by Thomas Aubrey.
The “Three Amigos Summit” on Nov. 18 in Washington D.C. appeared to reinforce President Joe Biden’s shift towards Trumpian protectionism. Biden refused to budge from his position of using tax credits to support domestic production of electrical vehicles, potentially damaging over 50 years of voluntary cooperation and trade integration between U.S. and Canadian firms in the automotive sector. On Nov. 24, the U.S. Department of Commerce stated it will impose duties of 17.9% on imported softwood lumber from Canada, which is twice the previous rate of 8.99%.
This shift towards protectionism should be of grave concern for investors as less-open economies are subject to greater inflationary pressures from rising labor costs. This is why the lurch towards protectionism in the United Kingdom following its exit from the European Union has depressed U.K. asset valuations despite their relative cheapness, and will continue to do so as set out in last quarter’s note.
Figure 1 highlights that despite the disruption to global trade caused by the pandemic, France and Germany are close to or have surpassed their 2016 levels of trade openness. The U.K.’s dramatic slump in trade openness – by more than 10% – shows no sign of reversing from its pandemic lows, and while the U.S. has bounced back from the pandemic lows, it is still down 4% from 2016 levels.
The concern for investors is that Biden’s protectionist outlook may not only prevent trade openness returning to its 2016 levels but send it into reverse, thereby stoking a sustained bout of inflation, negatively impacting asset prices.
Exhibit 1: Comparisons of trade openness since the re-emergence of populism
The current outlook for U.S. equities based on trended near term profits is positive despite current market anxieties about the omicron Covid-19 variant. Critically, this continued positive outlook for U.S. equities is supported by increasing corporate leverage, indicating that firms are anticipating higher future expected demand. Furthermore, consumer leverage hit its lowest level in nearly 25 years in Q1 2021, highlighting the potential for a significant rise in consumer demand following on from the increased level of investment by the corporate sector.
Exhibit 2: US Near term profit expectations and leverage ratios
Source: Refinitiv Datastream, Credit Capital Advisory
The main concern for investors is whether nominal and real bond yields will jump, thereby driving up the cost of funding and reducing profitability. Hence what ultimately matters for equity investors at the moment is the trajectory of yields. Although U.S. government bond yields have widened considerably over the year, they are still below pre-pandemic levels.
Crucially, the more important BBB rate, which determines the cost of funding of a typical corporate, has seen less volatility and is now around 2.3%, indicating that it expects inflation to fall, permitting real yields to creep up again towards positive territory. In addition, the market is beginning to take greater account of credit risk, pointing to a greater degree of normalization, with CCC spreads beginning to widen. This should be viewed as a further positive sign for BBB firms.
Exhibit 3: U.S. bond yields by credit category
The latest quarterly credit transition matrices from Credit Benchmark for North American corporates based on over 40,000 observations indicate the upgrade / downgrade balance is at its lowest level for bbb rated obligors compared to the 2018/19 period. This demonstrates that banks do not expect to see much credit deterioration for bbb rated obligors. Moreover, high yield names are also seeing significantly more upgrades than downgrades indicating the economy is still in the early phase of a new credit cycle.
Exhibit 4: Credit transitions by rating category
Source: Credit Benchmark, Credit Capital Advisory
While it is possible that both the U.S. bond and equity markets have it wrong about inflation, most of the inflationary debate has focused on micro data rather than on wages. But what ultimately matters for investors is what happens to wages rather than inflation per se, as inflation is impacted by numerous transitory factors. This is why both Paul Krugman and Scott Sumner have noted that inflation vs unemployment analyses are largely useless.
A brief analysis of the wages situation does indicate a rise in private sector nominal wage growth at 4.1% year on year, although real wages are still declining. This higher rate of nominal growth is why there are increasing calls for the Federal Reserve to accelerate the scaling back of their asset purchase program. The U.K. economy which has been hit by a much larger protectionist shock, is seeing rising real wages, and much faster year-on-year growth of private sector earnings of 6.5%, although some base effects remain in the numbers. In addition, the number of PAYE employees is above pre-pandemic levels with record job vacancies.
While the outlook for U.S. equities is still positive, if Biden’s increased protectionist rhetoric becomes a reality, then sustained wage-driven inflation can be expected. If that is the case, U.S. equities will start to underperform, following the United Kingdom down a road of poor returns and eroding investor confidence. Protectionism is bad for investors.
Thomas Aubrey is the founder of Credit Capital Advisory.