Japan's imposition of yield-curve controls marks the moment that monetary policy became subservient to government policy. Neil Dwane says "fiscal dominance" is a dangerous successor to financial repression–not just for investors, but for economies too.
With its new policy of yield-curve control, the Bank of Japan (BOJ) has begun supplanting financial repression with "fiscal dominance." This essentially means that Japanese monetary policy will now be subservient to government policy, which will use domestic fiscal measures such as wage controls to create the necessary levels of inflation that have up to now been hard to manufacture.
With this move, Japan has all but ended the pretense of central-bank independence. If the practice of financing fiscal policy with monetary policy is successful, it will create inflation that erodes capital savings in many bond markets, it will endanger the purchasing power of retirement savings, and it will threaten global trade by raising international tensions as currencies become more volatile again.
If Japan’s new initiative is successful, it could create inflation that erodes capital savings and threatens global trade
Will the world follow Japan's lead?
The BOJ’s recent changes are both a tacit admission that NIRP is not working and proof that Japan knows a new policy response is required to avoid a crushing classic recession. Japan's actions also move central-bank policy in a momentous new direction. The BOJ is promising to keep bond yields at their currently low levels while increasing the supply of yen into Japan’s economy until inflation meets or beats the BOJ's 2% target.
This sounds like continued financial repression but in reality it is much, much more. It will allow the Japanese government to fight the labor constraints of its ageing and shrinking population by implementing a "wages policy" that will mandate income and pay increases until inflation rises sufficiently.
The BOJ has raised the stakes in a dangerous game
With much debate at the Fed's latest Jackson Hole meeting about the policy responses needed to soften the inevitable US recession, the BOJ has substantially raised the stakes: It will be monetizing its government's financial needs at the expense of the yen. The Fed has admitted that it normally eases interest rates by approximately 5% during a recession, which it cannot do now. As such, it may resort to another significant bout of quantitative easing (QE).
Central banks now know that the longer QE lasts, the more it distorts economies and the harder it is to cease
For its part, the European Central Bank (ECB) has already begun to reach the limits of its own monetary programs, and it may be forced to taper regardless of its willingness to lessen its support for the economy. Indeed, central banks globally now recognize that the longer QE lasts, the more it distorts markets and economies, and the harder it is to cease.
Although fiscal dominance is so far limited to Japan, it could have profound implications for investors elsewhere
Clearly, we are migrating from a world of financial repression—where interest rates are held below stubbornly low inflation rates—to fiscal dominance, where the monetary policy of central banks becomes subservient to the solvency and fiscal requirements of their governments. This is a significant shift for many reasons:
- As Japan heads down this path, the yen and Japanese government bonds will likely come under pressure. A weaker yen would likely help Japanese exporters, but the overall trend against globalization and free trade may ultimately work against them.
- Although fiscal dominance is so far limited to Japan, it could have profound implications for investors elsewhere if other governments follow Japan's lead and ensure that their bonds no longer protect the purchasing power of savers.
- Whether economies stick with financial repression or tilt toward fiscal dominance, this negative environment may persist for decades. As such, global economic growth will remain slow and low, and investors' returns will be driven by their appetite for accepting volatility and risk.
- It continues to be important for investors to pursue alpha with active management, since beta returns are set to be low and volatile, which could undermine cheap index investments. And given the ongoing environment of volatility, investors should continue taking a close look at the risk-mitigation and diversification benefits that alternatives provide.
As the markets close the books on another tumultuous year, investors should keep watch on the rise of populist politics, China's re-emergence as a global growth engine and a renewed focus on government spending as interest rates remain low.
This past year has been an exhausting one for many investors: China started rebalancing, the Fed failed to raise rates, Europe grappled with Brexit, tensions rose in Ukraine and the Middle East, and the US suffered through painful elections before ultimately choosing Donald Trump. Surprisingly, while any one of these events could have caused a serious market setback, they kept plugging along valiantly—albeit with bouts of volatility—even as global growth stayed slow.
For their part, central banks all but exhausted themselves this year with their extreme monetary policies, prompting a renewed focus on fiscal expansion as one of the few remaining ways governments can hope to stimulate much-needed growth.
Moreover, economies around the world are still grappling with monumental levels of excess debt that are only serviceable at record-low interest-rate levels. As such, we expect 2017 to be a year of nominal growth and low returns as our long-running thesis of financial repression remains in full effect.
2017 outlook by region
- US: Escape velocity elusive as Fed tries to raise rates – yet consumers see little wage growth, and health-care costs start to rise. Trump boosts infrastructure and defence spending, pushes for return of cash held overseas. US dollar could weaken.
- Europe: Investors grow nervous about cloudy outlook from elections and triggering of Article 50. Euro-zone financials weaken, hurt by ECB’s moves toward tapering. Equities look attractive and high- yielding in a marketplace distorted by QE and NIRP. Growth should slow.
- Asia and EM: Fundamental economic restructuring in China, India and Indonesia offset stronger USD and slower global trade momentum. Rising global protectionism boosts regional development, spurring local consumer spending. Commodity outlook changes with China’s shift to oil and softs.
- Japan: Economic growth still very fragile as demographics and policy uncertainty affect confidence. New fiscal dominance allows Abe (with BOJ support) to legislate for inflation, which boosts domestic activity at yen’s expense.
5 investment themes to understand in 2017
As the markets close the books on one year and turn their attention to the next, investors looking to make informed decisions need to understand what's driving markets and economies. Here are the core themes to watch in the coming year.
Global economic growth: Still low, slow and dull
Investors should expect muted growth as the US enters its late-cycle period, Japan struggles with its ageing population and Europe suffers from Brexitosis. The US and EU should ultimately avoid recessions while staying stuck in the weakest economic expansions ever recorded. Emerging markets should prosper as China rebalances and much of Asia reforms.
Central banks: Rates "lower for longer” overall
We expect the US Federal Reserve to modestly increase rates, prompting central banks in emerging markets to lower their rates as inflation falls. The European Central Bank and Bank of Japan should maintain their loose monetary policies. We have passed peak global liquidity as central banks have pushed past negative interest-rate policies to begin supporting government spending.
China is still the big story, with Asia attractive overall
The biggest contributor to global growth is still China, which is requiring fewer industrial commodities and more oil and soft commodities as it urbanizes rapidly. Concerns remain over its capital position, but its "one belt, one road" policy for expanding trade and investment may be the new Marshall Plan the world needs after the Global Financial Crisis. With India and Indonesia now making significant reform progress, Asia offers the best balance of growth and investment.
Oil sees demand and supply fall into balance
For some time, we have advised investors not to expect oil prices to stay too low for too long, and our constructive position has begun to be validated. These very same low oil prices have led to receding industrial capital expenditures, and have helped demand and supply fall into balance. We believe a slightly rising oil price in 2017 should boost oil investment and global inflation, but we believe it will not ignite a new shale boom in the US. Supply will still be pressured by a fraught geopolitical situation in the Middle East, Latin America and Africa.
A change in political trends is underway
The tides of de-regulation continued shifting in 2016, and nationalism and populism gained ground: Brexit, the Walloons, Bernie Sanders and Donald Trump all played a part. Given the significant elections looming in Europe in 2017, politics should remain a key investment consideration—though some investors may simply stay away from certain markets despite attractive valuations. Monetary policy will also become more political as it becomes subsumed by explicit government policies of fiscal domination. As to where governments will spend the money their central banks print, we believe domestic infrastructure and defence spending will be the focus of many countries in the coming years.
Asia is investing in long-term competitiveness through increased R&D
Research and development as a percentage of GDP is highest in Korea and Japan
Source: OECD, Allianz Global Investors, data as at December 2013. *US, Canada and Israel data are as at December 2012. Size of the circle reflects the relative amount of annual R&D spending by the indicated country.
Taking action with a renewed focus on active investing
In many ways, 2017 will offer the same diet as 2016: Thanks to low market returns, investors who take insufficient risk will generally find insufficient results. Moreover, the historical long-term performance many investors hope to see again looks to be just that—a thing of the past. The future demands active, incisive hunting for capital-growth and income opportunities as we wait for a turn in the economic cycle to come one year closer.
Reaching objectives means taking risk
The broad market returns (beta) of many asset classes could feasibly go even lower: Without the earnings growth the markets have been waiting for, yields cannot fall further and equities cannot rerate higher. Taking some credit and duration risk—and employing dividend-focused strategies—may help protect the purchasing power of savings against inflation's ability to slowly increase health-care, education and living expenses.
Become more selective and active
As beta becomes more volatile, investors need to assess their desire for capital growth (through real assets like growth-style equities and property) against their need for income (which can be found in fixed-income and short-duration assets in Asia, the US and emerging markets). Investors can then use active strategies appropriately to generate above-market returns (alpha). Significant diversification with alternative investments can help.
Investing requires patience
As the markets increasingly focus on the short term, investors ironically must become more patient and contrarian: The power of compounding takes time to work in growth- and income-focused strategies, so a long-term perspective is essential for optimizing results.
Diversify, don't herd
Asset correlations and volatility are high, which could cause different asset classes to swing wildly in the same direction. Extreme monetary policy measures from central banks—such as negative interest-rate policies and quantitative easing—have also herded many investors into the same positions, which may reduce returns. Look for strategies that offer risk-mitigation and diversification potential—like alternatives.
Volatility is unavoidable, but manageable
Markets are increasingly susceptible to volatility as politics, geopolitics, divergent monetary policies and internal market structures all converge and evolve. Navigating this sea of uncertainty requires a clear direction and an ACTive mindset, with investors staying agile in their asset allocations, confident in their processes and thorough in their research.
Metrics to watch
Fears over deflation and disinflation could fall as inflation rises
- As monetary policy shifts toward supporting fiscal policy, it could create rising real-world prices.
- China's rebalancing – plus lower commodity prices and collapsing investment – will tighten supply chains, leaving pricing power in stronger hands.
- Fiscal dominance will allow governments to create inflation via legislation through higher minimum wages and other inflationary policies.
0.2% Eurosystem inflation Q4 2016
1.2% Eurosystem inflation + one year
Source: ECB as at Nov. 18, 2016. Inflation defined as year-on-year percentage change of the Harmonised index of Consumer Prices published by Eurostat.
Volatility could spike from passive’s rise and regulatory shifts
- The move toward passive investing globally has concentrated flows into certain market segments, which could become more volatile if flows begin to reverse.
- Regulatory changes have made the markets more shallow; markets have also been rendered less stable by the rising tide of high-frequency and algorithm-based trading strategies.
13.29 Volatility Index (VIX) as at Sept 2016
20.90 VIX average 1996–Sept 2016
Source: FactSet as at Sept. 30, 2016.