Monthly Investment Letter: what's next for monetary and fiscal policy?

This post was first shared on ubs.com/cio. Visit the website to find out more about UBS CIO investment views.

In making Apocalypse Now, director Francis Ford Coppola learned that if you want to get something done you need government helicopters, famously locating film production in the Philippines when the country’s then-president agreed to provide him with military equipment.

The need for government helicopters was also a theme in outgoing European Central Bank (ECB) President Mario Draghi’s recent press conference. When asked whether “helicopter money” would be helpful in stimulating the European economy, he said that “giving money to people, in whatever form, [is] a fiscal policy task, it’s not a monetary policy,” before adding that “it’s high time, I think, for the fiscal policy to take charge.”

While central bankers might judge it to be “high time” for fiscal policy to take charge, we don’t yet see helicopters full of money on the dawn horizon. Setting aside our own ideas about the cinematic merits of Apocalypse Now or the economic wisdom of helicopter money, in this letter I look at how we see developments in fiscal and monetary policy impacting markets.

Germany has the capacity to enact fiscal stimulus, but it appears willing to do so only after an economic crisis materializes. A split US Congress, meanwhile, is likely to block any large stimulus measures ahead of next year’s US presidential election. And while China has both the means and the will to use fiscal policy, it is likely only to pursue modest stimulus in this cycle, given its desire to constrain debt growth.

It will therefore likely be left, once again, to monetary policy to fight the current slowdown, and we expect central banks to continue to deliver monetary easing in the months ahead. This should help the US and Eurozone economies avoid recession, and mitigate market downside. It is also possible that trade policy could surprise to the upside before scheduled tariffs come into effect. That said, we remain skeptical that central banks, in the absence of a trade agreement, have sufficient firepower to drive meaningful gains in the market. We also have to acknowledge that hopes for a trade deal have been dashed many times before.

We position for this tactical environment through an underweight in equities, particularly international stocks, which are more susceptible to trade tension risks. We recommend an overweight to US dollar-denominated emerging market (EM) sovereign bonds, which offer a yield pickup over similar-risk corporate bonds, and to Treasury Inflation-Protected Securities (TIPS), which can benefit from higher inflation expectations being fostered by an easier Fed. In more-aggressive portfolios, we recommend an allocation to long-duration Treasuries to help protect against equity market volatility.

Fiscal policy

Whether governments should or can afford to spend more money is ultimately a political question. As investors, we need to understand the current political philosophy of those leading the major economies, interpret what that philosophy means for the likelihood of fiscal stimulus, and consider whether upcoming events might alter that philosophy or governments’ reaction function.

With this in mind, we currently do not foresee fiscal stimulus sufficient to drive further near-term upside in the markets in any of the major economies.

In the Eurozone, the Maastricht Treaty limits fiscal deficits to 3% of GDP, so the scope for stimulus in the region is limited. The region’s largest economy, Germany, does have the space to provide stimulus within this restriction, but it appears committed to its balanced budget stance for 2020.

Finance Minister Olaf Scholz has said that “we are in a position to counter an economic crisis with many, many billions of euros, if one actually breaks out in Germany and Europe.” But this merely confirms that fiscal policy will be reactive, rather than proactive, and the “many, many billions” was later confirmed to be EUR 50bn, equivalent to just 1.5% of German and 0.4% of Eurozone GDP.

Our conversations with senior economists and policymakers in the country suggest that the bar for changing this stance is set relatively high. While a major escalation in the US-China trade conflict or a hard Brexit may suffice to trigger a rethink, a technical recession alone may not be enough to trigger higher government spending.

The US has shown greater historical willingness to enact fiscal stimulus. Most recently, in 2017, it enacted tax cuts that boosted the country’s GDP by 0.3% in 2018, according to the Congressional Budget Office. However, a divided Congress means significant stimulus measures in the near term look unlikely.

We will be watching the US presidential race closely for signs of what the country thinks about the role of fiscal policy in shaping the economy these days. In particular, we will be listening for whether candidates float ideas for closer coordination between fiscal and monetary authorities. Such approaches could lead the US to run much larger deficits, albeit at the risk of higher inflation.

China has also used stimulus effectively in the past, most notably in the aftermath of the 2007–09 financial crisis when it helped the world avoid an even worse downturn. And this year it has already enacted a package of tax and fee cuts worth around 2% of GDP, while also permitting a larger local government bond quota of CNY 3.1tr this year vs. CNY 2.2tr last. This quota could even be raised in 4Q to support infrastructure investment.

Unlike in 2008, however, policymakers are far more conscious of the potential side effects of excessive stimulus, which include rising inflation, debt, and property prices. So any continued injections of funds into the economy are likely to be more measured and reactive, as well as subject to changes in the economic outlook and progress in trade talks with the US. Global investors are therefore unlikely to feel the effects of Chinese stimulus as much as they have in previous years.

In sum, the prospects of near-term fiscal stimulus in the US and the Eurozone are low, and action in China will depend on economic developments. With isolated exceptions, like India, most heavyweights of the world economy are likely to rely on monetary policy to help mitigate the current growth slowdown.

Monetary policy

Central banks have not just talked about the need for more governmental policy to support growth; they have taken action. In the past month, eight major central banks have cut rates.

The ECB unveiled a package of measures that included a cut to deposit rates, EUR 20bn per month of quantitative easing (QE), and financial help for banks. The Federal Reserve has cut rates by 25 basis points (bps) twice this year, and we expect further cuts, depending on economic developments. Governor Haruhiko Kuroda of the Bank of Japan has said that pushing its policy rate deeper into negative territory, from today’s –0.1%, is an option in his country. And the People’s Bank of China has lowered reserve requirement ratios by an additional 50bps, with further action expected.

Yet, while central bankers are committed to action, they are facing visible limits to the effectiveness of their current tool set. For example, the tiering of rates in Europe is a sign that the ECB is having to innovate to mitigate the adverse consequences of negative rates. China has had to introduce the new loan prime rate benchmark to try and improve an inefficient monetary transmission mechanism that has failed to meaningfully lower corporate funding costs despite sufficient bank liquidity. And in Japan, despite the negative rate policy since 2016, banks’ attitude to lending remains cautious.

The Fed, meanwhile, will be conscious that the effectiveness of lower interest rates may be limited at a time when political uncertainty is the primary reason for the economic slowdown. A working paper from Fed staff economists estimates that trade policy uncertainty has contributed to a 0.8ppt drag in world GDP growth over the past year, while Fed Chair Jerome Powell reminded us at a recent press conference that monetary policy only operates with a “long and variable lag.”

Central banks are trying to use the tools at their disposal to stimulate the economy at a time of slowing growth and muted inflation. But they are having to tread carefully to reduce the risk of unintended consequences, and with rates already so low, the effectiveness of their toolkit is questionable. It may require a resolution to the trade conflict to unlock some of the positive economic effects of their monetary policy.

Asset allocation

With most countries lacking the willingness to embark on a more substantial fiscal drive, and the efficacy of monetary policy under question, the probability of stimulus fueling meaningful medium-term market gains seems lower than usual. But if growth were to slow further, monetary easing, and the possibility of reactive fiscal policy do reduce the chance of credit stress.

This month we highlight three main investment ideas: underweight equities, prefer US stocks to their Eurozone counterparts, and favor fixed income assets that benefit from easier policy.

• We underweight equities. Stocks are being driven primarily by the outlook for US-China trade talks, with other geopolitical concerns such as US impeachment and Brexit clouding the picture. While central banks can put a floor under markets, we do not believe they have the capacity to push stocks significantly higher in the short term.
• We prefer US equities versus Eurozone equities. While we are underweight stocks overall, we expect the US market to outperform the Eurozone. This rests on our view that Eurozone stocks are more vulnerable in an environment of heightened uncertainty about global trade and fears of weaker global growth. We are neutral on US stocks, while recommending an underweight to international developed and emerging market equities, because we expect the US market to be more resilient. In addition, even after 50bps of rate cuts this year the Fed still has more ammunition than the ECB to combat slowing growth.
• We favor income-generating strategies. In an environment of slower growth, central banks will continue to ease policy. We still see opportunities for investors to earn yield in US dollar-denominated EM sovereign bonds, and also recommend an overweight to Treasury Inflation-Protected Securities (TIPS), which can benefit from higher inflation expectations. In more-aggressive portfolios, we recommend an allocation to long-duration Treasuries to help protect against equity market volatility.

In addition, we hold the following positions in our FX strategy:

• We now underweight the Australian dollar versus the US dollar. Global trade tensions which have weighed on growth sentiment in Asia should hurt the Australian dollar, which is often seen as a proxy for Chinese growth. Domestic demand and employment growth are deteriorating fast in Australia, which could lead the Reserve Bank of Australia to ease policy even further.
• We overweight the British pound versus the US dollar. The latest twist in the Brexit saga was the UK Supreme Court’s decision that the suspension of the UK Parliament, which strongly opposes a no-deal Brexit, was unlawful. Our base case remains for the UK to ask for an extension to the 31 October Brexit deadline instead of leaving the EU without a deal. GBPUSD currently trades at 1.23, well below our purchasing power parity estimate of 1.58. Meanwhile, the Bank of England is on hold, while many other major central banks are easing policies.
• We overweight the Norwegian krone versus the euro and Canadian dollar. While an uncertain global economic outlook hurts the krone currently, the Norges Bank could still hike rates one more time within the next year, given above-trend economic growth and inflation close to its target. The ECB on the other hand has announced easing measures including a cut to the deposit rate and a QE program. Given ongoing weakness in the Canadian housing market and the Bank of Canada’s dovish stance, we also remain cautious on the outlook for the Canadian dollar.

Please visit ubs.com/cio-disclaimer #shareUBS