Macro Monthly The policy handoff

As central banks struggle to reach their inflation objectives, we believe that fiscal policy is likely to play a greater role in economic stabilization.

28 Mar 2019

Highlights

  • As central banks struggle to reach their inflation objectives, we believe that fiscal policy is likely to play a greater role in economic stabilization.
  • In the near term this should be constructive for risk assets; easy monetary policy and fiscal support, particularly from China, are crucial in supporting global growth.
  • But further out, growing populism and falling concern about deficits could lead to much more aggressive fiscal policies, which could generate sharply higher inflation and yields.
  • Multi-asset investors should be cognizant of stock-bond correlations shifting from negative to positive territory over coming years.
  • Gradual diversification into real assets makes sense amid the monetary to fiscal policy shift.

In macro circles, March 2019 will be remembered as the month when central bankers on both sides of the Atlantic took a step back, looked at inflation relative to their respective targets, and communicated to the public—’this just isn’t working.’ Early in March, the European Central Bank (ECB) delivered forward guidance that there would be no rate hikes in 2019 and introduced another targeted lending operation to ensure bank access to funding. Tellingly, the Bank’s forecasts for growth and inflation, which take into account these policy adjustments, were revised down sharply and projected inflation won’t reach target even by the end of 2021. In other words, it was an admission that the policy actions they took that very meeting would not be enough to get them to their objective. With negative rates already at an extreme and creating pains for the banking system, and with quantita­tive easing (QE) approaching capacity limits, the ECB looked to effectively be throwing in the towel.

The Fed clearly wants to make sure it doesn’t fall into the trap in which the ECB (and Bank of Japan) find themselves. Despite sub-4% unemployment and their characteri­zation of a still solid domestic economy, the Fed orchestrated a momentously dovish shift at its March meeting, signaling more or less an end to the tightening cycle even before rates reached their estimate of neutral.1 In essence, the Fed has moved to a strategy in which it will let the economy run hot, in an attempt to drive inflation durably and symmetrically (including overshoots) to its 2% target. Whether the Fed will be successful in achieving this goal remains to be seen, but the clear message is that rates are going to have to be lower for longer if the Fed is going to have any hope of achieving its goals on its own.

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.

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.

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.

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.

Asset Class

Asset Class

Overall signal

Overall signal

UBS Asset Management's viewpoint

UBS Asset Management's viewpoint

Asset Class

Global Equities

Overall signal

Slightly positive

UBS Asset Management's viewpoint

  • We see a China-led stabilization of ex-US growth and the pause in US monetary policy tightening as key to prolonging the business cycle, just as they were in early 2016. In particular we view the probability of a recession in the coming year as low given the strength of labor markets and consumption across the developed world. We believe that the global economic growth is slowing to around trend rate, not collapsing.

Asset Class

Global Duration

Overall signal

Slightly negative

UBS Asset Management's viewpoint

  • After inconsistent Fed rhetoric prompted fears of a US monetary policy mistake in late 2018, a clearer and unequivocally more accommodative Fed narrative is now emerging. In our view, the Fed is now likely to let the US economy ‘run hot’ in order to rebase inflation expectations. With scant evidence of significant momentum in US core inflation, the Fed has considerable breathing room. 
  • The ability of China to cushion its slowdown is also likely to be key to the global economy and markets in the remainder of 2019. The Chinese authorities have a broad range of policy tools at their disposal and they appear willing to use the full breadth in achieving a difficult balancing act between derisking a highly leveraged and capital inefficient Chinese economy and softening the slowdown prompted by those deleveraging initiatives. 
  • In our view, risk assets discounted material concerns about factors including the potential impact of a protracted US/China trade war at the start of the year. The speed and scale of the rally in the face of disappointing macro data globally and downgrades to forward corporate earnings expectations suggest strongly that expectations for good news on US/China trade talks have now been largely priced in. We remain constructive on global equities, but the speed and scale of the rally in 2019 has tempered to a degree the conviction of that positive view. Up around 11% YTD in local currency terms, global equities have already delivered an above-average annual return in two short months. The likelihood of further material upside for risk assets in the short term is, in our view, now dependent on central banks allowing financial conditions to remain loose and on the ability of ex-US demand growth to accelerate from current weak levels. In particular, the effectiveness of the broad array of measures at the disposal of the Chinese authorities to cushion their growth slowdown remains critical.
  • We retain a negative view overall on developed world duration over the medium term. With global growth showing signs of stabilization, we think it is too soon for the market to be pricing material easing from the Fed. Moreover, we are unconvinced that the ECB will be unable to tighten this cycle. In our view, yield curves are likely to steepen as global growth rebounds along with inflation expectations.

Asset Class

US Equities

Overall signal

Neutral 

UBS Asset Management's viewpoint

  • US equities remain supported by solid corporate earnings growth and increasing capital returns to shareholders. But the most recent earnings season exposed vulnerabilities in some momentum sectors and illustrates how difficult a return towards more normal growth expectations can be – especially after a period of exceptionally supportive fiscal and monetary policy. We do not expect current headwinds for the IT sector to abate quickly given the present political and regulatory environment. While the recent derating leaves US equity multiples below recent averages, we continue to believe that the case for equities outside of the US is stronger.

Asset Class

Global (Ex-US) Equities

Overall signal

Neutral

UBS Asset Management's viewpoint

  • In Europe, growth has decelerated considerably, due to external and domestic factors. Externally, China’s slowdown and trade uncertainty negatively affected European exports. Domestically, political upheaval in Italy and France along with disruptive auto emissions regulations weighed on the economy. However, our longer-term base case remains positive, supported by solid domestic demand dynamics, attractive valuations and a likely stabilization of global economic conditions towards the second half of 2019.
  • We remain constructive on Japanese equities despite the near-term headwinds from weakening global growth. Diminished political uncertainties and ongoing structural reforms are supportive of higher price multiples while a solid underlying domestic economy suggests the outlook for profits is stronger than markets are discounting.

Asset Class

Emerging Markets (EM)
Equities including China

Overall signal

Neutral

UBS Asset Management's viewpoint

  • Emerging market equities have recently performed well despite a continued deterioration in EM corporate earnings. The surge in Chinese social financing bodes well for EM growth over the coming months. 
  • We remain broadly positive on China in the expectation of further measures to cushion the domestic growth slowdown. We believe that any broadening of the current trade standoff with the US is likely to hamper Chinese growth, but a gradual economic slowdown is already priced in and the Chinese authorities have already shown themselves willing to provide monetary, fiscal and regulatory support to help smooth the ongoing economic transition. Chinese equities still trade at a PE discount to other markets and further market liberalization could prompt a rerating as international capital starts to flow into Chinese assets following the inclusion of onshore Chinese equities in MSCI’s widely followed EM equity indices.

Asset Class

US Bonds

Overall signal

Neutral

UBS Asset Management's viewpoint

  • After the recent downward repricing of US rate expectations, 10yr nominal US Treasury yields are close to the low end of the range of our estimate of fair value. Nonetheless, US nominal yields look attractive relative to most other developed government bond markets on an unhedged basis. In the absence of a material pickup in inflation or term premium, yields are likely to remain range bound. Our overall assessment is neutral.

Asset Class

Global (Ex-US) Bonds

Overall signal

Slightly negative

UBS Asset Management's viewpoint

  • In aggregate, we see global sovereign bonds outside of the US as unattractive. The ECB has committed to low rates for some time, limiting attractiveness of core Euro area bonds. We find Italian BTPs attractive on diminishing political risks. 
  • Swiss bonds continue to look very overvalued and in our view they have an increasingly asymmet¬ric risk profile. The Swiss economy is relatively strong and we see Swiss bonds as vulnerable to attempts to normalize monetary policy by a Swiss National Bank increasingly concerned by the strength of the housing market.
  • Elsewhere we are more positive on Australian duration on a relative basis. We see the Reserve Bank of Australia taking a cautious approach to policy given elevated household leverage and slow inflation.

Asset Class

Investment Grade (IG)
Corporate Debt

Overall signal

Slightly negative

UBS Asset Management's viewpoint

  • Although we do not believe that a sharp demand slowdown is imminent, we believe IG spreads troughed for the cycle in early 2018. Moreover, we are concerned about increased supply, reduced demand, and potentially large number of “fallen angels” when economic growth slows down significantly and downgrades begin.

Asset Class

US High Yield Bonds

Overall signal

Slightly negative

UBS Asset Management's viewpoint

  • Current default rates in high yield are very low by historical standards. Given the still relatively positive economic backdrop, we do not expect a material pickup in US defaults in the near term. However, after the significant recent rally, spreads have now tightened to a point where we see the balance of risks skewed towards more widening.

Asset Class

Emerging Markets Debt
US dollar
Local currency

Overall signal

Neutral

UBS Asset Management's viewpoint

  • Spreads on EM debt relative to US Treasuries widened substantially in 2018 in the face of higher geopolitical risks, a strengthening USD and higher USD funding rates. However, EM local currency bond yields have rallied both in absolute terms and relative to US yields since September while EM hard currency bond yields began a rally in late November. This reflects investor expectations for a less hawkish Fed, less aggressive US trade policy, and/or more China stimulus.

Asset Class

Chinese Bonds

Overall signal

Slightly positive

UBS Asset Management's viewpoint

  • Chinese bonds have the highest nominal yields among the 10 largest fixed income markets globally and have delivered the highest risk-adjusted returns of this group over the last 5 and 10 years. We believe that slowing economic growth and inclusion in the Bloomberg Barclays Global Aggregate index next year should continue to push yields down during the next 3-12 months.

Asset Class

Currency

Overall signal

 

UBS Asset Management's viewpoint

  • As signs of stimulus from China begin to take hold, we expect ex-US growth to stabilize. Over time, we anticipate capital will flow from the US into earlier-cycle economies and that the USD will weaken, especially as the USD remains somewhat expensive on a real trade-weighted basis. Elsewhere, we continue to see strong valuation support for the JPY and see short AUD as an effective hedge against ongoing China weakness in an economy where domestic household leverage is likely to constrain growth.