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THE LONG VIEW July 22, 2016 7:41 am
Why the end of austerity would be an earthquake for markets
Michael Mackenzie
Shock proof. The resilience of markets is standing out as a defining feature, with setbacks shortlived and ultimately providing investors with a buying opportunity.
In a climate where everyone worries about the next nerve-jangling event, the past 12 months have been marked by bouts of turmoil and predictions of gloom that ultimately fall short.
The list includes China’s currency devaluation last August, the rout in commodity prices which triggered a plunge in the price of energy junk-rated debt and the global growth scare in January.
Recent slings and arrows have also failed to live up to their fearful billing for markets. Initial alarm cast by the long shadow of Brexit and bad loans made by Italian banks has been replaced by equanimity. In plain performance terms, we have a record high for the S&P 500, while the FTSE All World index has climbed 18 per cent from its nadir in February.
One obvious reason for the ebbing resonance of market shocks is the easy money policies of central banks, that subdue both interest rates and market volatility. In a world where some $12tn of bonds yield less than zero, a number of investors believe the limits of central banking have long been reached.
Welcome to the era of investing in an earthquake zone, where market tremors are routine and few think the big one will ever occur. Testing the shock proof status of markets therefore requires a departure from the current playbook that has dominated finance in the wake of the 2008-2009 crisis.
Eight years of austerity and a prolonged fall in central bank borrowing rates and bond yields have failed to deliver sustained economic growth. Hence the rise of populist politics, while calls for fiscal stimulus are steadily growing. It is a path being taken by Canada, with a post-Brexit UK looking to loosen the shackles. Both US presidential candidates, notably Donald Trump, are also focusing on the fiscal side of the stimulus equation.
Meanwhile, the test bed over the past two decades for policy experiments has been Japan and there, talk of “helicopter money”’ — whereby the budget deficit is financed by a permanent increase in the central bank’s monetary base and not via government bonds — is the current hot topic of debate.
Of the 160 fund managers surveyed by Bank of America Merrill Lynch this month, 39 per cent expect “helicopter money” in the next 12 months. That is up from 27 per cent in June.
For the broader global economy, any significant fiscal stimulus through infrastructure spending, vouchers for consumers and/or some combination of tax cuts is seen boosting growth and pushing up inflation expectations.
Patrik Schowitz, global strategist at JPMorgan Asset Management, says fiscal stimulus calls for buying cyclicals, rather than looking at dividends and long duration bonds. “The question is how much stimulus would be required to convince investors that it works,” he adds.
Given the extreme hunt for yield in recent years, the prospect of major fiscal expansion, particularly if undertaken by leading economies in unison, would amount to a significant shock for plenty of portfolios.
Piling into dividend-paying equities and long-dated bonds has helped these asset classes achieve gains of 20 per cent alone since last summer. An ever shrinking pool of positive yielding bonds has spurred a mad dash for any asset with some kind of fixed return.
Currently, investors such as pension and sovereign wealth funds are pumping money into emerging market bonds at a record pace, lured by yields that remain well above those of developed world sovereigns.
The result? A classic crowded trade, and, as market history tells us, these episodes never end well. A decisive flick of the fiscal switch to loosen austerity would herald a stampede from the best performing sectors of global markets. The ensuing surge in market volatility would prompt investors to sell their holdings based on risk management models — known as a value-at-risk (Var) shock — in order to avoid losses.
“There’s clearly a push away from austerity towards fiscal stimulus and a Var shock is a risk here and could be evolving as we speak,” says Chris Watling of Longview Economics.
And we have felt the Var tremors before, notably during the summer of 2013 with the taper tantrum and then, from last April, when the 10-year German Bund yield rose from just above zero per cent to near 1 per cent by early June. As yields and volatility rise, investors embark on a rotation into cyclicals, but as we saw last summer, this type of churning in equities is subsequently overwhelmed by broader market turmoil.
For now, the push for sustained fiscal measures as monetary policy reaches its limits, remains more talk than action. The potential for sparking a massive rush for the exit from what has been a relentless search for yield cannot be ruled out. One can only hope that markets simply experience another tremor and not the big one.
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