Investor positioning is as extreme as it has been since the dotcom bubble. In a neat bit of symmetry, it is some of the assets that were so detested at that time that now look most overinflated. Low volatility, high quality and defensive, with a yield, please — nothing else will do.
Investors are continually having to convince themselves that these lofty valuations and record-low yields are merited because growth is anaemic, deflationary forces abound and rate rises are years away. Nevertheless, we believe that changing perceptions over monetary and fiscal policy could overwhelm these factors and cause a meaningful and painful rotation within markets.
Base rate rises might be deemed necessary to cause such a shift in investor sentiment and positioning. But even then, as we have seen in the US, a rate rise in the world’s biggest economy has not thus far derailed the unquenchable search for stability and yield.
The two best performing sectors in the US year-to-date are by some margin utilities and telecoms services — not sectors you might expect to outperform in a “normal” tightening environment. Meanwhile, the US two-year government bond yield has gone from 1.05 per cent in December to 0.55 per cent at its July low.
While we do not think rate rises are on the agenda outside the US, we do see a realistic chance that bond yields everywhere will start to rise. This will probably be caused by the growing acknowledgment that having moved from QE to ZIRP to NIRP, monetary policy is now exhausted and has arguably failed in its aim of stoking nominal GDP growth. Crucially, at the same time, we expect to see a general renaissance in fiscal expansion, which has a better chance of achieving this elusive goal.
Japan is at the forefront of this evolution. Fiscal policy was always one of Shinzo Abe’s Three Arrows, but the noteworthy lack of meaningful action from the Bank of Japan in recent months leads us to believe that Japan’s hopes are now pinned on government spending. Governor Haruhiko Kuroda has all but passed the baton back to Prime Minister Abe, who understands that — with apologies to Chief Brody in Jaws — he’s going to need a bigger bow.
Central bankers will clearly keep talking the talk, reviewing their options, not ruling anything out, but essentially they have no bullets/arrows left — and know that some of their previous salvos proved to be the monetary equivalent of friendly fire, inflicting wounds on their nation’s banks through the adoption of negative interest rates. Meanwhile, there are almost no more bonds to buy. The Bank of Japan will own 50 per cent of JGBs by 2018 on its current trajectory.
The Bank of England presumably feels duty bound to act but we would question the efficacy of cutting rates further. A 0.25 per cent cut in base rates equates to £20 per month in the pockets of a typical floating rate mortgage holder. Big deal. It also further undermines the profitability of our beleaguered banks, the lifeblood of the economy, and hurts savers.
In Europe, Mario Draghi has been crying out for political leaders to do their bit on structural reforms and pro-growth policies, with little effect. But we are seeing a moderation of the fiscal constraints and penalties that were imposed in recent years to control deficits in the periphery.
Might this relaxation evolve into full blown stimulus in core Europe? With elections looming in France and Germany, incumbent governments might decide that they must fight fire with fire against their populist rivals, and fiscal policy must count as a decent bet to win votes. Fiscal rectitude, while apparently sound, has proven to be politically life threatening.
Meanwhile in the UK, the Brexit vote has given Chancellor Philip Hammond carte blanche to ramp up borrowing (at record-low interest rates) to invest and spend. An early election together with a bigger Tory majority would only increase his boldness.
To us, traditional fiscal policy seems like a more likely scenario than so-called helicopter money. Its premise, in its various theoretical guises, appears more fraught with risk in terms of acting as an outright currency debasement or of simply being a convoluted form of government balance sheet expansion.
This apparent exhaustion of central bank ammunition will inevitably give investors pause for thought. Remember what happened when Ben Bernanke first tabled tapering in May 2013? There was a major rotation — within a protracted sell-off — across assets. The perception that other central banks are done could have a similar impact. We think it is time to ensure that portfolios are not too exposed to this one, albeit very large, monetary dynamic — one which appears to have run its course.
James de Bunsen is a multi-asset fund manager at Henderson Global Investors
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