Pulling Fiscal Policy Lever
October 24th, 2016 6:15 amVia WSJ:
By Jon Sindreu
Oct. 23, 2016 3:23 p.m. ET
52 COMMENTS
A growing number of investors and policy makers, seeing central banks as powerless to revive an anemic global economy, are championing a resurgence of fiscal spending.
A move away from central-bank-led policy, and toward the use of the government’s taxing-and-spending power to revive growth, would end a years-long economic era and could cause upheaval in financial markets.
Investors, among them bond king Bill Gross, once feared that government profligacy was a death knell for sovereign bonds. Back in 2011, Mr. Gross dumped U.S. Treasurys and declared that U.K. government bonds were resting “on a bed of nitroglycerine.”
Today, he is calling for more government spending.
It is far from clear that the shift is yet upon the world—especially Europe and Japan, which are deep into the unprecedented monetary experiment of negative interest rates. But there are glimmers that it is coming.
The U.K. is wrestling with the market and economic effects of its June vote to leave the European Union. This month, the prime minister bashed loose monetary policy while her Treasury chief talked up spending on infrastructure and housing. Other European countries have eased off the austerity that defined their response to the continent’s yearslong debt crisis.
And the International Monetary Fund, once a proponent of budget cuts, now urges governments to spend more.
For several years, governments have feared incurring more debt to do so. Instead, they have left it to central banks to lower the cost of borrowing and thus encourage households and businesses to spend.
That hyperactive monetary policy has pushed up prices of assets—including bonds—and damped market volatility. Except for the occasional “tantrum,” stocks and government bonds have marched ever upward.
But there is growing evidence that central-bank policy is underwhelming: Households and businesses haven’t gone on a spending binge. What’s more, the policy has come at a cost to commercial banks, which have seen their profits compressed at a time when many are already weak.
So policy makers are toying with the old idea of having the government do the spending. Such a change, were it to come to fruition, isn’t likely to have the same salutary effect on stocks and bonds as central-bank stimulus, which relies on pushing up the value of financial assets.
“We are leaving this very certain, very comfortable investment environment,” said Guy Monson, chief investor for almost 20 years at London-based Sarasin & Partners LLP. “We are moving into a new world.”
The first sign is seen in bond yields, which rise when bond prices fall. In the U.K., yields are up sharply in the days since Theresa May and Phillip Hammond made their remarks.
Bond yields have crept up from their record-low levels elsewhere. In Germany, the 10-year bond now yields 0.007%—a tiny sum, but at least positive after being below zero for much of the summer.
Indeed, bonds have been the main beneficiaries of monetary stimulus. Since the start of the year, they are up 6.5% globally, figures by Bank of America Merrill Lynch show. They have even outperformed equities, traditionally riskier and higher-returning investments, which have gone up only 4.5%, according to MSCI.
Loose fiscal policy could mean higher bond yields, because central banks are expected to offset the inflationary effect of government spending by raising rates, or at least lowering them by less. Yields on bonds tend to follow interest rates.
Stronger global demand because of fiscal stimulus would help commodities, exporters and builders. Stocks more broadly might be mixed, because higher rates would weigh on them.
“If you had lots of fiscal expansion you could change the growth dynamics globally quite dramatically,” said Geoff Kendrick, economist at British bank Standard Chartered. “It would be a step back to somewhere normal.”
Fund managers at BlackRock Inc. believe higher government spending will mean a rough 2017 for bonds around the globe.
U.S. Treasury Secretary Jacob Lew said in September that policy makers are “no longer debating growth versus austerity, but rather how to best employ fiscal policy to support our economies.” The IMF has also moved beyond the “expansionary austerity” it championed in 2010.
Indeed, European officials decided in July against fining Spain and Portugal for spending too much.
“People have gone from believing stimulus is evil and you should balance your books to the realization that nothing is working,” said Mike Riddell, London-based fund manager at Allianz Global Investors.
On top of skepticism about its power to steer output and inflation, monetary policy is shouldering blame for its effect on banks. By pulling interest rates into negative territory and pushing down long-term yields, central banks have torpedoed the profitability of private lenders.
“It’s not really a win-win situation to keep doing this,” said James Athey, portfolio manager at Aberdeen Asset Management.
In the eurozone and Japan, bank shares have dropped roughly 20% and 29%, respectively, since the start of the year. Fiscal stimulus could change that.
“The first place where you will see it is Japan,” said Marino Valensise, head of multi-asset investment at Barings, who has started buying Japanese bank stocks.
Investors are also eyeing companies that directly benefit from public infrastructure works. Construction and engineering stocks in the S&P 500, for example, have lagged far behind since 2014, but this year are up 18% compared with 4.8% for the broader index.
Commodities, which have had a dismal couple of years, would be beneficiaries of stronger global demand as well. That would be good for emerging markets, which are often commodity exporters, even though a stronger dollar and an outflow of money back to advanced nations could pose problems.
“If there was a real snap-back in interest-rate expectations and in yield curves, that could in the short term cause some volatility for emerging markets, but overall you’d think that kind of action would be positive for world growth,” said Stephanie Flanders, chief European market strategist at J.P Morgan Asset Management.
Still, some investors warn that risky assets overall could take a hit, because higher interest rates make the returns they promise look less attractive.
“This could pose problems for equities, credit and high yield,” said Joachim Fels, managing director at Pacific Investment Management Co.
To be sure, most analysts expect central banks to keep interest rates low for a long time, as fiscal policy still faces much political resistance to be deployed in abundance.
“The extent to which it can happen is going to be limited” because of big public debt piles, said Didier Saint-Georges, a member of the investment committee at Carmignac. As a precaution, the French asset manager is reducing its exposure to bonds, but believes that betting on very loose fiscal policy remains too much of a risk.
“We are reluctant to get carried away,” Mr. Saint-Georges added.