Brett Lewthwaite, Head of Fixed Income and Currency
Tuesday 20 December 2016
Brett Lewthwaite, Head of Fixed Income and Currency
Fiscal hope will likely meet secular reality
There is a lot of optimism that Donald Trump will seamlessly return the US to ‘normal’, with policies that will increase growth and decrease inequality. However, little attention is being paid to the current structural environment - possibly because doing so would significantly dampen this enthusiasm.
We have characterised the current environment as essentially being ‘contained’. Since the Global Financial Crisis, central banks have provided significant support to economies and markets in the form of zero (even negative) rates and $12 trillion of quantitative easing policies - so already extraordinary stimulus has been applied to the global economy. Any time there has been a falter with economies or financial markets, central banks have stepped in to ‘balance’ the container and this was particularly evident at the beginning of 2016.
Markets have become dependent on this policy support and ‘contained’ environment, and we believe the election of Donald Trump has the potential to interrupt this.
The rise of populism
The main beneficiary of the policy responses to date has been financial markets rather than underlying economies. This has translated to growing inequality with average incomes in the US rising almost three-fold for the top 1%, while the bottom 99% have not had any increase in incomes. Trump’s policy rhetoric appealed to those effected by rising inequality but it remains to be seen if he can be successful in bridging this gap.
Given Trump’s often inconsistent statements, we discuss below three possible scenarios on how this could play out (a combination of each is also possible).
Trump scenarios and what we really need
‘All Talk’ Trump: In politics it is easier to say things than implement them. The structural challenges of elevated debt, central bank dependencies and demographics are too difficult to overcome and the status quo remains. Despite the optimism, hope meets structural reality and low growth, low yields and the chase for yield continues. The ‘container’ remains intact - just.
Fiscal Trump: Fiscal policy is additive to monetary policy. US growth improves but at the expense of even more debt. A higher USD will likely ensue which will ultimately hinder US growth. It will be difficult for the US to check-out and successfully go alone on a fiscal spend to boost growth - the ‘Hotel California’ effect. Markets initially perform well on better growth prospects but diverging economies ultimately leads to ineffective global growth outcomes.
Hard Trump: US focussed policy is enacted, decreasing global growth and trade. Populism spreads further and risk assets falter. The ‘container’ comes under significant pressure as global policy maker support is removed. Expect heightened volatility and with assets priced almost to perfection, the risk of a correction is significant.
What we really need - Global co-ordination: The above scenarios fail to address the real issues that are facing the global economy - in particular the debt problem. We believe structural reforms such as increased global trade, global fiscal initiatives, cuts to entitlement and benefits, and debt restructuring, are needed. However, given the rise of populism, not just in the US, this will likely remain on the wish list for a while longer.
We are wary that a new set of policies (fiscal rather than monetary) and de-globalisation over globalisation are the opposite of what has served financial markets very well over the last eight years. With that, we anticipate heightened uncertainty and increased volatility in 2017. Our current approach to multi-sector fixed income investing is to accumulate bonds on the recent weakness as we believe, there is a limit to how high bond yields can go with current debt levels. In credit we continue to hold investment grade as a core holding and will reduce high yield as reward diminishes or if uncertainty rises. Emerging markets are currently experiencing significant volatility so we are avoiding this sector for now but depending on which Trump we get there may be opportunities in 2017. To further protect portfolios, we will continue to utilise tail risk hedging strategies to counter the higher uncertainty and fatter tails
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