5 November 2019
The renewed focus on fiscal spending, both as a complement to, and as a substitute for, monetary policy is opening the door to relative value discretionary macro opportunities, according to GAM Investments’ Rahul Mathur.
“It’s quite clear that, with fiscal policy, the objectives of monetary policy will be reached sooner and with less side effects” – Mario Draghi1
“If negative nominal interest rates are perceived as a more permanent state, the behaviour of agents may change and negative effects may arise” – Swedish Riksbank2
There is a growing debate regarding the effectiveness of monetary policy in a world of ultra-low interest rates. Even central bankers, who appear to have exhausted their toolkit of conventional policies, have recently begun to call for more expansionary fiscal policy to support demand. At its October 2019 meeting, the European Central Bank (ECB) indicated that any additional monetary easing in the near term is likely to be marginal. Against a backdrop of continued deterioration in activity data and below target inflation, this capitulation suggests that monetary policy is struggling to gain traction. Additionally, where negative interest rates have been adopted, policymakers are increasingly voicing caution over the consequences of further distorting the price of money and, by implication, the pricing of risk. This distortion is most clearly visible in asset price inflation.
In some respects, the adoption of unconventional policies, such as quantitative easing (QE), indirectly laid the groundwork for greater coordination between monetary and fiscal policies. By creating reserves to purchase government debt, central banks effectively lowered governments’ funding costs during a period of declining revenue collection. However, there is no evidence to demonstrate that QE facilitated discretionary spending across developed markets. Central banks’ balance sheet expansion, in fact, coincided with sharp improvements in budget deficits across the major economies over the past five-six years. Having then implicitly created the conditions to help finance deficits, central banks are now explicitly compelling governments to increase fiscal spending.
Aside from the obvious questions that this may raise around the independence of central banks, the investment implications are significant. Should governments accept central banks’ call to issue more debt, central banks will likely, in turn, need to underwrite this policy by buying more debt, further blurring the lines between balance sheet expansion and deficit financing. Given the impact of the US / China trade war on global manufacturing and net trade, fatigue over post-crisis fiscal austerity, and, relatedly, the much improved public finance starting positions, the temptation for governments to loosen the fiscal reins is now likely to be irresistible. Additionally, expansionary fiscal policy can potentially have more traction when monetary policy is constrained, given the reduced risk of rising interest rates crowding out the full impact of fiscal spending.3 Increased fiscal spending is one of the very few areas that commands bipartisan support in the US senate. Fiscal policy is already turning expansionary in the UK and in Germany, where the structural deficit is forecast to widen by 0.2% of GDP over the coming year.4
Growing demands for expansionary fiscal policy in combination with accelerating US fixed income issuance over the coming years is likely to result in higher US rates and a generalised re-pricing of spread products. Additionally, while headline inflation has so far been largely contained by globalisation and modest real wage increases, the lagged impact of labour market strength and the escalation in trade protectionism may exert upward pressure on inflation expectations. The outlook for fixed income returns appears vulnerable and selective developed interest rate markets are especially stretched.
Idiosyncratic factors will ultimately determine the timing and combination of policy levers employed. European governments, for example, are constrained by the fiscal rules codified under the Maastricht Treaty. There remains, however, a greater need for fiscal expansion in Europe given the limited scope for further deposit rate cuts. In the UK, rates remain rich because of Brexit-related uncertainty. The relative richness will be difficult to sustain once there is clarity on Brexit. With the Bank Rate currently at 0.75%, the scope for conventional rate cuts to stimulate the economy is substantially smaller than in the past. The likely effectiveness of monetary policy has also declined given that most mortgage debt is now fixed-rate with longer maturity.5 Fiscal policy will need to be proactive. Based on estimates from the Chancellor’s September Spending Round, 2020 spending is forecast to be the most stimulative since the Global Financial Crisis (GFC). In the US, the inflation outlook is mixed; the slowdown in manufacturing is offsetting strength in the labour market. Despite unemployment at cycle lows and equities at record highs, the Federal Reserve is attempting to deliver what it has termed as a mid-cycle adjustment, in the hope that the trade-induced slowdown in manufacturing is contained.
In contrast to most developed market economies, the central bank of Mexico has taken advantage of high real rates to deliver 50 bps of policy easing since August. We believe Mexican fixed income is likely to continue to outperform as headline inflation moderates amid sluggish economic activity. Relative to the Federal Open Market Committee’s reaction function, Banxico may present itself as far more sensitive to the slowdown in global trade, given that manufacturing accounts for 55% of Mexican industrial output, 15% of GDP and 30% of payroll employment. Elsewhere, in marked divergence with the euro area, the central banks of Norway and Sweden are, respectively, either raising policy rates or preparing markets for interest rate hikes. This relative hawkishness is yet to be reflected in their currencies, which remain exceptionally weak on an historical basis.
The renewed focus on fiscal spending, both as a compliment to, and as a substitute for, monetary policy at the zero lower bound, represents a turning point in discretionary demand management. It expands the choice of tools available to policymakers and is likely to foster greater policy divergence between economies, based on the interaction of global risks, their individual economic cycles and idiosyncratic institutional frameworks. Against this backdrop, we believe that the investment outlook for relative value discretionary macro strategies is compelling, as they should be well placed to benefit from this changing environment. Already a number of high conviction themes have started to work, and remain at historically wide levels, suggesting the potential to offer both value and, importantly, the opportunity to generate uncorrelated returns for fixed income investors.
2Sveriges Riksbank Monetary Policy Report, October 2019
3Christiano, Eichenbaum & Rebelo. 2011
4Deutsche Bank, 30 September 2019
5Floating-rate mortgages account for 29% of the outstanding stock of mortgages, down from 56% in 2008 and a peak of 71% in 2012. Only one-third of fixed rate mortgages may be annually refinanced each year without penalty. – Samuel Tombs, Pantheon Macro, 29 October 2019
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