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.

With another cut from the RBA in October and expectations for further easing, in this update we examine the outlook for one of the central bank’s key targets; inflation. Our cash manager, Steve Campbell assesses the direction for the other – the labour market, which received greater emphasis in the latest statement from Governor Lowe. Meanwhile, the path of domestic credit continues to be directed by the global macro backdrop and as such we explain why we maintain flexible positioning.

Finally, humans’ impact on the environment has garnered even greater attention over the past several months and its importance for our clients continues to grow. We explain the evolving area of impact investing and illustrate the positive contributions it makes to the environment and broader society.

Australian Quarterly Update

With just over 12 months to go before the Americans return to the polling booths, Pendal Head of Bond, Income & Defensive Strategies Vimal Gor published his thoughts in the AFR on why the US economy is on a near-certain path to recession, and why President Trump’s new world order on trade is a success in the making.  

View the AFR article

In this edition of The Business, Vimal Gor, Pendal’s Head of Bond, Income & Defensive Strategies featured in a panel discussion to share his insights into the outlook for interest rates, Australia’s economy and key offshore factors to watch in 2019.

View the video here.

The 2017/18 financial year saw a return to more normalised conditions in global share markets. By ‘normal’ in this sense we refer to the levels of volatility and dispersion in stocks, sectors and countries that are historically more typical of markets. The post-GFC phase of ultra-low interest rates across the major economies came to a close and so began the process of structural adjustment from the ‘lower for longer’ disposition that has supported valuations for risk assets and kept sovereign bonds in the unloved basket. The task ahead for investors was to position portfolios for the inevitable unwinding of policy support and accurately predict the trajectory of interest rates and inflation. History has also shown that this is an imperfect science, fraught with variability.

Adding to the uncertain course for markets were disruptions to the political landscape. Investors were considerably influenced by Trump tweets, the emergence of populist power and trade war rhetoric as well as the more structural shifts relating to US tax policies, energy prices and household balance sheets. Developments in these areas frequently dominated the news headlines and generally left investors uneasy. But the underlying stories provided for a more sanguine assessment of capital markets and an important reminder for investors to buy the fundamental story of the asset and apply an active and focused approach to selecting investments.

Australian shares

The Australian share market certainly proved to be fertile ground for active decision makers. In aggregate, the market delivered a gain of 13.2% for the financial year, although there was considerable dispersion in the winners and losers at the stock and sector level. At the broadest level, Resources (+40.3%) considerably outpaced Industrials (+8.1%). The Materials sector (+29.9%) was a beneficiary of strengthening demand for bulk commodities such as iron ore. The Energy sector (+41.9%) was a standout performer, supported primarily by a 61% increase in the crude oil price. Such a rise proved fruitful for energy companies such as Santos (+106.9%) and Beach Petroleum (+217.1%) but acted as a tax on other companies, given the flow-on effects for input costs or consumer responses to discretionary spending.

“The spread of winners and losers over the past year reflects the multi-layered impacts of disruption, regulation and innovation. We’re likely to see these themes persist for some time, which is exactly the environment that will reward active, research-driven company selection.”
Crispin Murray
Head of Equities, Pendal Group

Big was not necessarily beautiful in 2017/18. Smaller companies (+24.4%) outperformed their large cap counterpart, in part reflective of the relatively high resources exposure. The prospect of tightening monetary conditions hampered the bond-sensitive sectors, which collectively rose by an uninspiring 0.7%.

Within the Industrials segment, Health Care (+27.7%) outperformed, although in common with the divergence in performance across the market, fortunes were mixed. At one extreme was Sirtex Medical (+97.9%) which benefitted from a bidding war for the company between US-based Varian Medical Systems and China-based alternatives fund manager, CDH Investments. In contrast, the laggards in this sector were Monash IVF (-35.6%) and Impedimed (-47.7%).

Also weighing on the industrials grouping were Telecommunication Services (-30.9%) and Financials ex-Property Trusts (+1.6%). Telstra was the major source of weakness for its sector, falling 34.4% on the back of its declining earnings growth and a cut to its dividend. Meanwhile, the major banks were dealt their fair share of challenges   a Royal Commission, higher funding costs and regulatory imposts   to name a few. ANZ Banking Group (+3.9%) was the pick of the big four banks, while Commonwealth Bank (-7.0%) was best avoided for banking exposure.

Listed property

The domestic listed property sector matched the performance of the broader share market in 2017/18. The sector benefitted from some supportive macro factors, primarily the pushing out of expectations for interest rate rises and a benign inflationary environment. In contrast to the dispersion theme across industry sectors, the property sectors exhibited considerably less deviation in performance. In aggregate, 33 out of the 34 A-REITs generated a positive return, with 23 of these being in excess of 10%. The big news influencing the sector was in retail land, with investors concerned about the impact of online competition. The exit of sector heavyweight, Westfield Group, following the takeover by European property giant Unibail Rodamco as part of a A$32b deal which completed at a substantial premium, saw around A$7b of cash proceeds out to find a new home. Across the sector, industrial property REIT, Property Link Group (34.4%) topped the table, while Stockland (-3.6%) dipped into negative territory.

“Fundamentals for the Australian property sector remain sound, but not uniform. We expect to see greater distinction between the quality and sub-par operators and across sectors over the year ahead as valuations are more closely scrutinised.”
Peter Davidson
Head of Listed Property, Pendal Group

Global shares

Global shares delivered a strong return for Australian investors, although a weaker Australian dollar limited the gain to 10% for investors that hedged the currency. US stocks continued to gather momentum against a favourable macroeconomic backdrop. Global markets suffered a temporary correction in February, triggered primarily by the latest US labour market data and fears of prospective inflation and uncertainties over Trump’s ‘policy on the run’ approach to resetting the global trade landscape. But where investors are concerned, America may already be great again – as indicated by the 14.4% total return from the S&P 500 Index in 2017/18.
US corporates also responded favourably to President Trump’s corporate and personal tax cuts. This, coupled with a resilient economy that now boasts annual GDP growth of 2.8%, solid jobs growth and unemployment at a 48-year low of just 3.75%, provide meaningful justification for double-digit returns from US shares. These data points supported decisions by the US Federal Reserve (Fed) to progress its monetary unwind, raising the Fed Funds rate on three occasions over the course of our financial year.

“Trump tantrums are actually helpful for us as investors. They distract those who follow the headlines and allow investors focused on fundamentals to hone in on the company narratives.”
Ashley Pittard
Head of Global Equities, Pendal Group

President Trump’s mantra on global trade led to ramifications for markets in Europe, the UK and Asia. The first in a series of tariff imposts against China came into effect in January, with ensuing measures levied on around US$50b worth of high tech and industrial imports from China. China’s own economy continued to grow, albeit at a declining rate of expansion as growth stabilised at a 6.8% annual rate. Shares listed on the mainland underperformed the Hong Kong bourse, while other emerging Asia markets were somewhat impacted by weakening sentiment from the trade rhetoric and higher oil prices. Japan continued to diverge in performance, delivering a return of 11.3%.
European markets had their own share of challenges, ranging from political destabilisation and the European Central Bank (ECB) continuing to pursue a gradual unwinding of monetary stimulus, through to consternation over the shape and form of Brexit. Returns from the region were an uninspiring 4.3%, even less for investors in the share markets of Spain and Germany.

Fixed income

It was a year of two halves for bond markets. Early in the period, further signs of growth taking hold in the major economies led to expectations of inflation returning in the near term, sending government bond yields higher. A change in the guard at the Fed was accompanied with the market’s notion that incoming Chair, Jerome Powell, would pursue an aggressive tightening agenda. This also coincided with the sell-off in equity markets and bonds also sold off, sending yields higher. The market has moderated fears since this time as the Fed progressed with its program of normalising interest rates. The European Central Bank (ECB) also progressed along a similar path of reducing stimulus, albeit at a more measured pace. In contrast, the Reserve Bank of Australia has retained its cash rate at 1.5% for a record length of time. A confluence of low wage growth, household indebtedness and benign inflation has kept the board from acting in concert with its global peers.

“The return of volatility was a significant shift in the market environment over the past year. As a defensive manager, our funds were well-positioned to benefit from the opportunities presented. We expect volatility to persist as markets continue to feel the effects of an ongoing liquidity drain and elevated political uncertainty.”
Vimal Gor
Head of Income & Fixed Interest, Pendal Group

The result was a very moderate return from fixed income. Global bonds returned 2.1%, while Australian bonds fared somewhat better with a 3.1% return. Credit spreads on Australian corporates tightened in the second half of 2017 alongside healthy risk appetite. This was driven by accommodative global central bank monetary policy settings, the much-anticipated US tax reform and better-than-expected reporting sessions out of the US and Europe. However, credit spreads subsequently reversed moves for the entire second half of 2017 in the first six months of 2018 as volatility increased on the back of fears over higher US inflation and geopolitical risks. Meanwhile, the Australian dollar weakened against the major counterparts over the year, down 3.7% against the US dollar, 5.9% against the euro and 5.2% against the British pound.

Investment implications

The normalisation process for monetary policies across the globe will erode progressively the valuation support that unilaterally low risk-free rates have provided to growth assets. This changing environment should also increase the level of dispersion in returns   both within and across asset classes   as focus returns to fundamental rather than market momentum drivers. That said, the speed and nature of this adjustment is uncertain and further complicated by more esoteric forces like global trade, political brinkmanship and structural changes in the shape and composition of industries.

Investors are likely to experience temporary bouts of volatility and greater dispersion between the performance of different asset classes, sectors, industries and companies over the next few years. Despite the uncertainties, this is very fertile ground for investors to take active, research based decisions on where and how to allocate capital. While some of the imbalances across markets may persist and warrant a degree of caution, we believe the greater risk would come from taking a set-and-forget approach to allocating capital.

Pendal continues to apply its multi-faceted approach to generating excess returns by looking through the headline factors that regularly skew market valuations and risks. Our focus is maintained on ensuring investments are actively managed to reflect the underlying stories that are driving risks and returns. Investors should also maintain an allocation to the Alternatives sector within a multi-asset portfolio. Through an appropriate selection of strategies, this sector offers diversification benefits with the potential to enhance returns.

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