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The Big Conversation

Episode 64: Will reflation kill the economy

This week we look at the success of the reflation trade and how higher equity prices are diverting capital from the real economy, higher commodities are a threat to margins and higher real yields could be a headwind for risk assets. The higher equities go, the worse it is for economic growth. Perhaps the Fed put on stocks is lower down than most people expect? In this week’s chatter we talk to FTSE Russell Managing Director and Head of Global Investment Research, Philip Lawlor, who outlines where yields can go before they become a problem for risk assets.

  • [00:00:00] Policymakers have a problem, they are throwing huge amounts of stimulus into the mix, but they're getting rewarded with higher commodity prices and higher equity prices before we've had an improvement in true growth. Whilst U.S. equities are a discounting mechanism, they appear to be discounting direct transfers of fiscal support from the Treasury into retail back pockets rather than profits being generated by a healthy economy. Higher commodity prices will impact margins, whilst higher equity prices make investing in stocks look far more attractive than supporting the real economy. The switch from monetary support toward fiscal support last year was supposed to shift the pendulum away from the last decade of soaring equities, despite sub-par growth of around two percent, to one of reflation and economic rejuvenation. Instead, we're now in danger of seeing a supercharged version of that period. Yes, we can expect GDP to rebound from the depths of 2020 and inflation to surge on the back of base effects, but true reflation needs economic growth to take the lead. Instead, it appears that rising equity markets could starve the real economy of capital. Rising commodities could impact input costs whilst rising bond yields could cause equity markets to come unstuck. In this episode of The Big Conversation, we'll be looking at some of the difficult decisions that policymakers need to make.

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    [00:01:24] So bond yields are finally beginning to impact equities, although so far it has been in the form of a powerful rotation from growth into value. That has come with some wobbles in the broader equity market. But the Dow Industrials has just made a new all-time high, even as the Nasdaq dropped 10 percent, its 9th fastest ever 10 percent correction on record. S&P volatility has remained very well-behaved so far. The quarterly expiry on the 19th of March may also be influencing the huge gyrations in popular retail stocks with high open interest in the options market. But all eyes are on the Fed who meet on the 17th of this month. Sharp equity falls have often provoked a policy response. So far, the sharp declines have been contained to a specific corner of the equity market that many argue is overdue some underperformance. Since the days of Alan Greenspan as head of the Fed however, there has been much discussion of the "Fed put" the supposed backstop to prevent excessive market, downside risk and volatility. We see many prominent examples of Fed intervention over the last 25 years, including the 1998 LTCM and Russia crisis, the dot com bust and the great financial crisis of 2008. Although the Fed's efforts had little impact on those last two where the clearing level for equities, was 50 percent below their peaks, despite aggressive rate cutting programs. Since 2008 the Fed has been sensitive to even minor pullbacks, consistently flip-flopping from a tightening to a listening bias every time the stock market came under pressure. In late 2018 it was their own rate hiking policy error that caused equities to accelerate into December the 24th, forcing them into a rapid U-turn. The justification in favor of the central bank intervention was the perceived importance of the stock market as a positive driver of wealth effects that would spur future economic growth. But did this really happen? Well during times of significant Federal Reserve intervention in the 2000s, Wall Street did very well, but not so much Main Street, who had not really recovered from the euphoria of the dot com era. In fact, the feedback loop of consistent rises in the stock market, fueled by a cap on rates, has led to a misallocation of capital and huge wealth inequality. Abnormal profits are the rewards of the entrepreneur, but abnormal equity returns have become the norm of accounting tricks and short term corporate goals. Therefore, does Fed Chairman, Powell need to adopt a different approach? In order to encourage capital into the real economy, they may need to make the equity market a bit less attractive as a destination. In fact, perhaps the Fed should actively discourage capital from seeking out an excessive equity return. The truth is that the Federal Reserve put has become too successful and instead of being a means of sustaining economic growth, it has become a major factor in spurring dangerous speculation that will detract from true reflation. How can wages increase when management in some of the most levered and inefficient companies are being rewarded for poor or non-existent profitability? A recent study by Deutsche Bank, for example, shows that for the 18 to 54 age group, 37 to 50 percent of incoming fiscal benefits are expected to go into equities. Or put another way, 50 percent of fiscal checks are not going into the real economy and growth. Now fiscal checks are only a small part of the one point nine trillion fiscal package, but we will not see true reflation if their punted on risk assets. The Fed's balance sheet has already been bloated to several trillion dollars, and the idea was that this Fed intervention would reboot bank lending and revive economic activity. But commercial banks don't lend reserves just because they have them. They need a client who's willing to borrow, a project worth lending to and collateral to protect against risk. If these are lacking, no amount of reserves will do the trick, and especially not when the government is willing to pay interest on their reserves. This is not an environment conducive to economic growth. And whilst much the focus remains on the equity market, the real constraint for policymakers is the growth in the stock of fixed income products from corporate to government bonds. These huge levels of debt relative to GDP, which have ballooned during the Covid pandemic, will only increase the sensitivity to faster and higher rates. The Fed put may therefore be in the fixed income market rather than the equity market. We're already seeing examples of yield curve control initiated by other central banks around the globe. In fact, a fall in the equity market might well have a beneficial impact on investor expectations if it collectively drives their capital into other investment opportunities or even just toward the sort of consumption which might finally help ignite the velocity of money again, which has collapsed despite the stimulus. To be sure, the Fed won't want a collapsing equity market. And if anything, the Fed put has actually been a cap on all types of volatility, equity, bond, and FX in order to ensure an orderly market. But if stocks were to drift lower from here, it might also take some of the fizz out of the bond market and help keep yields from triggering a true market collapse. The Fed and the Treasury need to find a balance between letting the economy run hot, but without a sharp rise in real yields that could hurt risk assets. But it also needs to find a way to direct capital towards the real economy so that growth, and that's real economic growth, can start to build and potentially recoup all the job losses of the last 12 months. Until we get back to full employment true reflation is unlikely. If equities and commodities are rising without true growth then the labour force will not be healed. So the key question for many market participants is what are the tolerance levels of both the market and the Fed for higher yields? Will the Fed bring in yield curve control to cap yields before the equity market reacts negatively to higher yields? Or will the Fed continue to be reactive and wait for the equity market to call for a rescue? Bolstered by past successes, they may be happy to let bond yields keep moving higher for now, especially if higher yields then provide more room to cut again in a future crisis. Even better for the Fed is if they announce the probability of yield curve control and yields automatically find their equilibrium level in the knowledge that the Fed will move from implicit to explicit policy if a specific level is breached. It's worked for Japan, with only a few moves out of the channel in recent years. However capping bond yields and capping the curve will have implications for financials. Currently, banks are performing extremely well, but in Japan, the ratio of banks to the broader market is still near the historical lows, and that ratio continued to fall after yield curve control came in in 2016. Capping yields could discourage banks from lending, again preventing the type of private growth that policymakers wish to stimulate with fiscal tools and driving investors straight back to the equity market for their capital gains fix. So there may well be a Fed put in operation today, but policymakers may just be thinking to themselves, "how do we make the real economy more interesting"? That could be achieved by making the equity market a little less interesting. Rising equity markets may be surprisingly bad for the economy because the higher they go, whilst growth is lagging, the more attractive they become as a destination for capital. Central bankers are not about to let the equity market take a nosedive, but they may be tolerant of lower prices if they can manage them down gently, rather than those straight down events like we saw last year and at the end of 2018. Curbing all forms of stock market volatility may therefore be running counter to the objective of an economic recovery that starts solving some of our deeper rooted problems. Now, obviously, the question of bond yields is perhaps the most pressing concern for investors today. So in the next section, I talked to Philip Lawlor, Head of Global Investment Research at FTSE Russell, with over 30 years prior experience managing multi asset and equity funds, about where bond yields could go and what that means for risk assets. 

    [00:08:59] Rising bond yields have recently been triggering rotations within equities and underperformance in emerging markets. But how far can yields rise? 

    [00:09:06] Well, in determining the danger that higher bond yields pose for risk assets, we've got to firstly determine what's driving the bond yields higher. And there are several elements here. One is this could well be bond yields responding to anticipation of a pickup in nominal GDP growth reflation narrative, bearing in mind longer-term nominal yields relate to nominal GDP plus or minus some sort of term premia account. Now, if that is the case, that's quite supportive for risk assets. That's telling us that we can anticipate a good recovery in operating leverage, in profitability, and that will then be us going back to a world of the negative correlation, what's good for for for equities is bad for bonds and vice versa. Of course, if the move in the bond market is all about a pick up in inflationary expectations, and bearing in mind the last three months, the key driver of the nominal yield has been breakeven inflation moving higher, then if this is telling us there's a sustainable move in inflation, that's not so good for risk assets simply because, as we saw in 2011, the markets could work out that that's got serious implications for corporate margins and real disposable income. And the other element is just really one of whether this is all about the bond vigilantes getting concerned about the central banks being not appropriately, appropriately positioned in terms of their accommodation. And as we saw in 2013, when you had the 'taper tantrum', the bond market moved ahead of forcing the central bank, the Federal Reserve, to taper its balance sheet. And this is, again, not so positive for risk assets. If this were to occur, then we're going to have the whole conjecture about whether there's a risk of what we call policy mistakes being injected into markets. Where bond markets go? I think we've got to take a long-term view on this and understand that bond markets and yields have been in a 40 year decline. They were in the high teens in 1980, they fell to sub one percent in the US last year. But if we look more recently, I think what we saw was an overreaction to the downside last year in reaction to the Covid deflationary risk, and there's a bit of mean reversion, I think the markets are naturally mean reverting back to the levels they were prior to the Covid shock of roughly one and three quarter or two percent. So it's more the manner of which they go. Going back to their over gradually in an orderly manner wouldn't spook markets too much I don't think. If they go in in one very sudden jump, that becomes a sign of more disorderly functioning. 

    [00:11:56] Rotations from growth to value stocks has been a key element of recent weeks. But can this momentum continue? 

    [00:12:03] The rotation element is a very interesting one here. And I think, again, we've got to understand, there are possibly three drivers of that. The first goes back to the natural inference if you're getting more growth expectation being built into markets, that people are looking for sectors that will participate in that economic recovery, both cyclicals, but clearly financials would benefit from that type of economic move as well. I think you've also got the clear inference from a steepening of yield curves and the pick up in bond yields that that's positive for net margins in the banking sector. That's the second positive. But the third one, I think, is the more significant one, which is a rising bond yield. Rising discount rate puts a lot of pressure on the highly valued quality stocks, these growth stocks that have been the star performers for the last four or five years in the markets are now bumping up against valuation headwinds, courtesy of this pick up in the discount rate. So the bond market is starting to give very strong signaling about the need to rotate out of these quality stocks into the value stocks and financials and banks are the key way of playing that type of factor rotation. 

    [00:13:18] Over the last decade, US equities have generally outperformed other major benchmarks. But can that leadership now come under sustained pressure? 

    [00:13:25] This is a 64 billion dollar question, is in terms of leadership shift is how significant will this be if we do start to see a really sustained move out of the US technology sector, given the US tech's dominance of both the US market, but also being the contributor, the driver of US outperformance, then this could create quite a big sort of feedback loop. I think the key thing to watch here will be whether you see this reflected in the US dollar. Asset allocators are very attuned to this, in the fourth quarter, we saw people playing the reflation trade as being dollar negative, and that was all off for growth differentials. But at the moment, what we're starting to see is people looking more at interest rate differentials coming back in, and that's adding a bit of support to the dollar. But the DXY dollar index was hitting key support levels, and that was very germane to whether this becomes a proper capital flow story out of the states. If the dollar were to weaken further from here, then I think you would see asset allocators looking to most probably move money out of the US into non US markets. I don't think we've seen that yet, but I think that's clearly going to be quite a key thing to focus on over the coming weeks. 

    [00:14:47] The next FOMC is on the 17th of March. So far, the Fed has been relatively confident about the policy tools at their disposal. 

    [00:14:53] Jay Powell is doing all he can to tell people 'we're not going to be panicked, we're not going to be spooked' we're going to maintain the view of being patient. I think that is the correct stance. They're well aware of the headwinds that the US and other labour markets around the world are facing over the coming months and that, yes, we are seeing some pickup in inflation, but it is most probably short term cost-push inflation that won't be permanent. And I think then they're going to be fairly relaxed to this higher bond yield. As I said, I think the thing that will create the problems is if it's seen as a disorderly move in the bond yield, if it's too rapid, too sudden, the vigilantes give it too much of a push, and the accusation is then that the Fed is behind the curve. That's when it becomes problematic. But I actually think they've got lots of firepower in terms of reinvigorating Operation Twist, going to formal yield curve management as a way of containing that. And I don't think, as I said, the Fed would worry if the bond yield went back to the levels it was at the start of last year, one and three quarter, two percent. 

    [00:16:03] The Fed will be watching closely. Markets are resilient to relatively gradual changes in bond yields in the dollar. But if the dollar and yields start to move too quickly, the Fed may be forced to increase its QE operation or initiate yield curve control to cap yields. If they do that, then risk assets and inflation expectations should have a lot further to run.