What can policymakers do to support growth? What levers do they have? How much room is there and how likely is it that this room will be used?
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With growth continuing to be positive but anaemic, after years of central bankers yanking at their monetary policy levers, the focus is gradually shifting to the politicians and their two main handles - fiscal and structural policy. With interest rates at record lows it makes sense to use fiscal policy to fund much-needed infrastructure investments, projects with positive effects usually spreading throughout the economy. And with increasing international competition it seems to be a good time to make the necessary structural policy changes to increase efficiency and stay competitive.
In our previous Compass we made the point that political events and associated short-term market moves usually turn out to be noise without major significance for medium-term investors. One of the reasons is that these events usually are ‘known unknowns’ the markets have prepared for. Another reason is that the impact on economic fundamentals tends to be limited.
But why is this? Why don’t the politicians do something radical to move the dial? The answer seems to be that this is much easier said than done. And this is why politicians often focus more on saying than doing. Fiscal policy appears to be constrained by government debt levels or the electorate in many countries. And structural reforms seem to be difficult to push through when there are increasing doubts about how equitably future gains will be distributed. This suggests that it is becoming increasingly difficult for politicians to meaningfully differentiate themselves. This may explain why the campaign rhetoric often seems to gravitate towards emotionally charged overpromises or side-shows. What some now refer to as ‘post-truth politics’, and others call ‘populism’.
What does this mean for us as investors? In our view, the most important implication is that it makes more sense to invest on economic and market fundamentals than political narratives. Medium- and long-term investors should look through and beyond referenda and elections and use short-term volatility as opportunities rather than as threats to the cycle.
Policymakers might not be as important as they sometimes make us believe. Even though they play a crucial role determining the rules of engagement and providing support in times of threat to the overall financial system, we should not expect them to have silver bullets to protect us from business and market cycles. There will be times when central banks with inflation targets will be forced to hike rates to the extent that it precipitates the end of the cycle. And with politicians finding it hard to promote fiscal discipline during good times, they will at times be forced into austerity rather than fiscal expansion during the downturns.
But even though we seldom see politics as the driver of economic and market cycles, we think it makes sense to be vigilant and open-minded, especially when the business cycle seems to defy ageing and when globalisation and technological change are stretching the social fabric in many countries. This is why most of this Compass is dedicated to policy.
Our articles cover the scope for fiscal policy in developed markets, the impact of the coming US presidential election, the developments following the UK’s decision to exit the EU, and the state of the Chinese economy and likely policy actions. This edition also includes the recurring outlook from our Tactical Allocation Committee, with our strategic and tactical exposures and rationale, and the recent update to our Strategic Asset Allocation.
In conclusion, we think that we still live in a world where economic growth is the norm and recessions are exceptions, and where it makes sense for a medium- to long-term investor to stay invested in portfolios with a tilt to risk assets. We also believe that careful analysis of the drivers of growth and inflation will improve the odds of timing economic and market cycles, rather than following the political narrative. Even though we recognise that some markets are becoming more expensive, we remain tactically overweight risk assets like equities and high yield bonds. Even though we think bond yields will creep up, as the current deflationary fears recede, we don’t expect this correction to be strong enough to derail the equity market.