The inexorable drift towards lower and lower interest rates is upending many assumptions; from the role of monetary policy in lifting the economy through to where investors look for yield. Australia and the US have positive rates for now. However, as growth slows further, inflation persistently undershoots central banks’ targets and governments prove unwilling to lift spending, rates are being forced closer to zero. This has raised speculation over non-traditional measures like negative rates, as already in place across Europe, as well as quantitative easing in order to move central banks’ key objectives back towards their targets. At Pendal’s recent Lighthouse event, the Bond, Income & Defensive Strategies (BIDS) team shed some light on the conundrum facing policymakers and what the future may look like when monetary policy is no longer effective.
Monetary means at their limits
Central banks around the world have been progressively targeting inflation since 1989, with our friends across the Tasman at the Reserve Bank of New Zealand the pioneers of its modern form. Over this time the policy setting boards have presided over the structural shift to lower interest rates, lower inflation and considerable economic expansion.
Since the 1990s we have seen a few economic cycles, with each changing the nature of policy effectiveness. Our Australian rates manager, Tim Hext, has experienced many over his career and notes every cycle has lower and lower interest rates. In Europe, several countries now have negative interest rates, led by Denmark, Switzerland and Sweden. They have joined Japan, where interest rates hit zero two decades ago, before turning negative.
The issue now is increasing risk aversion resulting from negative rates. Central bank tools are relatively blunt, so to obtain the desired economic response, even deeper negative interest rates will be required for Europe. This is the problem with blanket policy targeting through interest rates. When you’re a hammer, everything looks like a nail.
As such, to address the failures of the current regime there is growing recognition of need for a different policy approach. Enter Modern Monetary Theory (MMT). The thinking around this form of economic management was pioneered by American economist, Professor Bill Mitchell along with a cohort of academics and finance practitioners. MMT directly repudiates the thinking around government budget constraints which form the basis of the ideologically opposed Keynesian school of thought for economic management.
Breaking from tradition
The chorus is growing as central bankers increasingly appeal for help in the unruly task of economic management. In his last meeting at the helm of the ECB, Mario Draghi called again on greater support from the fiscal arm of policy. RBA Governor Lowe has echoed these calls amid the frugality that has characterised government spending at home, driven by a seeming obsession with obtaining a surplus.
Ultimately, if an economic crisis and recession eventuates it will drive radical political change, forcing governments to boost spending, cut taxes and pursue deeper structural reform. This may include elements of MMT, which we can interpret more as a framework, than a set of individual policies.
At the core of MMT is an ideology that upends the traditional view that considers the economy as separate from individuals, who seek to maximise their utility from it. Rather, MMT essentially sees the economy as the people and in turn, works for us as a collective.
Another conventional perspective which is uprooted by MMT is that governments should operate like households. This is an idea perpetuated by our personal experience with budgeting and debt. Simply, if we live beyond our means, there is a deficit which requires debt to finance. We then project this idea onto how governments should operate. As such, we have the notion that governments must raise revenue through taxes in order to spend, otherwise they will run a deficit and accumulate debt.
MMT takes an alternative view under a few assumptions, including that governments have control over their currency. This means a government could create money to finance spending, rather than raise it through taxes or a combination of deficits and debt. Such an approach can be followed when there is excess capacity in the economy and the need for stimulus.
What creates inflation?
The notion of creating money for spending may raise some eyebrows, given concerns over the idea of money printing resulting in inflation running out of control. However, such worries require consideration of the force behind money creation. As has been proven by the recent era of massive central bank stimulus efforts, inflation is not purely supply-driven. It does not matter how cheap money is to borrow or how much is available, ultimately it depends on demand and a borrower’s ability to borrow.
Government spending can stimulate this demand and taxes can reduce it. In the MMT world, a key policy that can be used as part of this mechanism is a job guarantee program. If economic activity is weak with low inflation, jobs can be created to absorb idle capacity, and as capacity becomes stretched, inflation will rise. True inflation can only emerge once full capacity is reached. As inflation rises, the government can cut spending and raise taxes to bring the economy back towards balance. In this way the policy acts as an automatic stabiliser.
Such a job guarantee program also supports an idea that anyone who wants to work will work. If the private sector can’t absorb them, then the government will. It will guarantee you a job. There are plenty of public services that are needed – building public facilities, cleaning community spaces or whatever host of other productive activities.
A new New Deal
In the US a similar style policy was implemented in the form of the Civilian Conservation Corps – one of the most successful New Deal reforms introduced by Roosevelt in the 1930s. Looking at the debate in the US now, Tim believes it is not a matter of when a form of MMT arrives, but who will move first – when will they do it, how they do it, and who will then follow.
“For example, you could have a 50-year infrastructure project, which you break down into 5-year, short term projects. This can be slowed as inflation rises. And if inflation rises too far, taxes can be hiked”, he says. “The currency may take a hit, initially, but as growth kicks in, that will flow through to the currency.”
Tim highlights the case of Japan, which has struggled to stimulate growth, but boasts one of the lowest unemployment rates in the world; “everyone’s got jobs, everyone is happy. Why do you need GDP growth if everyone is happy? It begs the whole question of why do you need GDP growth for GDP growth’s sake.”
Looking elsewhere, the UK is likely growing closer to adopting some form of MMT. Their economy is really weak now. And once you see job guarantees coming, then others will follow. Tim notes “You won’t announce we’re doing ‘modern monetary theory’, but you will announce job guarantees. The first implementation will be the UK. The US will follow at some point.”
Investing in an MMT world
With significant experience in rates markets as Head of the boutique, Vimal Gor believes secular stagnation is a problem that is likely to persist for a long time to come. In the medium-term and for the practicalities of investing, the baton of policy stimulus will likely not be passed completely from the current hands of central banks to governments. Arguably, even within an MMT world with more of the heavy lifting done by government spending, we will remain in an environment of structurally lower yields over the long-term. The need for rates to remain low or lower represents further opportunities for bonds as we see the race to the bottom continue. Bonds will also continue to offer investors the important safe-harbour that is critical when risk-assets like equities suffer and as such, will remain a vital part of an investor’s portfolio.
The market is now expecting a greater chance of a cut by the RBA than a hike over the next year. At the same time the central bank has held firm in its bias to leave rates on hold. In this quarter’s update our Australian rates PM, Tim Hext, offers his views on the outlook for 2019 and what could move the dial. We also assess the prospects for the local credit market, where macro risks have weighed on investor appetite and liquidity has become increasingly scarce. Meanwhile in cash markets, funding cost increases have fuelled out-of-cycle mortgage rate hikes. Our Cash PM, Steve Campbell takes a deeper dive into the causes and also examines issues in the RMBS market. Finally, we discuss new developments in the ESG arena including NSW TCorp’s first green bond issuance.
We hope you find the piece useful and welcome feedback from readers.
View our Australian Quarterly Update here.
Equity markets, particularly in the US, have been in a well-established bull run accompanied with very low levels of volatility. In fact, the S&P 500 had not experienced a greater than 5% drawdown over the 18 months to January 2018. This bull market has been facilitated by concerted efforts from central banks to provide freely flowing liquidity. After such a long cycle it is not unusual to see a spike in market volatility as investors’ sensitivity is heightened in anticipation of a change. We saw this in early February, with the catalyst being a jump in inflation expectations in the US.
The following provides thoughts from each of our investment boutique heads on the implications for markets and how they are responding.
Australian equities
The Australian market’s fall in early February reflected an adjustment in relative valuations with the US, rather than concerns specific to our market. There are also signs that the selling was exacerbated by some investors scrambling to unwind their low-volatility positions. Despite this, the size of the decline was lower than for the US, given Australia’s more defensive character. These falls were followed by a reasonable rebound, resulting in a 0.3% return from Australian shares for the month of February.
The recent company reporting season revealed quite a different scenario. Earnings growth for industrial companies, in aggregate, was around 9% which exceeded market estimates and we have seen a net upgrade to consensus forward earnings expectations. It is earnings growth that has driven the market’s returns over the past year. A number of companies have reported resilient operating conditions and we expect earnings growth of mid-single digits this year. Add the return from dividends and we can expect to so total returns in the high single digits for the year.
We believe the market’s rating will be supported at current levels, which is underpinned by several factors:
• Valuations are not excessive. The 12-month forward P/E for the S&P/ASX200 is slightly higher than its historical average, but consistent with the low interest rate environment with the RBA showing no indication of a material policy shift in the near term.
• There is no sign of a recession. Australian growth remains muted, however tailwinds are emerging, such as the rise in corporate capital expenditure and the large pipeline of infrastructure. In combination with a small pick-up in mining investment and a housing slowdown which remains moderate and controlled, we think the Australian economic outlook remains reasonable.
• Inflation in Australia remains benign. The monetary conditions in the US do not reflect the situation in Australia, where inflation remains muted and the RBA has given no indication of aggressive hiking.
• Liquidity withdrawal remains modest. The withdrawal of liquidity from the equity market as a result of central bank actions does present a risk to valuations over the medium term. However, we expect this trend to be moderate globally. The US economy has displayed a historical sensitivity to bond yields and we would expect the Fed to temper their tightening efforts if there are signs of an inordinately adverse effect on growth.
“Bouts of volatility can provide the opportunity to pick up stocks we like at an attractive buying point.”
Crispin Murray, Head of Australian Equity Strategies
As active managers, market volatility creates mis-pricing – and more mis-pricing means more opportunities. Any change in volatility does not typically change our fundamental view of the market and where we see compelling investments. For example, at the moment we see the disruption of long-standing industry structures and business models as a key area of opportunity. Likewise, we also hold some previously unloved stocks where we think the market has not yet appreciated a turnaround in earnings. We also see some opportunity among those growth stocks which have not been pushed to challenging valuations. Bouts of volatility can provide the opportunity to pick up stocks we like at an attractive buying point and our large and experienced team looks to take advantage of these moments as they occur.
Global equities
The US earnings season commenced in late January and indications to date show no material shift in the operating environment for industrial companies. According to data based on 90% of S&P500 companies that reported quarterly earnings, 79% of those exceeded the market’s consensus estimates. The group has on average delivered 14.9% earnings growth over the prior period and commentary from management has been generally favourable. Against this backdrop it is difficult to call the February correction in share prices as anything other than a realignment of valuations. The fundamentals of a bear market are just not there.
“Rather than be concerned over higher future interest rates, we would seriously question the quality of companies that have not taken advantage of ultra-low interest rates.”
Ashley Pittard, Head of Global Equities
We take the proposition of higher interest rates in the US this year as a given, and inflation will find its way in a lagging fashion. Returns from global equities are likely to remain positive this year, although we expect a greater degree of divergence in fortunes across markets and geographies. In broad terms we expect:
• A story of two halves – Global equity markets are likely to experience a strong first half, buoyed by strengthening economies and the broad-ranging boost of Trump’s corporate tax cuts and incentives. These conditions are likely to force the hand of the Fed and interest rates will rise ahead of market expectations for the year and weigh on equities. Hence, returns should be similar to their longer term average.
• US and European companies are well placed to continue to do well – Earnings reports are continuing to show that companies are operating well. Europe has entered their earnings season and given the synchronised growth globally for the first time in a decade, European corporates should deliver similar aggregate results to their US counterparts.
• Aussie dollar stability – The Australian dollar is likely to be range-bound in the US$0.75-80 band as we have seen over the past five years, which shouldn’t have a material impact on returns from global equities.
• Market valuations in select areas to remain attractive – Although the market has rallied, certain industries remain fundamentally attractive. Consider that US banks are trading below 1.3x book value, while pharmaceuticals are on an unchallenging PE ratio of 10x.
What is more of interest to us is balancing the assessment of companies that are achieving operational excellence and are using the buoyant economic conditions to generate strong cashflow. Rather than be concerned over higher future interest rates, we would seriously question the quality of companies that have not taken advantage of ultra-low interest rates to skilfully deploy capital and grow their businesses. We give merit to companies that have shown the ability to command a dominant position in their industry. They are much better placed to show resilience in varied market conditions.
Bond markets
Over the past year the market has been focusing on forward indicators of consumer sentiment and US economic growth such as manufacturing and services sector outputs to support expectations of economic growth. These have been in a generally positive trend over the past few years, however, consensus expectations of higher inflation have failed to materialise. We think that inflation will surprise on the upside this year but we are weary of expecting too much of a rise until we see sustained wages growth coming through. Pent-up expectations to seize upon the first signs of inflation was taken by the market as a precursor to inflation rising from stagnant levels.
“We are cautious of expecting any meaningful pick-up in inflation until we see the whites of its eyes.”
Vimal Gor, Head of Income & Fixed Interest
Whether a benign inflation outcome can continue is the subject of much debate. We are cautious of expecting any meaningful pick-up in inflation until we see the whites of its eyes. What is of significance to markets is if central banks expect inflation to pick up and continue to unwind their unprecedented monetary stimulus. This is a real possibility in the US given that there are two major fiscal forces now in play – company tax cuts and an extension of the debt ceiling. It is exactly the wrong time to be adding stimulus when the economy is running at near full capacity. We believe this will force the hand of the Federal Reserve to counter the inflationary impact, which will be negative for bond yields as the yield curve steepens. The risk then arises that this compensatory tightening will lead to recession in late 2018 or in 2019.
In the shorter term, we expect:
• Higher volatility for both equity and bond markets – Historically, heightened inflation expectations have been followed by a pattern of higher market volatility.
• Investment grade credit to outperform sovereign and high yield debt – Segments that benefitted strongly from the global wave of liquidity are now the most vulnerable areas of the credit world. This includes certain emerging market sovereigns and high yield corporates. An unwinding of favourable market conditions may be particularly unkind to these areas versus more structurally resilient investment grade credit.
• Australian inflation to lag the US – Inflation in Australia will surprise on the downside. Hence, the RBA will need to closely watch unemployment and wages growth before it can consider any pre-emptive strike against inflation. We find it difficult to build a scenario where the cash rate rises while wages languish and spare capacity remains.
Looking more broadly, the easy financial conditions and fiscal support from the past decade have left a legacy of debt, which raises concerns over financial stability and ultimately results in higher levels of market volatility going forward. We are positioned to capitalise on this environment with tactical exposures to investment grade credit.
Asset allocation
It is important to put bouts of market volatility into context. Markets have experienced strong gains in the last few years so a correction like the episode in February was inevitable. However, what market volatility does illustrate is the importance of a well-diversified portfolio. While equities are a critical component in delivering long-term growth to a portfolio, this exposure needs to be balanced by assets that are diversifying – bonds, foreign exchange exposure and alternatives can all help to stabilise returns.
“One interesting feature of the recent sell-off is that bonds, in general, failed to provide a cushion against market volatility.”
Michael Blayney, Head of Multi Asset
Each episode of market volatility is different. For example, in the global financial crisis the correction was led by credit, with equities following and government bonds providing capital gains to help insulate portfolios. One interesting feature of the sell-off (although a very small correction compared to the GFC) is that bonds, in general, failed to provide a cushion against market volatility.
In a “normal” equity market sell-off, government bonds benefit from a ‘flight to quality’ effect, as investor demand for bonds increases. As the most recent volatility was initially triggered by fears of inflation and rising interest rates (poor conditions for bonds) this caused US bonds to sell off (with Australian bonds mixed depending on the term). The reaction in credit markets lagged equities, and while spreads widened, eventually there was no sign of panic, with investors exhibiting greater focus on strong underlying corporate fundamentals than shorter term equity market volatility.
While we believe that bonds are an important component of a portfolio, this instance of market volatility also illustrated the importance of holding both foreign currency and alternative assets – when one of your stabilisers fails to provide the desired protection it is important to have others. Currency exposure was particularly valuable in this instance, with the recent fall in the Australian dollar from US$0.81 to below US$0.78 providing a cushion to market volatility. When the Australian dollar falls in value, assets denominated in foreign currency become more valuable for Australian investors.
Recognising the inherent uncertainty of financial markets, we continue to hold a broad range of diversifying exposures to seek to smooth out inevitable bumps in the road.