What is the real growth question to ask?
February 28, 2018
As we begin 2018, there is little doubt that global growth is on its strongest footing since the financial crisis, which has many market participants forecasting that inflation is about to return and this is the year we would finally normalize monetary policy. At our recent Strategic Forum, we acknowledged the strong growth outlook, but for us the more important question is not whether growth is strong enough to lift inflation, but is it strong enough to surmount the impact of the removal of all the extraordinary central bank support we have become so dependent on?
The first Macquarie Fixed Income Strategic Forum for the year, held in late January, is always one of our most interesting forums. It occurs amid a deluge of expert "new year outlook" opinions from all walks of market life, confident in their predictions of what is in store for the year ahead. These (generally always) positive views are then embraced by markets, however realistic they may be. This combination makes for a great backdrop for debate and discussion, especially when our own views are often cautious about this outlook.
The forecast everybody is talking about
Over recent years, there has been a sense of déjà vu at the beginning of each new year, with a general theme of "This year growth will be strong, inflation will return, and central banks will finally normalize monetary policy." Yet this prospect of normalization ultimately fades as each year progresses — some years more quickly than others. Our team has always been more skeptical of these new year consensus views, focusing more on the structural challenges and extent of central bank interventions in determining our views and portfolio positioning.
In some ways, the beginning of 2018 has patterns similar to past years. As we came together for the Strategic Forum, we reflected that 2017 was another déjà vu year, as hopes of a new, pro-business US administration making impactful change took much longer to implement than the market had anticipated. However, we acknowledged that by the start of 2018, some progress was occurring and that global growth was on its strongest footing since the financial crisis and could well be poised to pick up in a synchronized fashion. As such, it did not surprise us to find that “everybody is talking about” strong growth and the prospect of a wage-led pickup in inflation as their big themes for 2018.
In our discussions, we investigated these themes and noted the possibility for an upside surprise for growth, particularly in the US, due to tax cuts and deregulation that are under way, at least in the first half of the year.
In terms of inflation, we looked at many different measures and determined that it is hard to find one that indicates inflation is currently trending higher — most are tracking sideways at best, and some are actually falling. In fact, inflation remains locked below the target levels of many central banks. Despite this, the consensus view appeared to be that inflation was actually picking up, and that central banks appeared to be shifting toward the removal of policy accommodation as a result.
Our analysis for solid-to-stronger growth and skepticism that inflation was picking up led us to question whether growth would be strong enough to create some wage pressure and therefore inflation. The evidence suggested otherwise, but we did highlight that even the possibility of inflation becoming an embraced market theme was something that may test what has been a very low volatility market environment. While we acknowledged that this is what everybody is talking about and that we were more measured than consensus, we conceded it could be a tradable theme for the near term.
The realities nobody is talking about
We then highlighted what "nobody is talking about (but should be)." We discussed that the two most significant factors driving fixed income markets since the financial crisis are debt and extraordinary monetary policy by major central banks. Indeed, the $US20 trillion in quantitative easing (QE) intervention and abnormal (negative) setting of interest rates, exhibited best by the trillions of dollars of negative yielding global bonds, has caused the most incredible insatiable chase for yield.
These real structural forces are easily pushed to the side by the excitable market consensus, whose pre-crisis hardwired textbook thinking reverts to the economic relationships of the past, such as the notion that debt does not matter. Even more perplexing to us is the view that the reversal of this central bank intervention, which was so instrumental in elevating risk asset prices, seemingly is not relevant and not worthy of factoring into the outlook for 2018.
We place indebtedness alongside the other structural challenges facing the global economy, including the improvements in technology, demographics, and dependencies, and note the old adage that high debt levels and high yields are not natural dance partners and will not coexist. Given that we are way past a point where Schumpeter’s creative destruction phase will play out without devastating economic fallout, our conviction remains high in our structural view that there is an embedded limit to how high bond yields could rise, providing solid comfort that a cap to this risk exists. If we are wrong, the higher yield impact on debt levels should quickly result in slower economic growth, testing risk assets, and increasing the desire to hold defensive assets. This is structural and heavy, hanging in the background like a dark cloud — it is not going away.
The $US20 trillion central bank intervention and unnatural setting of interest rates, also known as the global chase for yield, has played the dominating role in all fixed income markets since the financial crisis. It has caused bond yields to remain low, credit spreads to tighten (troubled creditors and countries included), and risk asset prices to trend higher.
While it is great that at the start of 2018 the economic environment is better than it has been for quite some time, market participants cannot just now ignore these highly supportive forces. Whether this central bank influence slows, stops, or changes direction is a key factor in considering the outlook. The more important question in our mind is not whether growth is strong enough to lift inflation (in our view, it probably is not), but is it strong enough to surmount the impact of the removal of the single biggest multiyear support to this incredibly complacent, low volatility, environment we have been in?
In considering these significant influences, and the other structural factors affecting the global economy, we believe central banks will need to be highly cautious and very patient with shifts ranging from varying degrees of less easing to policy tightening. Otherwise market disruptions, volatility, and financial conditions will increase and quickly dampen economic growth. Indeed, given how much monetary policy stimulus was (and still is) required, and how long it has been in place, it is rational to expect a challenging withdrawal. As such, the market commentary that appears eager to consider an imminent surge in growth and inflation driven by pent-up demand seems misplaced.
While we acknowledge growth may improve further in the near term and may move inflation modestly higher (again in the near term), we doubt growth and inflation will be strong enough to sufficiently change the central bank dynamics to end the chase for yield this year. The reaction since the Strategic Forum is a good demonstration of the embedded self-reinforcement mechanism that has been built into this debt-addicted and central bank-dependent market. The scenario goes: Growth picks up, yields rise a little, risk and confidence crumble on fears of indebtedness and central bank withdrawal, curtailing subsequent growth and inflation, and yields stay low. Using more debt to fix a massive indebtedness problem was never going to fix the underlying problem and return economies to “normal.” It was only ever going to treat the symptoms and make the real problem larger and even less solvable, however pleasant it has been to enjoy the central bank support and hope otherwise.
At our Strategic Forum in September 2017, the view was that we should not fear duration, as it will predominantly be driven by the structural realities facing the economy — the debt overhang, the improvements in technology, and demographic headwinds. While credit markets had already benefited from the ongoing cyclical upswing and further upside was limited, we believed that credit markets remained fundamentally sound and there was still room to participate while gradually scaling back risk. These views served us well over the past year.
As we enter 2018, provided our general consensus that the chase for yield will remain a predominant driver of fixed income this year, then little has changed. Accumulating duration is a sensible strategy in a multisector portfolio. Credit remains supported by solid and improving fundamentals, but we acknowledge that valuations are stretched and elements of risk reduction should continue. If our views evolve more toward the growth environment being strong enough to allow for greater central bank withdrawal, we would advocate a case of patience in accumulating duration, awaiting higher yields, and concurrently reducing credit exposure on the belief that sustained higher yields would materially affect risk sentiment and the pricing of credit-based securities regardless of solid fundamentals.
The views expressed represent the Manager's assessment of the market environment as of February 2018 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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