For some time, conventional wisdom has been that the importance of economics eclipses pretty much all else. Bill Clinton’s campaign manager famously coined the phrase “It’s the economy, stupid”, on the way to beating George Bush in 1992. Politicians routinely consider GDP growth as a proxy for measuring their success (even though spending on education and spending on tear gas would both be considered positive). Meanwhile, central banks are increasingly focused on extending the economic cycle via loose monetary policy, whatever that means for debt levels and capital misallocation. This sits well with the investor, with Goldilocks being the holy grail, where the economy isn’t too hot (inflationary) or too cold (recessionary/deflationary).
It is true that until 2016 (Brexit and Trump) politics had played a fairly back-seat role, at least in developed economies, for the past decade or two. The reality, though, is that economics doesn’t operate in a vacuum. Economies are of course populated by humans, and so society and politics are very relevant. Indeed, for those with short/selective memories, three of the last six US recessions have been caused by politics, or more specifically, geopolitics and, very specifically, the oil price.
Meanwhile, there has been a steady financialisation of Western economies, particularly the UK and the US, where financial services accounts for an increasing share of the economy. As economies and financial markets have become ever more entwined, so the state of financial market conditions has an elevated impact on real economies. As a result, the central bank job of overseeing the economy increasingly means ‘managing’ financial markets, which in reality has meant inflating asset prices.
The dynamics behind this are captured in the graphic below. As growth slows, so the next round of QE is heralded. In turn, this leads to rising asset prices, rather than having a significant impact on real economic growth, as financial engineering such as share buybacks is often preferred to increasing capital expenditure, which would more likely lead to a virtuous cycle of sustainable economic growth. So the cycle continues, feeding discontent and populism, as larger and larger elements of the electorate see their elected officials (and unelected officials such as central banks) continue a policy which favours those with assets (e.g. houses and equity), versus those without.
What breaks the cycle? Probably not more of the same. Indeed, momentum is building for a new approach which incorporates some form of combined expansive fiscal and monetary policy, whether this is Modern Monetary Theory (discussed recently in Perspectives) or Monetary Policy Three (MP3).
But what’s vexing markets currently? Whilst it’s not the geopolitics of oil prices that are driving financial markets, it is the geopolitics of trade wars, as the two largest economies continue to butt heads. Markets have consistently underestimated the persistence of the trade war, assuming that it is in everyone’s best interest to find a quick solution. Whilst there is a truth in Trump being sensitive to domestic financial market and economic conditions, the closer we get to the 2020 presidential election, maybe this is actually a cold war, not a trade war. Again, the mistake might be to view economics in isolation, instead of building in geopolitical and political dimensions.
Whether it’s a trade war or a cold war is unclear. However, we don’t try to answer the US$64million questions in portfolio construction as, by definition, they tend to be pretty unanswerable. Instead, as the two titans slug it out, we have reduced exposure to global trade, for example global cyclicals, and instead have a number of positions which are under the trade war radar, such as a basket of Indian equities.
What does this all mean for investors more generally? Well, if we assume central banks will prohibit tight financial market conditions for an extended period (see taper tantrum I 2013 and taper tantrum II Q4 2018), we might assume that macro is dead, or at least the economic cycle is stretched and, for that matter, so is the credit cycle. Or, in other words, “It’s not just the economy, stupid!”
These assumptions contribute to our base case of Goldilocks in the short to medium term, and further out increasing inflationary pressures, against the backdrop of more pressure on fiscal policy and a chipping away at the independence of central banks. For our portfolios in the meantime, equity is increasingly dominated by quality growth, where companies with visible earnings growth should continue to do well, and in bonds we make some assumptions around yields being capped, so are more comfortable with longer duration US Treasuries.
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