Can the "brotherhood" behind Nvidia and Tesla continue in the second half of the year?
Note: This strategy is based on Dolphin Research's sharing content for Longbridge high-net-worth clients' private event in late August.
In Dolphin Research's strategy summary for the previous quarter, we discussed why the US economy did not experience a recession in the article "Unraveling the Mystery: Where Did the Recession Go and Will It Come Back?" However, this content mainly focused on explaining how better-than-expected EPS supported stock prices.
However, valuation is composed of both EPS and PE, and PE is determined by liquidity (as shown in the chart below: the bull market in 2020 was largely driven by excessive US dollar liquidity), market risk appetite, and long-term expectations.
In the case of US stocks, especially tech stocks such as Tesla and Microsoft, their EPS has not significantly expanded this year. The increase in stock prices is mainly contributed by valuation, and even companies like Nvidia are in a state of double growth in EPS and valuation. After experiencing a continuous correction in the third quarter, the valuation percentiles of the two major markets are still in the 60-70% range of the past five years.
This time, Dolphin Research focuses more on explaining the issue from the perspective of actual liquidity changes and trying to understand the marginal changes in funds and liquidity in the second half of the year, as well as their potential impact on equity assets.
1. A Fact - The Fed's Tightening "Price without Quantity"
2. A Question: Big Government Spending Like Water
3. Two Derivative Issues of Loose Fiscal Policy:
3.1) Will the US government continue to spend money like water?
3.2) Who is the real source of funding behind the financing?
4. What will happen if deficit financing relies on bank reserves?
5. Strategic Implications
1. A Fact about the Fed - Tightening with "Price" but without "Quantity"
a. Monetary Policy:
Starting in March 2022, the Fed began raising interest rates. So far, the Fed has raised rates 11 times, bringing the federal funds rate from 0-0.25% to 5.25% to 5.5%.
From the perspectives of monetary quantity and price policies, the tightening of prices has been basically maximized. The current policy rate of 5.5% has exceeded the real interest rate in both headline and core measures, whether in terms of static YoY or MoM annualized rates.
b. Monetary Supply:
However, in terms of the dimension of monetary policy, although the Federal Reserve has already announced the pace of quantitative tightening: starting in June 2022, reducing the balance sheet by $47.5 billion in the first three months, and then reducing it by $95 billion per month, including $60 billion in Treasury bonds and $35 billion in MBS.
However, from the current progress, there has been no discount in the intensity of interest rate hikes, but quantitative tightening is actually problematic:
According to the original plan for reducing the balance sheet, the total amount of Treasury bonds and MBS to be redeemed by August this year should be close to $13 trillion;
As of August 16th, the reduction amount of Treasury bonds and MBS was only $9.5 trillion, completing only 75%, falling short by $350 billion.
While reducing long-term bond assets, short-term assets have exploded due to unexpected events: the liquidity crisis in mid-March in small and medium-sized banks in the United States has led to additional emergency lending by the Federal Reserve, with $250 billion in liquidity remaining.
Due to the Federal Reserve's rescue of small and medium-sized banks and the original quantitative tightening intensity falling behind schedule, a total of $600 billion in liquidity has been recovered less than the original plan.
II. A fiscal issue: the spendthrift big government
2.1) "Loose fiscal policy vs Tight monetary policy": A rare and bizarre combination of macro policies!
Since June last year, after the Federal Reserve's monetary policy began to tighten in terms of quantity and price, the fiscal policy in the United States has shifted to substantial looseness in the second half of last year (due to the nature of borrowing new to repay old, which significantly increased the deficit rate that can generate new physical work). A rare combination of monetary tightening and fiscal looseness has emerged!
a) After the deficit rate returned to pre-pandemic levels in the second quarter of last year, it started to rise again in the third quarter. With the federal government's debt ratio approaching 100%, the US fiscal spending remains excessive. By the end of the second quarter of this year, the deficit reached $1.4 trillion, with a deficit rate that truly reflects the physical work volume of 5.25%, and the comprehensive deficit rate including interest payments is 8.5%** (as a comparison, the red line for the domestic deficit rate is basically 3%)**
b) In other words, if the deficit rate in the United States from the second half of last year to the present is about 3% higher than that of a normal economic year, it is equivalent to an amount of about $600 billion in terms of the physical work volume of the real economy. Calculating before and after this, it means that the US government has injected an additional $600 billion to $700 billion into the market through the deficit, and this funding is the highest in terms of money multiplier (it may have already passed from enterprises to households and turned into household consumption or stock purchases).2.2) Who pays for the fiscal deficit?
Everyone pays for it with their own savings. The Ministry of Finance is no exception, as it also has its own savings account.
PS: The US Treasury's savings account is held at the Federal Reserve in an account called the Treasury General Account (TGA). The money in a normal person's bank account may come from government revenue or borrowed funds. However, due to the continuous budget deficit of the US federal government, the money earned is not enough to cover the expenses, resulting in a significant shortfall. Therefore, the increase in the balance of the Ministry of Finance's TGA account is essentially borrowed funds.
Normally, the TGA account needs to be maintained at a reasonable level to ensure the ability to make payments when project expenses are needed. This is similar to the concept of individuals needing sufficient cash flow to meet daily expenses.
The TGA account, as a deposit held at the Federal Reserve, is a liability on the Federal Reserve's balance sheet. Since net assets can be ignored, the simplified balance sheet of the Federal Reserve can be roughly expressed as: Change in Treasury securities = Change in (currency in circulation + TGA deposits + commercial bank deposits + reverse repurchase agreements).
As the Federal Reserve has been selling Treasury securities, its assets have been decreasing, and the decrease in liabilities has a significant impact on liquidity. When studying this issue, Dolphin Research divided it into two periods based on the resolution of the debt ceiling issue in June of this year. An interesting finding was made:
a) From the end of June last year to the end of May this year:
Before June of this year, due to the unresolved issue of the US debt ceiling, new borrowing was not possible, and the Federal Reserve continued to sell Treasury securities. The decrease in liabilities was mainly the funds in the TGA account.
This means that although the government has repaid the money borrowed from the Federal Reserve, without an increase in its income capacity, it still spends as it needs to, resulting in the depletion of the TGA's treasury.
Looking at this issue from another perspective, this injection of money can be seen as offsetting the impact of the Federal Reserve's quantitative tightening. By injecting money in the form of a deficit, it has a better monetary multiplier effect and can generate more real economic output.
b) From June to the end of July (as of July 31, when the Ministry of Finance updated its borrowing plan):After resolving the debt ceiling in June, the government has started replenishing its Treasury General Account (TGA).
PS: Here's an important basic knowledge about the balance sheet:
The three major liabilities of the Federal Reserve account for 100%: Treasury notes in circulation, reverse repurchase agreements (borrowings from commercial banks by the central bank), and deposits: a. Reserves held by commercial banks at the Federal Reserve; b. Deposits of the Treasury Department at the Federal Reserve - TGA.
Federal Reserve assets: Treasury bonds 62%, Mortgage-Backed Securities (MBS) 31%, total 92%.
The decrease in assets equals the decrease in liabilities: The proportion of the Federal Reserve's net assets to total assets is basically zero.
So, a simplified Federal Reserve balance sheet would be:
Treasury bonds = Cash in circulation + TGA deposits + Commercial bank deposits + Borrowings from commercial banks by the Federal Reserve (reverse repurchase agreements)
When the Federal Reserve's assets:
- Continue to decrease in Treasury bonds and MBS,
Meanwhile, the liabilities of the Federal Reserve:
The TGA account needs to be replenished, and the balance needs to increase.
Therefore, other liabilities of the Federal Reserve must decrease significantly in order to achieve balance in the balance sheet mentioned above.
Dolphin Research has noticed that from June to mid-August, during the rise of the TGA, the liability that decreased significantly was overnight reverse repurchase agreements (as shown in the chart). So, how should we interpret the meaning behind this chart?
Dolphin Research believes that the true meaning of this chart is:
A) If we consider that by the end of May, the Federal Reserve's quantitative tightening released the money in the TGA account back into the US deficit (which would generate a higher money multiplier effect), offsetting the impact of the Federal Reserve's quantitative tightening.
B) Therefore, from June until now, the Federal Reserve's quantitative tightening is achieved by continuously reducing the amount of reverse repurchase agreements, which means the Federal Reserve is continuously shrinking its net borrowing from banks to finance the US deficit.
Why is this path feasible? Here's an interesting finding:
A) By the end of July, the US government has mainly been financing through short-term debt issuance, resulting in a severely distorted issuance ratio (the data in the chart below is for the period until the end of July 2023).
B) However, coincidentally, since May of this year, short-term interest rates in the US have consistently been higher than overnight reverse repurchase rates: using funds from low-interest reverse repurchase agreements to purchase slightly higher-yielding short-term debt makes the interest rate spread worthwhile.
In other words, since June, although the TGA account has slowly been rebuilt, it has actually been financed through reverse repurchase funds. Reverse repurchase is originally the funds that the Federal Reserve uses to withdraw short-term liquidity from banks, which has little impact on the real economy. Now it is being used to finance the deficit, which brings additional liquidity to the real economy (including the equity market).
So far, the Fed's quantitative easing has been largely offset by the fiscal deficit, and the deficit, with its higher money multiplier effect, has been injected into the real economy, providing support for economic growth.
Three, two derivative issues of loose fiscal policy:
The only problem is that there are two issues with implementing countercyclical fiscal deficit behavior during a period of high economic growth: a) Will the US government continue to spend money like water? b) If they do continue to run a deficit, who will they borrow money from in the future? Next, Dolphin Research will continue to delve into these two issues.
3.1) Will the US government continue to spend money like water?
a) Is the deficit rigid or elastic from the source of the deficit?
Revenue side: In the first seven months of this year, personal income tax decreased by 400 billion compared to the same period last year, which may be related to the higher returns on personal equity accounts; employment and retirement-related revenues increased by 111 billion, confirming that employment in the United States is indeed relatively good. Total fiscal revenue decreased by nearly 400 billion from January to July.
Expenditure side: In addition to the record high debt level and the additional interest payments due to the high increase in government bond rates (110 billion US dollars), the other additional expenditures are mainly distributed evenly among social security, pensions, education and training, and public services, with the majority of the additional expenditures being rigid.
It can be seen that the fiscal deficit in the first half of the year is partly due to passive reasons for the decrease in revenue, and the majority of the additional expenditures are relatively rigid, making it not easy to reduce expenditures.
b) This government is also in the transition period, and whether it is a big government or small government ideology during the election period, it is difficult to reduce the deficit ratio, and Biden himself is a proponent of big government.
c) Dolphin Research has done a reverse calculation based on the budget of the Treasury Department:
On July 31, the U.S. Treasury Department updated its borrowing plan, mainly focusing on increasing financing for the deficit and replenishing the TGA account balance:
Increase borrowing scale: Borrow 1.007 trillion US dollars in the third quarter, which is 274 billion US dollars higher than the May forecast; the financing plan for the fourth quarter is 850 billion.Reasons: Economic growth on the revenue side has slowed down; the Federal Reserve's interest rate hikes and quantitative tightening.
Accelerate the reconstruction of the Treasury General Account (TGA): By the end of September, the cash balance should be replenished to $650 billion (originally planned to be $600 billion); by the end of December, it should be replenished to $750 billion. Reality: As of August 16th, the TGA balance is $380 billion.
Next, Dolphin Research estimates the additional financing demand from August to December:
To rebuild the TGA balance from $380 billion to $750 billion by the end of the year, there is an additional financing demand of $370 billion.
Based on the recent level of the fiscal deficit, the corresponding additional financing demand is estimated to be $1.1 trillion per month ($150 billion in physical investment + $70 billion in interest payments).
If the Federal Reserve plans to sell $60 billion of Treasury bonds per month, the Treasury needs to refinance from other bond buyers, resulting in a demand for $300 billion.
The monthly sale of MBS is $35 billion, which is a market liquidity effect (not a new financing demand for Treasury bonds).
The total financing demand for the above three items is $1.77 trillion, while the financing demand announced by the Ministry of Finance for the third quarter is $1 trillion, and for the fourth quarter is $850 billion, totaling $1.85 trillion for the second half of the year.
According to Dolphin Research's estimation, with a fiscal deficit of $1.1 trillion in the second half of the year, the broad deficit rate for 2023 is 7.6%, and the narrow deficit rate (excluding interest payments) is 4.8%, which is still a high level of deficit rate. This means that the current borrowing plan still implies loose fiscal policy.
Based on the analysis in section 3.1), we can make a basic judgment: the US government will continue to spend money like water, and the fiscal policy will still be loose.
3.2) So, who will provide the liquidity in the second half of the year?
As mentioned earlier, the liquidity in the first half of the year came from the shrinkage of the TGA, and as of the end of July, it came from overnight reverse repurchase agreements. So where will the deficit come from afterwards? It is still the same formula: Treasury bonds = TGA deposits + commercial bank deposits + cash in circulation + money borrowed by the Federal Reserve from commercial banks (reverse repurchase agreements).
From August to the end of this year:
On the asset side of the Federal Reserve: If the original plan is executed, a. Treasury bonds + MBS will decrease by $475 billion; b. The $250 billion previously injected by the Federal Reserve to save small and medium-sized banks will also mature gradually.
On the liability side of the Federal Reserve: The TGA will consume $1.1 trillion to pay for the deficit, and at the same time, this balance will increase by $370 billion (the gap in between will be filled by borrowing).
With the decrease in the asset side and the increase in the liability side of the TGA, other items on the liability side need to be reduced by $850 billion.
a. In terms of the financing structure of US bonds, there is a shift from short-term bonds to long-term bonds; the yield on long-term bonds is generally below 5%, while the interest rate on reverse repurchase agreements is high and the term is short, so the interest rate spread and duration no longer match. (Note: Pay close attention to the issuance structure of long-term and short-term bonds in the second half of this year).b. The circulating currency is closely related to the real economy and cannot fluctuate greatly.
After excluding all these possibilities, the ability to withstand such a significant reduction in volume probably relies mainly on the commercial banks' reserve deposits with the Federal Reserve. Currently, the reserve balance is 3.2 trillion dollars, and if it is reduced by 800 billion dollars, it is basically equivalent to a 26% reduction in volume.
Fourth, what will happen if we rely on bank reserves for deficit financing?
- Conclusion 1: Liquidity is drained during the process of increasing debt, putting pressure on the equity market.
Let's take a look at the relationship between commercial bank reserve balances and the equity market: historically, when reserve balances decline, the equity market generally follows suit. Essentially, this means that funds from the real economy are being drained, and equity funds are being siphoned off to the debt market.
- Conclusion 2: Rising long-term bond yields and a strong dollar cycle suppress growth-oriented equity assets.
In a normal economic environment, during a period of high federal deficit rates, the yield spread between long-term and short-term bonds widens. Due to the short-term interest rates being highly anchored to the Federal Reserve's policy rate, the widening yield spread is essentially driven by rising long-term yields. In the current situation of an inverted yield curve, the inversion is actually narrowing.
In this current situation, short-term bond yields are highly anchored to the Federal Reserve's policy rate, while long-term bond yields are already at a high level of 4-4.3%. Let's consider two hypothetical scenarios:
Scenario 1: If long-term yields remain unchanged, short-term yields may asymmetrically decline faster due to expectations of interest rate cuts.
Based on the previous analysis that expansionary fiscal policy offsets contractionary monetary policy, and considering the supply-demand imbalance in the labor market that still needs to be resolved (labor market issues can be followed in Dolphin Research's strategy weekly report), it is not realistic to expect an immediate interest rate cut. High yields indeed need to stay for a longer period of time.
Scenario 2: If high yields persist and short-term bond yields do not decline, then long-term bond yields may remain at a high level.
Dolphin Research believes that Scenario 2 is currently more likely.a. Due to the high level of deficit and the need to address the contradictions in the labor market, high interest rates are required to stay.
b. Among the triangle combination of deficit, TGA reconstruction, and Fed balance sheet reduction, both deficit and TGA reconstruction demands are relatively rigid.
c. Currently, only the Fed's balance sheet reduction is a relatively automatic and controllable action. If the liquidity is drained too quickly and has a significant impact on the capital market, the Fed may continue to slow down the reduction. Previously, due to the crisis in the small and medium-sized banking industry and fiscal ceiling issues, the Fed had slowed down the pace of balance sheet reduction.
Dolphin Research here uses a rough estimate in the industry: assuming a long-term inflation center of 3% (rather than the Fed's expected 2%), the actual interest rate before the pandemic was 0.5%, and it will be 1.0-1.5% in the future. The increase is usually tens of basis points of term premium. The long-term interest rate theoretically reaching around 4.5% is also acceptable, and currently, it is already close to the upper limit at 4-4.3%.
V. Strategic Significance
What are the implications of these changes for investment in the second half of the year? Dolphin Research will briefly discuss the implications.
1) Debt Assets:
a. Currently, even long-term bonds are approaching the central position of 4.5%. After reaching this level, it will be easier to go down than up. In addition, the risk-free return itself is relatively high, which is favorable from both a certainty and marginal perspective. There is an opportunity for bond assets.
2) Equity Assets
However, due to the combination of liquidity drainage and relatively high valuation, equity assets may still need to continue adjusting for some time. But in terms of allocation:
a) Bond-like equity assets: Equity assets with good fundamentals, dividend-paying ability, strong defensive capabilities, and resistance to decline.
b) Truly counter-cyclical new technology cycle assets, but they need to adjust their valuations to a reasonable state - such as NVIDIA, Tesla, etc.
The allocation of these two types of assets should be adjusted according to the macro rhythm.
3) Under these changes, what about Chinese assets?
In addition to using bond-like equities for defense and growth stocks for offense as mentioned above;
a) Hong Kong stocks are on the edge of the US dollar liquidity market. When the US dollar is drained, Hong Kong stocks and corresponding RMB assets will experience larger declines.
b) However, fortunately, the valuation of Chinese assets in the current Hong Kong stock market is already low enough, and most Chinese asset companies either have good performance or weak performance within expectations. From a fundamental perspective, it is weak fundamentals with sufficient expectations and often in a BEAT state.
When the US dollar liquidity is drained to a certain extent, further suppressing valuations, it will actually fall into a safer margin faster. In the absence of larger external macro changes (such as war narratives, etc.), the pit of liquidity drainage will become an opportunity for domestic funds to bottom fish and achieve excess returns.
Risk Disclosure and Disclaimer for this article: Dolphin Research Disclaimer and General Disclosure
Please refer to the recent Dolphin Research portfolio weekly reports:
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- "Inflation vs. Liquidity Drain, Tough Times Ahead in the Second Half of the Year"
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- "Has the US Reached the Peak of Interest Rate Hikes? Is There Hope for Hong Kong Stocks?"
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- Is the US Stock Market Still Celebrating? Economic Schizophrenia, Beware of Excessive Optimism
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