Start as you mean to go on?

We noted last quarter that markets had begun 2019 by celebrating the dovish shift in policy from the Federal Reserve (Fed). With US central bankers showing more sympathy to the plight of financial markets than they had previously been willing to, the S&P 500 index (of US equities) rallied. In one sense, the rest of the quarter was a continuation of this bout of bullishness. Global equities, as measured by the MSCI All Country World Index, delivered a +11.7% return in local- currency price terms, the second best opening quarter since the index was launched in 1988. The ‘risk-on’ price action in equity markets was mirrored in the credit markets, where spreads tightened.

By the end of the quarter, much of the damage done to risk assets over the course of 2018, and in particular during the final quarter, had been repaired. The optimistic interpretation of the first-quarter rebound in equity markets and credit spreads is that the easing of policy by China and the more accommodative developed-world central banks is set to arrest the global growth slowdown in short order with a reacceleration later in the year.

However, the message from markets over the quarter was not unequivocally bullish. Digging below headline equity-market indices, company and sector leadership casts doubt on the likelihood of a sustained reacceleration of the global economy. Once again, ‘growth’ companies (those deemed to be able to grow in a low-growth world) have resumed leadership. More conspicuously, safe-haven government-bond yields declined over the quarter, with the decline accelerating in March. This saw yields on sovereign debt in countries such as Australia and New Zealand (countries that largely escaped the worst of the financial crisis) strike all-time lows.

The decline in US government-bond yields was particularly remarkable. By the end of the quarter, the US yield curve was inverted across many sections of the curve. Historically one of the more reliable indicators of recession, the inversion of the US yield curve unsurprisingly garnered much attention. Once again, unsurprisingly, ‘this time it’s different’ arguments are being put forward. It would, however, be remiss to dismiss completely the message from the bond markets, although the lag between inversion and recession, when one has followed, has varied and has often been several quarters.

Bonds are for the economy; equities for policy

Over the course of the quarter, economic data pointed towards a continued slowdown in the global economy. Europe exhibited by far the worst deterioration. German GDP finished 2018 up 1.5% year on year (a five-year low). Italy’s travails continued, its economy slipping back into technical recession in the fourth quarter. Expectations of a European rebound in the first quarter were disappointed, with industrial production continuing to decline on a year-on-year basis. The US, which was largely immune from the global slowdown of 2018, started the year in mediocre fashion. China, the greatest cause for optimism on the economic front, given the slew of easing measures announced since the second half of 2018, largely disappointed over the course of the quarter, although it managed to give cause for optimism in March with signs of economic green shoots.

The bulls on the other hand appear to focus on the continued easing of policy. The world’s major central banks have collectively adopted a more dovish stance over the course of the quarter. It began with Federal Reserve Chair Jerome Powell stating the case for patience on further rate hikes at the turn of the year, and his counterparts largely followed suit. The message delivered had a common thread: increased economic uncertainty, with the balance of risks tilted to the downside. At the European Central Bank’s (ECB) March meeting, growth forecasts for 2019 were slashed from 1.7% to 1.1%. The downturn in the outlook prompted the Governing Council to push out guidance on the timing of the next rate hike to 2020 and implement a new round of bank financing – effectively quantitative easing (QE) by the back door. Not to be outdone, the Fed delivered a dovish surprise at its March meeting by indicating there would be no rate hikes in 2019 and announcing an end to quantitative tightening in September.

In China, the much-watched total social financing numbers (a broad measure of credit) released for January confirmed a change in policy focus from financial stability to economic stability. According to the data, China’s financial system printed CNY 4,635 billion ($682 billion) of new credit in the month. For context, this is equal to Saudi Arabia’s annual output. Tax cuts were announced to the tune of CNY 2 trillion, and the People’s Bank of China (PBoC) cut the reserve requirement ratio by 1% for good measure.

It could be suggested that the bond markets have been focused on the economic data, while equity markets have been given the benefit of the doubt to policymakers. While corporate earnings remained robust throughout 2018, the outlook has dimmed along with the economy. As such, equity-market returns so far in 2019 have been driven by a rerating. From a valuation perspective, policy relief and a lower discount rate has been the focus for equity markets this year. For now, bad economic news is good news for investors. This is not a case of just right (neither too hot nor too cold); it is simply a case of not too cold – ‘Slowdilocks’ rather than Goldilocks. But how slow is too slow, and for how long can economic growth falter without weighing on the equity market? Slow may be OK for a while, but not on a sustained basis.

Secular stagnation revisited

With more than $10 trillion of bonds showing negative yields across the world, bond markets clearly suggest a downturn in the economic outlook. At the end of March, Germany sold 10-year debt with a negative yield for the first time since the autumn of 2016.1 With bond yields submerging below the zero line, the talking heads are dusting off the secular stagnation thesis. An increasingly negative German yield curve is widely seen to support the hypothesis of the ‘Japanification’ of the eurozone.2 Japan’s experience was of course unique, particularly with respect to the scale of the damage done by the bursting of its twin stock-market and real- estate bubbles in 1990. However, there are many interesting parallels, not just for the eurozone, but more broadly across the developed world.

In the wake of the global financial crisis, credit growth in the US and Europe has been depressed in relation to the preceding decades. In part, this was attributable to the fact that banks were having to rebuild their capital, but it was also because indebted households and companies demonstrated a preference for paying down debt despite plunging interest rates – the opposite behaviour the monetary easing that followed the financial crisis was supposed to encourage.

This is precisely the dynamic identified as a ‘balance-sheet recession’ by Richard Koo in his book ‘The Holy Grail of Macroeconomics’ which analysed Japan’s post-bubble economy. As a result of this environment, loan growth turned negative and remained depressed for many years after the financial crisis. While credit growth has picked up more recently in some countries, it remains subdued compared with the pre-crisis period. Also echoing the Japanese example, both the US and European nations responded to the financial crisis with large-scale fiscal stimulus in tandem with ultra-loose monetary policy. When public-sector debt ballooned, policymakers retreated to fiscal orthodoxy, just as the Japanese have repeatedly done since 1990. As fiscal policy was tightened, the economy subsequently slowed.

When worries about secular stagnation reached their peak in the first half of 2016, they were allied to concerns that, with interest rates already zero and public debt levels already high, governments and central banks were out of ammunition (monetary and fiscal), and economists debated whether any policies could avoid sustained low growth rates. However, in response to the economic slowdown, China had already begun implementing a major fiscal stimulus package in the second half of 2015, financed by the PBoC. President Trump put his own fiscal stimulus package together once elected. Combined with renewed monetary easing from the ECB and the Bank of Japan, this put the global economic show back on the road.

Mo’ money, mo’ problems

We have noted previously how the policy tightening that began in 2017 was responsible for declining financial-asset prices and the slowdown in the global economy, and we are back to facing the same question as in 2016: what should be done in response to an economic downturn when interest rates are already close to zero? Among the proposed answers are variants of monetary finance. Proponents of ‘modern monetary theory’ argue that government spending financed with money printed by central banks should be the normal mechanism for managing nominal demand. Ten years of central-bank-funded asset purchases have disproportionality benefited the financial markets over the real economy, and led to levels of inequality not seen since the 1920s. It is unsurprising that there are growing calls for central banks to print money for the many, not just the few. ‘People’s QE’, as advocated by the UK Labour Party, is one such example.

The valid insight behind these propositions – that governments and central banks together can always create nominal demand – was explained by Milton Friedman in his 1948 essay.3 However, the consequences of such policies cannot be fully predicted, nor will they always be desirable. The experience of history is that monetary financing of fiscal deficits is rarely characterised by restraint once embarked upon, with ensuing inflations typically proving to be hugely harmful to the functioning of society.

Taking from Peter to feed Paul

Hjalmar Schacht, president of the Reichsbank (the former German central bank) from 1923 until 1930, was reappointed in March 1933. In addition to being reinstated as president of the Reichsbank, he was made minister of the economy. Schacht was given two overriding objectives – to combat unemployment and find the money to rearm. Displaying a level of invention that distinguished him as the most creative central banker of his era, immediately upon taking office, Schacht threw the whole baggage of orthodox economics overboard. He embarked on a massive public works programme, which was financed with money printed by the central bank. Over the next few years, in response to an enormous injection of nominal purchasing power, the German economy experienced a remarkable rebound. Unemployment fell from 6 million at the end of 1932 to 1.5 million four years later. Industrial production doubled over the same period. But the recovery was not quite the miracle that Nazi propagandists made everyone believe it was. Although there were some very visible achievements (the creation of millions of jobs, and the construction of the famed autobahns for example), the boom remained stunted and lopsided. Much of the increase in production came in arms-related industries, while the production of everyday consumer items such as clothing, shoes and furniture stagnated. As a consequence, the standard of living of ordinary Germans barely rose at all. They had to make do with a drab existence of shoddy goods such as sugar made from sawdust, flour from potato meal, gasoline distilled from wood, and margarine made from coal. Behind the gleaming achievements, the bulk of them geared towards war, the Nazi economy was plagued by shortages, and relied heavily on rationing to allocate scarce consumer resources.

The rebuilding of the German military machine was only possible thanks to the inflationary policies of the Reichsbank. Ultimately, any inflation is a redistribution. In the case of Nazi Germany, inflationary policies were used to appropriate a larger share of production for the state at the expense of the consumer. The same occurred in the other countries that fought the Second World War. The printing of money to finance wars is an extreme example of how inflationary policies can be used to the detriment of the people over whom rulers, elected or otherwise, preside. However, less conspicuous forms are replete in government spending, which is rare ly commended for its efficiency and efficacy. Importantly, the greater the role of the state, the smaller the role of the market in the allocation of scarce resources.

The ‘Green New Deal’, as campaigned for by US politician Alexandria Ocasio-Cortez, argues for the use of central-bank money- printing to finance socially and environmentally desirable investment. Given the admirable nature of these intentions, few would disagree with such initiatives, but, while the intention is noble, the outcome is not always as intended. Nonetheless, as we have noted before, the mood music of populism, and the backlash against (crony) capitalism calls for more state intervention in the economy, not less. Faced with slow growth, political discontent, and large inherited debt burdens, monetary finance (once a taboo option according to economic orthodoxy) is likely to become increasingly mainstream. However, it is dangerous to view it as a costless route to solving long-term challenges.

UN petit coup de whisky

The more pressing concern is the current policy easing efforts which, while more orthodox in nature, at least in the context of the post-financial crisis period, have received fresh impetus since the turn of the year. We continue to assess the possible impact of this easing on financial markets and the global economy. Historically, there has been a lag between policy easing and an upturn in the economy. Sometimes, conditions are such that an easing of policy is not sufficient to arrest a slowdown. The risk is that, if the economy continues to slow, earnings will remain under pressure. Under such a scenario, the rerating of equity markets over the course of the first quarter arguably leaves them vulnerable to disappointment on the earnings front.

It should be noted that Jerome Powell is not the first central banker to respond to economic and financial stress. Benjamin Strong, first president of the Federal Reserve Bank of New York and the de facto head of the Federal Reserve System, was arguably the first central banker to use monetary policy to actively manage the economy. By the end of 1926, Strong and other central bankers were already worried about three of the factors that would eventually lead to the economic upheaval at the end of the decade – the US stock-market bubble, excessive foreign borrowing by Germany, and an increasingly dysfunctional gold standard – issues that in many ways are echoed by those of today. In 1927, the economies of Europe were slowing rapidly. Furthermore, European nations lacked the institutional cooperation to address the underlying cause of the issues. As a result, financial capital was leaving Europe in favour of the US, leading to a tightening of financial conditions which further exacerbated the economic woes. There was one way for the Fed to help Europe, or at least buy it some time: it could lower interest rates. Strong recognised that, were the Fed to cut interest rates, it would, as he predicted to Charles Rist of the Banque de France, give the stock market “un petit coup de whisky”. It is unlikely he anticipated the drunken ride that was to come. In August that year, following the Fed cut, the market immediately took off. By the end of the year, the Dow had risen by over 20%. The volume of broker loans (loans used to fund the purchase of stocks) had risen to a record $4.4 billion from $3.3 billion the previous year. Turning to today, a similar rise in financial- market speculation in response to the current central-bank easing appears to have echoes of that past era.

In 1931, at the public post-mortem of the 1929 stock-market crash, Adolph Miller testified to Congress that the easing of credit in the middle of 1927 was “the greatest and boldest operation ever undertaken by the Federal Reserve System… [resulting] in one of the most costly errors committed by it or any other banking system”. Miller and others argued that, by artificially depressing interest rates in the US to ease financial conditions in Europe, the Fed helped fuel the stock-market bubble that subsequently crashed two years later. The bigger the bubble, the larger the bust.

[the easing of credit in the middle of 1927 was] the greatest and boldest operation ever undertaken by the Federal Reserve System… [resulting] in one of the most costly errors committed by it or any other banking system.

Adolph Miller


This is a financial promotion. These opinions should not be construed as investment or any other advice and are subject to change. This document is for information purposes only. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell this security, country or sector. Please note that portfolio holdings and positioning are subject to change without notice.