2013 – Limited growth and new monetary policy regimes
As 2012 draws to a close, three things about central banks and monetary policy are becoming more apparent. Firstly, central bankers are concerned that they are being expected to fix all the ills in their economies and they believe monetary policy cannot achieve such ambitious targets. Messrs Bernanke and King have both recently expressed concerns about the limits of what monetary policy can deliver in the face of fiscal austerity. Secondly, successive doses of Quantitative Easing (“QE”) are generating diminishing impacts on markets and on the real economies. This is a problem that the Bank of England has recently been highlighting about QE in the UK. In the US, the recent, and fourth, QE announcement from the Federal Reserve, which will mean over $1 trillion of money printed every year until further notice, saw the US stock market fall on the day, in contrast to all previous QE announcements. Thirdly, Central Banks are exploring new policy targets: in the US tying policy change to the unemployment rate; in Japan seeking to increase the inflation target; and in the UK discussing the idea of a nominal GDP target in place of an inflation target. As 2013 begins, investors need to take into account the above developments in their investment strategy.
There are two distinct scenarios for 2013. In the first, economic recovery and job creation continue to disappoint, in which case it appears increasingly likely that governments will tell Central Banks to concern themselves much less about inflation and more about unemployment. If so, they would be doing this just as the Central Banks are coming to the conclusion that their current policies to boost growth, are not working very effectively. The results would be monetary policies that are far more inflationary in intent than has so far been the case since the crisis – this would be a significant regime shift for monetary policy.
Investors therefore will need to seek greater protection from the risk of such a regime change. This requires heavy weighting to assets that would do well in the face of a generalised increase in investor inflation expectations. These assets would be index-linked bonds and gold. The performance of company shares in a scenario of rising inflation expectations is mixed – over the long term company profits would be expected to rise with higher nominal growth, but in the shorter term, rising inflation tends to lead to lower valuations. Conventional bonds would suffer very badly in an environment of higher inflation. Commercial real estate would, in the very long term, be expected to act as a form of protection against inflation (as rents rise with inflation). However, a combination of high unemployment and the shift towards virtual retailing is acting as a significant dampener on demand for office and retail space. Short term prospects for returns are limited to current rental incomes alone.
In the second scenario, where the global economy does improve enough for unemployment to fall at a rate that was satisfactory to policy-makers, the response from financial markets would also be likely to be higher yields on conventional bonds, together with higher company share prices. Given these two scenarios (of which the first, disappointing growth, is more likely), the preferred investment strategy is to be at least neutrally invested in shares, heavily under-invested in conventional bonds and heavily-invested in the “insurance policies” of index-linked bonds and gold.
Returns on cash will remain very low in 2013 and in fact are likely to decline further if further monetary easing takes place – the aim of the Central Banks being to over-supply liquidity to the financial system. Given the exceptionally low yields available on government bonds, it is difficult to imagine a scenario in which they deliver strong returns. Corporate bonds, which performed very well in 2012 as credit risk perceptions declined, still offer higher yields than government bonds. However, they no longer have the potential for significant gains from a further narrowing of the yield premium (over government bonds). Other areas of the bond markets where the yields are still attractive relative to their risks, are emerging market local currency bonds and short duration, high yield bonds in the US.
The Eurozone economy, the UK’s largest trading partner, looks most likely to continue to disappoint next year, and so create problems for policymakers. Its key economic issue (and Mrs Merkel’s favourite trio of statistics) is that it boasts 7% of the world’s population, 25% of the world’s GDP but 50% of the world’s social spending. This is at the same time as its demographic patterns are about to deteriorate significantly in the face of a very weak birth-rate and a rapidly expanding population of pensioners. The sense of existential crisis about the euro may have passed for now, following the ECB’s promise to be prepared to act as purchaser of last resort for sovereign government bonds, but the danger for the euro in 2013 is more likely to come from the streets of Greece or Spain, as continued austerity bears down even harder on the public. The Italian election is also likely to see a strong performance from anti-austerity parties. The Eurozone enters 2013 in recession, and its financial system woefully undercapitalised. For Eurozone markets to perform well in 2013, the ECB will need to be seen to be actually printing money – this is still an unlikely prospect, given the deeply conservative approach to monetary policy of many of the ECB members.
The Japanese economy starts 2013 with a newly-elected Prime Minister who campaigned on a promise to stimulate the economy aggressively and have a higher inflation target. A weaker yen would be enormously helpful to Japanese industry regaining competitiveness, and after a 23 year long bear market, the stock market may finally be in a position to move higher.
The US economy, still by some distance the largest and most important to the world economy, should continue to grow modestly, but not at a rate that is likely to bring down unemployment sharply. The short term is clouded by fears over the “fiscal cliff” negotiations, the results of which are likely to produce some modest austerity, which, if European experience is any guide, will cause some damage to growth prospects. Expect a mediocre year for returns from US assets.
The Chinese economy, the single largest contributor to global growth, appears to be seeing a pick-up in its growth rate after the below-target 7.4% report for third quarter GDP growth. Growth is unlikely to return to the double-digit growth rates seen in the last decade, but should be of higher quality for stock market purposes. Instead of relying on exports of low-cost labour manufactured goods and state-sponsored investment spending, Chinese growth in the future is more likely to come from satisfying the increasingly demanding Chinese consumer. China is also in the fortunate position of having considerable scope to ease monetary policy in conventional ways should its growth prospects deteriorate. These more conventional methods are generally more effective in the face of weak demand, than the unconventional methods that Western Central Banks are currently forced to use. Asian equity markets are once again expected to be the best-performing region of the world in 2013.
The UK economy remains buffeted by the trends from the European, US and, to a lesser extent, the Chinese economies. The government’s fiscal austerity programme bites a little harder in 2013 than it did in 2012, but the change in Governor at the Bank of England is likely to lead to a wider discussion about monetary policy means and objectives, which may support the UK bond and equity markets better than those of the Eurozone. Expect a modest year for returns from UK assets and a weaker Sterling following its surprising strength in 2012.
In conclusion, global economic risks are, in our opinion, biased to the downside for 2013. If these risks are realised, the clamour for a policy response will be very great. The shift from the 2008 conventional policy responses of lower interest rates and higher government spending to the less conventional 2009-2012 policies of QE may well then develop into a shift to very unconventional policies. These have not to date been openly discussed, but could include such ideas as (i) using QE to buy shares rather than government or mortgage bonds, (ii) using QE to buy foreign government bonds (equivalent to deliberately pushing down the exchange rate), or (iii) pushing new money more directly into the real economy by for example printing money to pay a “citizen’s dividend” in the hope that it would be spent. These are all theoretical ideas that would normally strike inflationary fear into the hearts of Central Bankers, but may appear next year as the logical next steps in monetary policy.