher corporate profits, if there are no significant changes in investment, private savings, or dividends. These higher profits then push up stock prices. The identification is easy—it's just accounting—although teasing out the causal relationship between deficit and profit can be difficult in practice. But deficits of around 6% of GDP outside of crises are rare, and it would be surprising if they did not affect the economy.

Recent legislation related to the dollar, such as the Anti-Inflation Act and the Chip Act, add to the doubts. Since January 2022, U.S. construction spending has grown at a compound rate of 52 percent. Perhaps not surprisingly, the government's contribution to GDP growth is higher than usual:

But here's the wrinkle. Popular measures of “fiscal impetus”—the cumulative addition to the growth rate through fiscal policy—are not far from zero. Below is one of the widely cited indexes from the Brookings Institution. Far from lifting growth, it suggests that public finances were a moderate drag in the first quarter of this year:

The way to solve this problem is to remember that financial motivation is a second derivative measure; It tells you about changes in growth, which itself is a rate of change. It takes a widening deficit to accelerate growth. A high but stable deficit can set a floor on demand, but it cannot stimulate growth beyond the economy's underlying “potential” growth rate.

At this point the careful reader might wonder, wait, isn't the deficit actually increasing? The answer is yes, but mostly because of the interest calculation. As the chart below shows, the primary deficit (i.e. ex-interest) is expected to remain stable as a share of GDP even as interest payments rise:

This is important because primary deficits have a different macroeconomic impact than government interest payments. Traditional leveraged spending borrows from investors to build a bridge, for example; The money earned by construction workers then flows back into the economy. But when money is instead borrowed to pay ever-increasing interest expenses, think about the receiving end: term-matching investors, bond funds, and foreign governments. They do not necessarily switch and spend their interest income on American goods and services. In other words, their “propensity to consume” is low. Rising deficits driven by interest expenditures, rather than a widening primary deficit, are less stimulating.

The result: although the headline deficit has risen, the impact of government spending on growth may now turn to the negative side. Ian Shepherdson of Pantheon Macro points out in a recent note that the impressive growth rate in the industrial building and construction sector is slowing, from more than 80 per cent year-on-year in mid-2023 to 37 per cent in January. Meanwhile, state and local government construction spending also fell 1 percent in January, the first monthly decline since August 2022. Shepardson argues that declining savings and loan tax revenues bode poorly for future spending on savings and loans, as this shows Chart:

It's a reminder to investors that markets are sensitive to changes, not levels. Even in a financially dominant system, dominance can fluctuate. Markets appear optimistic about growth, but if fiscal motivation turns permanently to the downside, it will test how deep those convictions really are. (Ethan Wu)

The Stock of the Great British Bargain, Part Three: Responses

I wrote last week that although UK stock indices look very cheap – even cheaper than is justified by the UK market's tendency towards old economy sectors – I have struggled to find individual stocks that look like bargains.

Two UK equity fund managers wrote to say I had not researched enough.

Alex Wright, who runs Fidelity International's UK fund, says he often looks for like-for-like comparisons between UK stocks and roughly equivalent stocks from elsewhere, where half the pair is in the UK at a discount. He sent me four pairs of UK/US currencies: Banking, Standard Chartered, and Citi; In Home Builders, Kern Homes, and Lennar; In tobacco, Imperial and Altria brands; In defense contracting, Babcock International and Lockheed Martin. In each case, the historical growth or expected future growth is much higher for the UK half of the pair, yet the stock is cheaper. Here's the data he sent that explains the discrepancies:

I asked Wright what was the catalyst for closing these evaluation gaps. He noted that the influx of M&A deals suggests that corporate buyers are seeing value in the market: Spirent Communications and DH Smith both received multiple takeover offers last week at significant premiums. It's a matter of spreading that enthusiasm to stock investors.

Wright likes StanChart more than similarly cheap Barclays because it has a better growth profile, mostly due to its exposure to Asia, where it has strong interest rates and FX business. Since Bill Winters became CEO in 2015, he has made the bank much less risky, he says.

Ben Rawson, co-head of UK equities at Martin Currie, wrote to defend Barclays. It trades at a 50 percent discount to book value, while JPMorgan Chase, for example, trades at an 80 percent premium to book. Here he explains that stock prices failed the strategic renewal recently announced by the bank:

Investors evaluate banks based on price-to-book ratios with reference to the return on equity that the company can achieve. Since Barclays failed to consistently deliver a return on equity in excess of its cost of equity, the shares were valued at a significant discount. . . BARC's management recently unveiled a multi-year return on capital enhancement strategy. . . It's clearly a leap of faith. . . Whether these ambitions can be achieved. However, with the current valuation effectively reflecting that they are not doing so, there is room for significant upside in the share price if improvements are made from here.

In addition to the share price dooming Barclays' strategy, Rawson believes that rising interest rates, if they persist, will make the banking industry more structurally advantageous to investors. I agree. While a rapid rise in short-term interest rates can lead to lower credit quality, non-zero long-term interest rates, all other things being equal, will increase industry margins.

I leave it to readers to decide whether there is any chance of Barclays' latest strategic reboot succeeding. You can read FT's coverage of it here , here , and here .

One good read

How the Atlantic turned things around.

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