Macro Monthly The policy handoff

Exhibit 1: The Fed and ECB have been unable to sustainably hit their ~2% inflation targets

Unsurprisingly, with the power of central banks to achieve their objectives so publicly in question, calls for more help from fiscal policy are growing. A moderate approach put forward by former IMF Chief Economist Olivier Blanchard², former Treasury Secretary Larry Summers and others argues that governments should use the opportuni­ty provided by low interest rates to issue debt and increase spending on things that are likely to boost future productivi­ty, such as infrastructure and education. More controversial is the sharp rise in popularity of Modern Monetary Theory (MMT). The underlying assumption behind MMT is that as long as a country is able to ‘print its own currency,’ there are no fiscal constraints to the amount of borrowing it engages in. Under MMT, fiscal policy would take the baton from monetary policy as the primary stabilizer of economies. In essence, governments would increase spending and ensure full employment until resources are used up and inflation is sustainably at target.

Politicians are paying attention. The fast growth of populism in developed economies is inextricably linked to rising inequality, fueled in part by extraordi­narily accommodative monetary policies post-crisis which have supported asset prices despite sluggish economic growth compared to prior recoveries. This combined with continued low yields despite rising debt levels has made the general public less concerned about budget deficits (Exhibit 2). Naturally, politicians have seized on this change in mood; there was little pushback from ‘fiscal hawks’ to the significant later-cy­cle deficit expansion brought on by tax cuts and the bipartisan spending bill. More recently, politicians on the progressive left have seized on MMT as providing theoretical backing for expansive new spending initiatives. Ultimately, it seems the public demand for politicians to boost higher nominal GDP growth outcomes will only grow, and deficit considerations are unlikely to constrain them.

² https://piie.com/newsroom/short-videos/olivier-blanchard-benefits-and-costs-public-debt

Exhibit 2: US voters are less concerned about public debt even as it rises

What does this all mean for markets? In the near term, the gravitational pull towards more fiscal stimulus is healthy for risk assets. French President Macron’s concessions to the yellow vest protestors, Italy’s populist shift, and some modest loosening from Germany are helping to provide Europe with their largest fiscal impulse since the financial crisis (Exhibit 3). While still only adding a few tenths of a percent to growth, it is helping to cushion the economy amidst external headwinds. And with 10-year bund yields near zero and no shortage of fiscal space, there is plenty of room for Germany to do more. China’s targeted fiscal easing is proving necessary to protect against trade headwinds and prior deleveraging. These steps are crucial to support global growth, which has been decelerating but is likely finding a bottom over coming months as a result of these policy maneuvers.

Exhibit 3: Fiscal policy is contributing to growth in Europe in 2019

But as the importance of fiscal policy to economic stabilization grows, so does the uncertainty of its effects. While expansionary monetary policy is good for bonds and pushes investors out the risk curve, expansionary fiscal policy increases the supply of bonds investors need to digest. Moreover, a truly aggressive fiscal expansion could finally revive inflation and inflation expecta­tions in a swift and non-linear fashion. The net result of this occurrence should be a sharp increase in bond yields and the discount rates applied to risk assets. Multi-asset investors have generally benefitted from the last twenty years of disinflation and the negative correlation between stocks and bonds. But there is plenty of historical precedent for a positive relationship between bonds and equities—and bond weakness could well catalyze equity weakness. Or at the very least, bonds may not protect against declines in equities as well as they’ve done in the recent past.

Exhibit 4: Stock - bond rolling correlation (36 month)

The bottom line: Asset allocation

While we expected central banks to remain patient in order to extend the business cycle, even we were surprised by how quickly the Fed took rate hikes off the table. Continued accommodative monetary policy along with more supportive global fiscal policy, particularly out of China, is still a constructive backdrop for risk assets near term. As the Fed attempts to run the economy hot in order to generate an inflation overshoot, we maintain exposure to breakevens. Further out, we are keeping a close eye on the shift towards populism and the potential for much more aggressive fiscal stimulus backed by ideology like MMT. Independent of normative judgements of whether it is sound economic policy, a fiscal shift of that magnitude is unlikely to be friendly to risk assets. Such an environment would typically favor additional diversification towards real assets, such as precious metals or real estate.

Asset class attractiveness

The chart below shows the views of our Asset Allocation team on overall asset class attractiveness, as well as the relative attractiveness within equities, fixed income and currencies, as of March 28, 2019.