Fiscal QE: when, where, and how to play it
Markets are underestimating the probability of 'fiscal QE': In our opinion, the likelihood of some form of fiscal QE by one of the G4 central banks over the next 3-5 years is high, for the following reasons: i) given the age of the US cycle, history suggests there is a 60% chance of a US recession within the next three years; this would require real rates to fall by 5%, which is very hard to achieve; ii) conventional QE is having increasingly unwelcome side-effects (e.g. banks' NIMs falling, ‘zombie’ capitalism, and potential housing bubbles); iii) fiscal QE is effective (the multiplier on government spending is 1.8x, and there is a shortage of infrastructure investment in many developed markets); iv) it's more acceptable politically, as it can target the median household via construction jobs and tax cuts/incentives; and v) we believe that strong structural disinflationary forces (technology, China) will continue to make it hard for central banks to hit their inflation targets. Ultimately, central banks' holdings of domestic government debt could be swapped into very long-dated zero coupon bonds, meaning increased government spending has little financing impact
We rank the likelihood of fiscal QE by region: Based on shortage of existing infrastructure, need for stimulus, how constrained monetary tools are and policy flexibility, we think Japan is most likely to conduct some form of fiscal QE, followed by the UK, the US and lastly the euro area.
We identify five types of fiscal QE: The most likely of these is implicit (governments spend while central banks print) or funding of profitable infrastructure projects. We think Japan is most likely to move first but will probably resort to tax cuts/spending (given its high-quality infrastructure). Within the UK, we believe infrastructure QE is most likely to occur within 3-5 years. While political hurdles to undertaking infrastructure QE are greater in the Eurozone, we describe a form of revamped Juncker Plan which might work legally, practically and logically but would need a crisis and time to organise.
Equity and sector implications: We focus on stocks that would benefit from infrastructure QE and look attractive regardless. We introduce an overweight on European construction (previously no weighting), as the construction share of GDP is at a 20-year low (Travis Perkins and Assa Abloy look cheap on Credit Suisse HOLT® with eCAP awards), and stay overweight cement (LafargeHolcim). The outlook for US non-residential construction looks attractive, with a compelling need to upgrade infrastructure (Halma, Wolseley). We like defence companies with strong local content benefit (Thales). We include a sensitivity analysis based on a 5% increase in construction/defence spending for the respective companies. Into fiscal QE, real rates should fall, which would re-rate equities (US P/E multiples could rise to c18x on our fair value model). The fall in real rates would also support the gold price (where, anyway, central bank diversification could lead to a sixfold increase in gold demand). US names that would benefit from the themes above (with an eCAP and cheap on HOLT) are: Johnson Controls, Raytheon, General Dynamics.