Waiting for Fiscal – Guest Post by Jay Pelosky
This post by Jay Pelosky (bio below) was written for Itau’s Global Connections on April 29, 2016, it covers in depth some of the main topics we’ve been debating on The Ticker District.
Waiting for Fiscal
In Samuel Beckett’s famous play “Waiting for Godot,” the actors wait endlessly and in vain for someone who never materializes. That feeling of endless waiting is on full display in economic and financial circles; hopefully the wait for fiscal policy to join the fight against global economic weakness will not be in vain. The perverse coupling of ever more fearful IMF global growth warnings and new year-to-date highs in global equities suggest an unstable state of affairs. Self-levitating financial markets on one side, and on the other, fretting policymakers worried that it’s all about to implode and wanting to be sure history shows they gave the warning.
It does seem as if markets are finely balanced between fears that Central Banks, the main policy actors to date, are scraping the bottom of the monetary-policy barrel with negative interest rate policy (NIRP) and hopes that perhaps fiscal policy is about to return to the stage, stimulating growth & inflation, saving the day and rehabilitating the reputation of the political class all in one fell swoop. Thinking ahead as to which way the balance might tip – in fear or in hope – is critical, given the strong sense that the status quo will not hold indefinitely.
Let’s begin with a look at why CBs need help, consider how NIRP sets the stage for fiscal policy and examine the big idea that could win the White House before concluding with investment implications (think barbell workouts).
Why Central Banks Need Help
Central Banks need help – they have been throwing pretty much all they have at the low-demand, weak-growth, disinflationary global environment for years, and much to their chagrin, they have achieved astonishingly little. Where they have succeeded is in stoking financial markets and creating political tinderboxes. On the economic front, growth is subpar (at least relative to historical standards if not potential growth rates), while inflation is well below target across the developed economies. Not a great scorecard.
Arguably the ECB, BOJ and Federal Reserve have all failed to achieve their inflation mandates; worse yet, forward break-evens and consumer expectations imply this failure is in danger of being internalized by consumers. Given that debt levels across the developed world are far higher today than in 2008, this failure suggests that future growth will be weighed down by heavy debt, debt loads that are not being reduced by inflation’s stealthy advance.
The recent descent into NIRP by the ECB and BOJ suggests there is indeed a lower bound of rates, marred as the policy has been by concerns about the potential negative impact on banking sector profitability (and rapid negative impact on bank share prices). Attendant currency strength is also disconcerting, though most likely due more to the Fed’s pause in its rate hike cycle. Generating a pickup in growth and inflation with a deeply wounded financial sector would seem quite difficult. Both the ECB and BOJ have implied they would rather extend their asset purchases than go deeper into NIRP, supporting financial markets but not the underlying economies.
As economies weaken, the political environment continues to deteriorate, with the term sophisticated state failure now being employed to describe the slow migration of political discontent from the fringe to the center. We may also be witnessing the beginning of sophisticated economic policy failure, failure generated partly by commission in monetary policy terms: too little, too late, cut short too soon; and by fiscal policy omission: not here, not now.
The US Federal Reserve is in a self-described rate hiking cycle, but three years after then-Chairman Bernanke first suggested pulling back on QE (May 2013), the expected inflation rate in the US has continued to fall, suggesting a loss of faith in the Fed’s ability to execute on a core part of its mission. Such a loss of faith has become a topic du jour and was discussed in these pages last Fall (see “The Big Fear,” published on September 24, 2015). Should investors truly lose faith in CBs, the downside risk to financial asset prices in general and to equities in particular would be significant,
NIRP Fears Stimulate Fiscal Policy Hopes
The fear that CBs may not be able to execute their growth and inflation mandates stands in sharp contrast with buoyant financial markets. This fear of failure and the market and economic implications of such are fueling the IMF’s dire warnings. The questions around NIRP’s rollout and the untested nature of further monetary policy measures (helicopter money) has had the beneficial effect of setting the stage for the return of fiscal policy. A loosely coordinated embrace of fiscal policy is closer to reality today than at any time since the Great Financial Crisis. That is the hope.
How Fiscal Policy Comes to Pass
Fiscal policy is already on the table, though its return has generated very little attention. Perhaps that’s because it is being launched by Canada’s new Prime Minister Justin Trudeau (though someone has clearly noticed – Canada’s equity ETF is up roughly 15% year to date). Perhaps to launch fiscal policy one needs to be a new leader who can make the case for a policy change. The other type of leader likely to embrace fiscal policy is a leader who has very little choice, such as Japan’s Prime Minister Abe.
The BOJ’s surprise decision to stand pat in order to assess its NIRP puts further pressure on PM Abe. The upcoming G7 summit in late May is fast becoming a must-act date. At this meeting, one can look for PM Abe to announce a large fiscal stimulus package to reverse Japan’s slide back into deflation and recession (Japan’s LEI is at a six-year low). The fiscal package is likely to include significant
Act Together, Act Now
One can also look for PM Abe to challenge his G7 peers to join him in implementing fiscal policy to spur growth and inflation. Unlike the so-called Shanghai Accord, this challenge is likely to be made quite publicly. Given that one of the IMF’s recent pieces on the global economy was entitled “Act Now, Act Together,” this call to global fiscal arms is likely to be met by multilateral approval.
Next up is likely to be Europe. ECB head Draghi is all but pleading for fiscal policy to support his monetary efforts. NIRP’s introduction in Europe has been less than successful to date, with EU bank stocks down sharply at inception coupled with Euro strength. Draghi has also adopted a wait-and-see attitude to further monetary policy action, which signals that investors will be without fresh ECB support for the next several months, creating further impetus for a turn to fiscal policy.
The opportunity exists to announce spending measures to help ameliorate the migrant issue, which is the hot issue in Europe. Once the Brexit vote is taken, the question of how to house, feed, clothe & integrate all these folks will be front and center. Germany, with its budget surplus, is more than capable of bringing fiscal stimulus to the table, but so is Europe more broadly, given a 2.5% budget deficit, down from well over 4% just a few years ago. Room exists for fiscal policy to be brought to bear – can Angela Merkel regain her form and lead the way?
The Big Idea to Win the White House
Canada leads the fiscal policy race-off; Japan comes next, followed by the EU, leaving only the US to join the party. The presidential candidate who seizes this opportunity will likely become the next president of the US, in large part because by doing so he or she will demonstrate that the cry of inequality, echoing across America this campaign season, was heard loud and clear. Once elected, the new president can announce a major fiscal stimulus package right off the bat, taking advantage of the traditional honeymoon period and daring Congress to put itself on the wrong side of the inequality debate with a no vote.
The new president will likely be bolstered in this effort by Fed Chair Yellen, who will explain that the last thing the Chair wants to do is introduce NIRP, given the near $3 trillion in US money market funds. Consider that with the introduction of NIRP in Japan, its money market fund business froze, all $14 billion of it. Note the difference in scale and consider the implications.
The president could announce that the sacrifices of the past years had laid the groundwork for this new program, noting the sharply reduced budget deficit and the fact that US government spending on goods & services (not including transfer payments) had declined to 17% of GDP, a level last seen some 66 years earlier! The weak Q1 GDP data further reinforces the risk that the US economy could be flirting with recession by early 2017, if not before.
This program could also seek to bring the private sector to bear with record corporate cash levels, while pension funds and other long-term investors would be more than happy to engage in infrastructure-related projects with long-term maturities and decent yields (see “Market environment driving asset owners to revolution,” published in Pensions & Investments on April 22, 2016). This is true in Europe and Japan as well, where insurance companies and pension funds are deeply worried about what NIRP means for their ability to meet client obligations.
The poor quality of US infrastructure has been an open secret for years. However, a president who recognizes that the new growth drivers of e-commerce, urbanization and regional integration require high-quality roadways, ports, tunnels and airports, etc., should be able to frame infrastructure in an entirely new light (see “The Tri Polar World 2.0 – A New Global Growth Model,” published on March 26, 2015).
A pro-growth, rebuild-America program that brings together the public & private sectors to create jobs and long-term investment opportunities is a big idea that could propel one of the current candidates to the White House. Interestingly enough, Donald Trump may be best placed to make this case, as he has no historical baggage, lacks an economic plan, has some success as a builder and developer and has positioned himself as an outsider who will bring jobs back to America.
The choice seems to be coming down to CB-sponsored helicopter money or fiscal policy. Everything in between has been tried and found wanting in terms of ability to generate demand, growth and inflation.
However, there is no guarantee that the scenarios laid out above for any or all the main players will come to pass. It would be prudent therefore to consider a world where the US economy flirts with recessionary conditions while Japan and Europe slip back into recession. This would be unlikely to bode well for the still-struggling emerging economies (EM).
Such an environment could create a self-reinforcing downside spiral of declining growth, falling inflation and rising debt levels that would in turn lead to reduced spending, as money goes to pay down ever more onerous debt. As noted in a recent piece (see “Where to Next?”, published on March 31, 2016), the Fed’s decision to back off its four-rate-hike scenario has been sufficient to reverse the dollar’s rise, which in turn has facilitated at least a near-term bottom in commodities and supported stabilization in China. This holding pattern remains fragile at best; either significant further dollar weakness (Fed reverses course – NIRP introduced
The Barbell Portfolio
Financial assets have come a long way since February’s lows. It’s been a straight shot higher for most asset classes, led in large part by short covering, which has pretty much run its course. However, the global economy has not kept pace, and as noted above it has weakened over the same time period. A pullback would seem overdue. Financial asset valuations are not cheap, technicals are questionable and earnings lackluster at best. Cyclical stocks have rallied sharply, while bond yields have fallen, an odd combination. Investing with confidence remains a challenging proposition.
It may pay to consider employing a barbell strategy at this point. Risk assets (equity, credit) on one end and safe assets (cash, precious metals, sovereign debt) on the other end. As one grows more comfortable that fiscal policy will indeed be employed on a broad basis, then risk assets with a cyclical bias (EM, commodities) can be added/increased, and conversely if it seems like the fiscal scenario is unlikely to come to pass, then safe assets can be increased. Think swapping out DM for EM equity exposure, defensive sectors for cyclical, and sovereign debt for corporate credit.
Within the equity space, the main call remains to be underweight the asset class. US equity has been impressive in this rally, yet risk-reward does not seem appealing given valuation and earnings concerns. Foreign investors have been huge sellers of Japan equity, the most since 1987. Should fiscal policy be adopted broadly, these investors would likely flow back into Japan as a play on global growth while the yen could weaken as the safe haven bid fades. The Abe government needs to step up to the plate. Europe faces multiple challenges, but all are well known; the risk here would seem to be dead money.
Emerging markets are a tough call. To date, the focus here has been on USD EM debt, and that has worked quite well. Local currency debt has ripped higher and would seem extended. The same can be said for equity. China’s growth rebound is underpinned by a large stimulus and is unlikely to be sustained beyond a quarter or two. It would seem prudent to see how EM equity responds to China’s sugar high wearing off before getting very aggressive. Using pullbacks to build a position in the minimum-volatility EM ETF is one way to participate with some protection.
Corporate credit remains appealing in the US & Europe, including HY, preferreds, MBS and other options. Long-duration sovereign debt has been a big winner year to date – if fiscal policy is embraced, it would likely be challenged.
Commodities have been a big surprise, with some absolutely amazing moves off the lows of earlier this year. With demand weak and production cuts still more talk than action, it’s hard to get excited about the space at current prices, though one has to respect oil’s ability to hold the $45 level even with the failure of the Doha talks. Precious metals remain attractive in both a NIRP and a fiscal-stimulus environment.
It’s hard not to get the sense that a big move lurks beyond…. The embrace of fiscal policy would suggest an equity breakout, while if investors lose faith in CBs, a breakdown to the February lows and perhaps beyond is a real risk. That both seem plausible suggests that the barbell is the right portfolio workout until things become clearer.
Jay Pelosky is Principal of J2Z Advisory, LLC, a global asset allocation and portfolio strategy consultancy for institutional investors. Jay advises clients and invests personally based on insights gained from 30 years of financial market experience in over 45 countries. For the past decade, he has invested his own capital in a global, multi-asset, ETF-based Asset Allocation strategy. He sits on the board of Franklin Holdings (Bermuda) Ltd. and serves on the advisory board of Carmel Asset Management. Jay teaches a graduate level course, The Art and Practice of Global Investing, at The George Washington University and is a founding member of the New America Foundation’s World Economic Roundtable. His formal Wall Street career spanned twenty years and included positions on both the buy-side and sell-side. At Morgan Stanley, he launched the Firm’s global asset allocation and global equity strategy research products. He also formed and co-chaired the research department’s asset allocation committee. Jay created the firm’s Global Emerging Market Strategy (GEMS) product and initiated its equity investment, research, and strategy efforts in Latin America.
Follow him on Twitter: @jaypelosky