In August, Signature postulated that markets were at a moment of regime change from deflation to reflation. In fact we had discussed, over the preceding nine months, the need for asset allocators to prepare to tack away from the consensus deflationary scenario. The changing policy mix held the key to timing. If fiscal policy replaced bond purchases and negative rates as the policy mix – big asset allocation shifts would be required.
There were three fundamentals drivers for our reflation call in the summer of 2016:
- Financial conditions – essential capital channels had repaired in bank systems and credit markets. Specifically, high-yield, emerging markets and peripheral European markets were more sound.
- Economic growth – the multi-year emerging market growth slowdown was ending. Critically, U.S. and Chinese growth appeared to be stable.
- Commodities – energy and metals prices and demand had stabilized, providing support to commodity countries’ national accounts and currencies.
The last key driver was that an economic/financial backstop to the system was being restored via the shift to a hybrid of fiscal policy and monetary policy (more on this later.)
In sum, inflation expectations would drift higher. The environment for risk-taking had been restored. Real assets would outperform nominal ones. Stocks > bonds.
The implementation of this view into our portfolios was fairly straightforward. First off, we liquidated our gold and cash and put it to work in equities. We trimmed our investment-grade bonds, bought inflation-linked bonds and held onto our high-yield bond positions. Within equities we somewhat shifted from rate sensitives toward cyclical assets and emerging markets.
For a long-term perspective on this development, it should be noted that this reflationary/growth episode is likely just a brief deviation from a largely deflationary, low-growth trend driven by demographics and technology.
The coordinated global pickup in growth may be more than a six-month flirtation. Since Lehman, risk-on windows have opened and closed quite quickly. This episode could be a few years of expansion, making it highly investable. Recall that the U.S., Europe and emerging markets have all been through sharp economic downturns and credit cycles in the years since 2008. They are still recovering. Only China has yet to suffer that adjustment, but it is unlikely that 2017 is the year in which that happens.
In the fall of 2015, markets faced a deflationary credit crunch. A tough economic environment was running up against an exhausted monetary policy backstop. Buying protection against equity risk made sense in that environment.
We spoke at length about monetary policy exhaustion, making fun of European Central Bank President Mario Draghi’s contention that “There is NO limit” to central bank action. Theoretically he was right, central bankers could carry on with large asset purchases into any manner of assets, but there were constraints on execution such as liquidity and more importantly political constraints. The distortions in asset prices that resulted from monetary policy fed into political arguments that monetary policy was fuelling inequity. But that was not enough to provoke a political response… Brexit was.
Brexit provokes change
The Brexit shock changed political perspectives overnight, in a manner that was confirmed with Donald Trump’s victory in the U.S. presidential election. Elites woke up to the anti-establishment threat. They woke up to the needs of those parts of society that had been left behind in the past 20 years. They woke up to the risks of abrupt dramatic changes to the status quo. And they decided to spend in a political calculation aimed at stability.
- The U.K. led this charge with new Prime Minister Theresa May launching high-speed rail, nuclear plant, roads and airport investments.
- Canada followed suit with a $180 billion 10-year plan and a federal infrastructure bank.
- Trump campaigned on a $1 trillion infrastructure spend and tax cut plan.
- China has loosened fiscal purse strings in 2016 and committed to do more in 2017 as an offset to the economic drag emanating from transforming the old economy.
- The European Union got on board last with a communique urging national governments to undertake fiscal expansion in 2017/18. This policy would serve many purposes – ranging from domestic politics to international relations. It would also help address the economic and monetary policy challenges. Lastly, it could support the EU’s efforts at stabilizing its banks.
At long last, central bankers may be on the cusp of receiving some government support. Austerity has fallen from fashion. After years of being trapped at the zero bound and living in fear of triggering a collapse in asset markets by hiking rates, today normalization becomes possible. The behaviour of equity markets in the face of the bond market selloff suggests just this. Growth raises the value of future cash flows which more than offset the higher discount rate. A gradual rate hike path will somewhat restore the potency of monetary policy for the next recession, which is a good thing. Clearly an abrupt rise in rates will damage the real economy, but moves to date are easily manageable. This tug of war between growth and interest rates will wage on for the next few years. In our view, investors have only begun to adjust to the new higher growth dynamic in their asset mix.
On two other issues: de-globalization and France
A lot of attention is being rightly put to the Trump trade policy, where many questions remain. I suggest that calling this the “end of globalization” is off base. Most countries around the world are still in favour of deepening trade relations, including the U.K., China, Africa, Latin America, Europe, Japan and Canada. This sentiment was on display in Lima at the APEC meetings last week where China gladly stepped into the trade advocate role that America appears to have dropped. Yes there will be more production localization but globalization is not over. A better conception of what is happening is Obama’s description that we face a course correction for globalization towards a model that assists those most impacted.
The confusion of Brexit will be a major impediment to foreign investment into the U.K. Europe looks set to make an example out of the U.K.’s decision to leave as incentive for the remaining EU members to stay. I suspect that Brexit has actually reduced the risk of an EU break up, which is the opposite of the conventional view. In this regard this weekend’s French Republican Party primary was welcomed news. Francois Fillion, performed well in the first round making him the likely next president of France, come next spring’s elections. His aggressively reformist, anti-state, pro-market agenda is a breath of fresh air. Finally Germany may have the partner it craves in France – someone who could restore French competitiveness and the French economy. At the very moment when the global industry is reconsidering their U.K. footprint, France may be offering up a more interesting alternative. This could be the most positive development for Europe in the post-crisis era.
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