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Episode 9

The fiscal future 

Published on: December 23, 2019 • Duration: 15 minutes

This week we take a look back at the stranglehold that monetary policy has had over markets. Despite the best efforts of central banks, growth and inflation have remained sluggish, whilst the very investment framework is undergoing a structural change. Will fiscal policy break that deadlock over the next 10 years or will this change in direction break the market?

  • [00:00:04] In this, the final episode for 2019, the big conversation, we're going to take a look back at the last decade, a decade in which central banks played a pivotal role in the era of monetary madness. And then we’re going to look forward to the next decade and ask if this will be about the rise of fiscal policy and MMT. These days, it's almost taken for granted that the current investment environment is a normal investment environment. But I'm sure that the last decade will reverberate throughout economic history because of the influence of central banks and maybe ultimately their impotence. Central bank balance sheets expanded dramatically with the combined efforts of the Bank of Japan, the People's Bank of China, the European Central Bank and the U.S. Federal Reserve adding around 13 trillion, an unimaginable number a few years ago, to the balance sheet since 2008. And as you can see on this chart of bond yields against periods of U.S. and European QE, and I could have used inflation expectations on this chart as well, it would have been the same pattern. But these yields have fallen over the last decade quite dramatically, which is what you'd expect when central banks are buying bonds in vast quantities, although yields fell the hardest during periods in which the central banks weren't active and then tended to flatline or rise during periods when they were active i.e. yields were rising and bonds were falling, when the central banks were buying bonds. Now in the face of it, that would seem to be the wrong way round. And I think what it does is it reflects just how broken the global economy was in 2008, where without the central bank juice, yields and economic growth could potentially sink into depression type levels. Maybe yields should have fallen much further in 2009. And this dynamic has seen some real absurdities appear. And at one point we had 17 trillion of negative yielding debt globally in 2019. We had the hundred year Austrian bond doubling in value over 12 months and people believing that the Argentinean hundred year bond would not default. I mean, I want to call them anomalies, but they've become normality as they've arisen because of this rampant money printing, which rather than creating inflation, which was the initial expectation of pretty much everyone in the market in 2009, its ended up lowering inflation expectations and these lower expectations have helped guide bond yields to even lower levels. But why is growth so low? Well, I think the system was broken and this repeat of free cash was not the fix. But as balance sheets rose, velocity of money collapsed in a self-fulfilling prophecy. Yields fell, discouraging investment and lowering long term expectations further. So capital effectively transferred from central banks and found its way into things like corporate buybacks with very little economic value outside of the wealth effect for the wealthiest. And yet the US has experienced its longest expansion, but it's just not been a very powerful one. And equity prices have outperformed equity profits, whilst the usual balancing mechanism of valuation has been distorted by the rise and rise of passive investing at the expense of active investing. For investors, this has been one of the most monumental changes over the last decade. The shift out of active mandates into passive mandates that include rules based investing, such as minimum volatility in risk parity, it's been quite a truly stunning move, and if it carries on at this pace, we even see the end of investing or at least investing as we have known it for the last 30 40. Who knows? Hundred years. Falling bond yields make equities look relatively more attractive and appealing, even though in absolute and historical terms they are pretty much expensive. And into this bizarre world, we now have investors buying bonds for capital gains and equities for income, which really is the wrong way round. But maybe that's going to be normality for the next 10 years. And so what are some of these other distortions that we've had? Well, we've seen this rise of the unicorn and this plague of zombie companies, which are another offshoot of central bank largesse. Unicorns, which are generally tech oriented stocks or, like We Work, stocks that want to sound like they were technology stocks. They managed to attract sky high private valuations without ever turning a profit because cheap capital was always available to support them. Well, that may now have come to an end with some of the WeWork Debacle. Zombie companies are companies with terrible growth prospects, and often these are our old world models in desperate need of CapEx. And they were and are still able to raise capital. And the credit markets in order to fund the gluttony of share buybacks juice their share price higher. So companies that probably should have failed by now have been plugged into the life support machine of endless central bank credit, even looking healthy to shareholders. And the share buyback is clearly one of the dominant forces of the last 10 years in the equity market, particularly the US. But effectivelhy that's a transfer from taxpayers to shareholders and also from workers to shareholders because wages were getting squeezed and that was in order to maintain margins. Their overall profits, as we've seen earlier, have gone nowhere. And this has also led, therefore, to this ever burgeoning stock of triple BBB and high yield corporate credit, I think triple B accounts for about half of US investment grade debt with one or two large corporates accounting for a significant portion of the total. And overall, the spreads of high yield versus investment grade have compressed as have tripled versus double B, and this compression could be a negative sign for the future as it tends to occur towards the end of the credit cycle. So the stock of credit has built to a record level. Spreads are tightening. But what could be the tipping point? Well, that's kind of looking to the future. And I guess the important thing is what is the next 10 years have in store for us? And is there anything out there that could be this tipping point? Well, if the last decade was unquestionably the decade of central banks and monetary policy, the next 10 years are expected to be the decade of fiscal policy, leaning on the monetary efforts of the central banks to helpfully fund spending sprees whilst keeping markets in check. And governments the world over are either contemplating this direction or have already engaged in it. And economists have been falling over each other to encourage it. And their mantra is not that unorthodox accommodation hasn't worked, but rather it's that it's not been done in sufficient size. And central bankers and policymakers have taken the view that they can spend and spend and spend because interest rates are so low. And this is something that Kenneth Rogoff, who wrote the book This Time is Different, has noted is a very, very dangerous supposition. In fact, in an op ed he wrote in December 2019, he argued that the notion that almost every advanced economy can allow their debt to drift up towards the Japanese levels without any great concern about long term consequences is very flawed for a large number of reasons, not least because it largely assumes that the next crisis will be like the last, which is very unlikely. But nonetheless, moves are already underway to engage the fiscal authorities, i.e. governments on a spending spree. And this is why when Mario Draghi, who is the outgoing ECB president, his parting shot was a return to unlimited bond buying. And many have pointed out that the ECB will be limited in its efforts because of the capital keys, which will prevent the ECB from buying more than, I think it's roughly 30 percent of any one country's debt. And yes, that's true. But if each government now increases the amount of debt in circulation in order to fund a spending binge, then the potential for debt purchases is indeed unlimited, at least until the ECB is 2 percent inflation target is reached, which many cynics think could be never. But as we know from what Draghi said, the ECB will do whatever it takes. And the big question on the back of the fiscal impulse is will this change the inflation risks from deflation or disinflation to inflation? The inflation debate is always wracked with controversy. However, in this instance, what I'm talking about is the sort of inflation that forces the Fed or other central banks to react faster and harder in terms of raising interest rates. Now, there's a strong case to say that future inflation risks under a concerted fiscal regime will swing the risks from persistently low inflation and low growth to significantly higher inflation because the fiscal policy will have a higher velocity than monetary policy and QE, which mainly found its way into asset prices rather than economic growth. However, others will rightly point to Japan, which has been experimenting with extreme forms of both monetary and fiscal policy, and point out that it didn't really have a significant impact on Japan's GDP growth because the headwinds of demographics and debt and those headwinds can be seen in many parts of Europe and Asia today as well. Therefore, one of the key questions with fiscal policy is how long, if at all, but how long will it take to shift from low inflation to high and dangerous inflation? Will we get a period of grace where inflation hits a growth sweet spot, which will imply higher equity prices yet again. Within all of this, therefore, what will happen to bonds? We've been in this four decade bull market which has helped support equity prices. But will bond yields start to break higher and decisively move out of this trend channel that's dominated the last 30 years, particularly in the US, where many were already predicting a V shape move in yields with yields moving to the upside until we saw that dramatic move through the summer of 2019 in which we saw that record stock of global yields moving into negative territory. But if higher bond yields increase the risk of a collapse in the ability to service debt and a collapse in equity prices, then any bout of inflation would be very short lived and we would quickly move back into a deflationary bust. And that's not disinflation. That would be deflation. And that's why central banks will continue with monetary policy such as QE and they're going to let inflation run hot whilst holding bond yields down. If inflation does pick up, inflation is likely to outperform bond yields ie it'll go up faster than yields. This will mean real yields will fall. And this is one of the key arguments for holding gold. Gold has been moving inversely to the direction of real yields and real yields - that's nominal yields minus inflation - when real yields fall, gold has tended to go up. And so it's going to be better to be long gold rather than short bonds. If this type of scenario plays out, the relative performance of commodities should improve versus equities as well. Now the ratio of the S&P 500 versus the broad commodity index has been close to the all time wides or lows depending which way you look at it. Fiscal expenditures should increase demand for commodities, but simply don't expect this to be like the China experience of the noughties. No one will be doing fiscal expenditure on that sort of scale. So the outlook for equities remains incredibly uncertain. This current expansion, particularly in the US, is very, very long in the tooth and the equity market is stretched and extreme again, particularly in the US. But can that combination of monetary and fiscal policy keep that overall framework intact? This is also a market that's being driven less and less by fundamentals and more and more by passive flows, which are themselves a direct result of that framework which had been created by that relentless distortion of central bank liquidity. Whilst it's very hard to calculate, it may be that already the stock of passive and rules based funds has now overtaken the stock of actively managed funds. One of the great areas of debate is whether the actions of central banks can continue to levitate markets even if the underlying economy's deteriorated. Now the historical perspective is not good, with both of the equity market collapses between 2000 and 2010 materializing despite the best efforts of central banks. But as we saw in 2015 16, when the markets were on the edge after a bout of US dollar strength and a mini devaluation in China, the central banks stepped in to settle markets with a new round of liquidity in that kickstarted the current leg of the bull market. Central banks have been targeting a low volatility regime, or perhaps it may be more accurate to say a stable volatility regime, but they cannot afford to see disruptive events occur in bond, credit equity or affect markets for equities. We need to keep an eye on the momentum in profits. Credit Capital Advisory shows the relationship between the Wickselliasn differential and the S&P 500 since 2002. Now the Wicksellian differential, it describes whether the rate of profit growth is increasing or decreasing. And unsurprisingly, it's closely related to equity market performance at the experience of the last 10 years has been like a supercharged version of 2003 to 2008. And if the economy and profits are turning, that it increases the risks to lots of highly levered assets could move into a default cycle at the same time. And it's an event like this that's more likely to trigger an economic downturn. So if you look at the rate of profit growth and it looks like it's turned, then there could be trouble ahead. So in summary, if the last 10 years were all about monetary policy and its failure to create economic growth, the next 10 years will be about fiscal policy and a renewed attempt to break the deadlock between lower inflation expectations in order to keep the profit cycle on an upward trajectory. The fear, however, given debt, demographics, pension shortfalls and the extremes in assets across the world is that the one thing that central banks want could be the very thing that brings the edifice crashing back down. And given our starting point, the next few years should turn out to be an exhilarating roller coaster ride for all global investors.