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The Big Conversation

Episode 83: Did central banks stop the reset?

This week we have a conversation with Andrea Zazzarelli, Chief Investment Strategist at Fathom Consulting, about whether the economy and market have entered a new cycler after the COVID recession, or whether policymakers have supercharged the previous one. Using Refinitiv’s best-in-class data, they look at the before and after growth trajectory and the impact of fiscal policy, as they answer a question from one of last week’s viewers. The direction of inflation is probably key to understanding if this is a new cycle or the old one on steroids.

  • Roger [00:00:00] Last week, we looked at whether the economy was undergoing a mid-cycle slowdown, since then, bond yields have continued to fall, with the 10-year yield continuing to shrug off the higher inflation data and nudging below the 1.13 mark, suggesting a slowdown in activity. One of the questions we received, however, asked whether the pandemic was merely a drawdown in asset prices and that instead of resetting to a new cycle, the old cycle was still in play, having been supercharged by the government response. It was a great question, so I spoke to the Chief Investment Strategist of Fathom Consulting, who partner with Refinitiv, about whether the economy has transitioned to a new cycle or whether the old one remains in place.

    Roger [00:00:43] Andrea, great to see you, and I kind of want to get into the, the depths in some ways of where we are, if we are in a different cycle today than where we were? What i really want to think about here is, when we had the pandemic, we got the recession. Now was that recession a reset, or was it not? Did we see, or are we seeing the old cycle continue? But before we get into that, what I'd love to get your view on is roughly where we were on the old cycle, before the pandemic hit, where were we in terms of growth and how the economy globally was doing?

    Andrea [00:01:14] Yeah, that's it's interesting because the pandemic hit at a very interesting time, which was, if you remember, post GFC, I think that the cycle was dominated by a series of mini-cycles in a way that were dominated by the ebbs and flows of monetary policy. And right at the end of twenty nineteen, we were probably at the trough of the, one of those mini cycles and things were actually looking up as far as we were concerned. Part of that was I think what we'll look at 2019 is quite being quite perhaps, a large pivot in terms of policy, because you know what dominated 2019 particularly the second half, was the Fed doing a massive U-turn on, on hikes, and really that paved the way for fiscal policy being the dominant force from a macro standpoint, something we haven't seen for decades. And actually that played really, really nicely as covid hit, because the fiscal transfers that had been put in place where fundamental in helping navigate through those periods. Monetary policy took a little bit of a backseat to fiscal policy throughout covid they did still massive QE amounts and transfers, risk transfers by absorbing corporate debt, for example, which was all very helpful in maintaining credit flowing. But I think what the normal factor was really putting cash in the hands of the consumers. So, yes, it was in my view, covid did reset the cycle, with and with some peculiarities, particularly with regards to fiscal policy.

    Roger [00:03:20] And in some ways, what we saw, I guess, was that, you know, what we normally expect from the end of a cycle, when it's a recession is the recession has been formed because of the business cycle beforehand, whether it's over-leverage, or whether it's a bad reaction from the central bank, which might obviously be to over-leverage. When we came to that, and when we got to the end of 2019, obviously we had very, very high levels of corporate debt already. Household debt was quite high. Then we got the recession, and it was such a shock to everybody, the speed it came because it was an exogenous shock. And the response, as you say, the fiscal response came very, very rapidly with that off the chart monetary. Did we get the deleveraging that we normally would get? Because normally people would say end of a cycle, you get deleveraging, you get a reset, not just a recession, but a reset. Did we actually get a reset at the end of the last cycle as we came through?

    Andrea [00:04:14] So we didn't quite get the reset. If your template is one that is, that you're using as the one from the GFC, I think, or even the dotcom bubble, we certainly didn't see a deleverage in terms of the amount of the company defaulting. As we said, monetary policy was laser focused on making sure that didn't happen in terms of making sure that, you know, they locked up secondary offerings in the corporate market, and even primary issuance. Where we saw some deleveraging was, has been really, in the household sector. So those fiscal, large fiscal checks that have been issued by governments throughout the world, particularly the Anglo-Saxon world, has been much more generous than the cash transfers. That have helped, they helped consumers pay down debt. And also some of them have been saved up, that's why we've seen massive spikes in savings. That is something that is part of why I think it's a different cycle, because those dynamics will be well into play before in 2019 or even the early part of 2020, and they will deeply shape where we're going to go next in terms of the macro landscape and eventually the market landscape.

    Roger [00:05:37] Do you think that the, you know if we sort of have fiscal coming in effectively being a sort of reset. Are we now in a position where policymakers have effectively ended at least the cycle for risk assets? Because it feels like almost you know, if you're an alien looking at the world today, you go, oh, wow, you know, when you have a deep, fast recession and asset prices rise, then actually slow growth or no growth or negative growth is really good for asset prices, which seems kind of weird because obviously 20 years ago, it was always the other way round. Are we now in a world where this is a market which will suffer if we see growth pick up and yields go up because it's instability for asset prices? And are we still in the world where low growth and the threat of liquidity, fiscal and monetary, is what really is driving things? So actually we don't want growth, we don't want to go back to anything showing real growth?

    Andrea [00:06:30] I don't think we want don't want growth, I think. I think we do want growth. But I think what you said is spot on in the sense that the market, due to policy choices, have basically the big policy innovation that we've seen in 2020 is basically throwing out the towel on the austerity. So now we have procyclical fiscal policy at the same time as we have procyclical monetary, monetary policy was still extremely accommodative monetary policy. And that has led essentially to a market priced to perfection, and any small changes that might disturb that pricing to perfection will create market wobbles, that the, complication is that navigating those markets is become much riskier because their priced to perfection, but also more difficult from a macro standpoint, having to disentangle how, the transmission mechanism from policy, to economy, to markets is much more complex now that was post-GFC.

    Roger [00:07:47] And within this sort of within this cycle, I sort of actually have sympathies with the view from the person asked the question that there's a lot of traits of the old cycle that never ended, they just got extended, in fact, almost on steroids. But at the same time, what I was talking about last week was that we sort of moved from this early phase of cyclical stocks and commodities doing really, really well, to now in this patch where bond yields have started to surprise to the downside. Where do you think this is? Because the reason why people think it's sort of mid-cycle it may be these very, very concentrated shorter cycles now is because we've gone from what was very clear, a reflationary stroke inflation impulse, to now something where people are going, oh, crikey, what's going on here? Where do you think or where do you stand on that? Are we just seeing one of these dips that you always get as a recovery moves on, just happening a bit quicker? Or is it that the excess or that the belief in the inflationary story, maybe it's got a little bit ahead of itself?

    Andrea [00:08:40] I think we are in a very interesting juncture. I think the way I characterise it is that through the very effective policy that we've had, helped us navigate covid pandemic, one of the effects has been actually growth has constantly surprised on the upside. So we've seen this over and over. Even in the recent months. Growth has kind of being progressively been upgraded. But there are also base effects to that growth that are coming on stream. And so now we have, so we've got, been progressively better growth, but also we're sitting right on the cusp of those peak base effects. So we're looking ahead, the pace of growth is set to slow down. So I think the market is contending a little bit with those two, with those two forces.

    Roger [00:09:45] And what you talked about, the fiscal side of things, we're talking about what is a new era of fiscal? It's probably the first time we're seeing fiscal dominate in this way since really Thatcher and Reagan in 1980. But at the same time, what we're now getting from in the US is well we're going to do fiscal packages, where we give loads of money and build infrastructure, but we might put up taxes, corporate taxes, income taxes, capital gains taxes. Do we, when we talk about because what we're really talking about here, if we're having inflation is loose monetary and loose fiscal, is it loose fiscal if we get packages for infrastructure, but also taxation on the other side? How should people think about that?

    Andrea [00:10:23] I think that is the crux of the question. That's what makes fiscal policy the added complication to this new cycle, in our view. And I think the big pivot there is that with fiscal leading the way, fiscal puts money into the real economy first, unlike QE, which at a first approximation worked by putting money and liquidity into financial markets first. So the financial market reaction is a little bit of a derivative of what may happen in the real economy once that liquidity plays out in the real economy. Whereas in the old world of the GFC you had portfolio rebalancing effects, the market would rally risk, it would be risk on risk off, very dominated by the ebbs and flows and liquidity. Here if you want, inflation is a symptom of that fiscal liquidity being in the real economy. And I think, the way we see it is that I think by this, I think the central banks would be very happy with a little bit of inflation going forward, and partly because, as you said, avoids having to raise taxes as much as they would have had otherwise. Basically inflation is a tax if you want, it's a stealth tax politically much more acceptable than having wrangle through Congress or in order to pass it. But I think the biggest risk for markets going forward is that if inflation does get out of shape and forces the hand of the monetary policies, I think that's the biggest risk to be honest. We don't think it's our central case scenario. I think central banks will see through the inflation. But unlike what central banks are telling us, we are a bit more sceptical, I would say, about how transitory these inflation shocks might be. This inflation story still has got legs, this reflationary stories, and how it plays out. If central banks do hike rates, which we don't think they will, but in that scenario, we will see, you know, incorporating that scenario is in our overall risks for the markets. We would see probably one in four, one in five chances of a twenty percent decrease in equity prices by the middle of twenty twenty two. So those, those are the kind of risk that we would attach to that, that come to that come with the market being already priced to perfection and the risk that central banks might be forced.

    Roger [00:13:08] And do you think that because what you're saying with the fiscal side, are you, so are you expecting that this very large record level of personal savings, you know we've seen the savings rate going higher, personal savings are built up, trillions of dollars. Some of that's already gone to deleveraging. Do you think that's still a large amount of that that will come in as spending and it will be a wall of spending at a time when we still tight on supply and therefore, that's what you're going to get inflation from?

    Andrea [00:13:33] Exactly. I think that's part of the story. I think obviously that the bottlenecks is part of the story. But even I think the way, if you look at central bank’s assumptions about their outlook for inflation, they were originally built in on a five percent gradual decrease per year of this increase in the stock of saving, which we thought was way too conservative. Then they kind of changed to 10 percent. If you look at some of the surveys, and that's also where we are coming out in terms of our assumptions and modeling these scenarios, we see that what's more reasonable to expect is some, somewhere around the region of twenty-five percent of the savings will be drawn down over the next two or three years.

    Roger [00:14:20] It sounds like overall then that you, that there are many elements of the last cycle that have rolled over into this cycle. But the key thing here is because we started fiscal, we've never had the fiscal before, not in this size and style before. But you would therefore say that this is the beginning of a new cycle, one that's going to be driven by fiscal, one where we don't really have a playbook for it, so we're just going to have to kind of find our way through the weeds as it goes along?

    Andrea [00:14:46] It's a much more complex playbook, that's all. I mean, I think throwing austerity out of the, out of the equation, I think it's, you know, the markets, people playing, not playing, but investors, they will need to understand the interplay, not just the monetary policy, but how liquidity is being impacted by fiscal supply, increasing bonds. I think if fiscal as, if we all end on fiscal, which to some extent seems like they are, the austerity orthodoxy is largely out of the window I think, then you know we need to understand that more debt supplies, mops market liquidity, takes liquidity out. And that's what QE is going to start doing. To a large extent, QE is essentially offsetting larger fiscal supply, that supply, then we're in a market environment that again is priced to perfection and liquidity dynamics will be very different.

    Roger [00:15:56] Many of the traits of the old cycle do remain in place, particularly the high levels of debt and leverage. Clearly the equity market, at least in the US, has been a major beneficiary, though many now are thinking it's in bubble territory. Some households have delevered and are now sitting on significant savings that could quickly be turned into consumption. So many of the old trends have been supercharged. The key differentiation between then and now is the deployment of fiscal policy to supplement monetary policy. This has altered the outlook. Whether you believe in inflation or not, the inflation debate is alive in a way that it wasn't two years ago. And this will probably be the deciding factor. If markets settle back down into a disinflationary trend after a quick inflationary shock, then policymakers have probably prolonged the old trends. If we see inflation surprise to the upside for an extended period of time, then we can probably class this as a new cycle with each section compressed into a shorter time frame. The answer to whether this is a new cycle or the old one prolonged therefore probably boils down to the debate about whether the current price spike is transitory or not.