We see monetary policy divergence reaching a new extreme in the year ahead. We think the Fed is likely to hike interest rates at least twice, while the European Central Bank (ECB) and Bank of Japan (BoJ) stretch further toward the limits of their easing ability.
With growth still struggling on both sides of the Atlantic, the focus for stimulus is shifting toward fiscal spending, both as a backlash against years of painful austerity and in recognition of a need for infrastructure upgrades. This transition is important to watch as it could provide a better policy mix to support growth and corporate earnings, or it could drive debt and inflation sharply higher and spark more volatility in developed or emerging market assets.
Global Infrastructure: Many Variables Will Determine the Potential Beneficiaries
Source: GSAM. As of December 2016. For illustrative purposes. Goldman Sachs does not provide accounting, tax or legal advice. Please see additional disclosures at the end of this publication.
Monetary policy since the financial crisis has played a key role in suppressing volatility and supporting both developed and emerging market asset prices. But this regime of global easing has likely peaked with the Fed tightening and the ECB and BoJ nearing the practical limits of their asset purchase programs.
What the ECB and BoJ do next could be pivotal. In 2013, the first indication that the Fed would reduce its asset purchases drove global markets into a “Taper Tantrum” marked by sharp declines in emerging market assets and developed market corporate bonds. With the ECB and BoJ buying bonds at a pace that cannot be sustained indefinitely, markets are on guard for Taper Tantrum 2.0.
For now, we think the BoJ and ECB can manage market perceptions of their asset purchase programs. In December, the ECB combined its announcement of an initial reduction in monthly asset purchases from €80bn to €60bn with a nine-month extension of the program to end-2017. The market response was benign, as the ECB seems to have taken the scarcity issue off the table until sometime after Europe’s key 2017 elections (see “Europe’s Election Calendar”). Since we think inflation will remain below target in 2017 and continued easing will be necessary, we expect the ECB will announce a more explicit tapering in the second half of the year, and may follow the BoJ’s lead with some form of yield curve control.
In the near term, however, higher rates and potential additional bond issuance, driven by fiscal easing, should help somewhat to increase the availability of bonds the central banks can purchase. And if tapering is driven by a material improvement in growth or inflation—not our base case in Europe or Japan—markets may be reassured by the prospect of a sustainable recovery in the developed world’s largest economies.
We believe Europe’s low inflation and continued ECB accommodation will continue to support German Bunds, and policy divergence with the US could drive the euro to parity versus the US dollar. The weaker economies of peripheral Europe are vulnerable to volatility-driven spikes in borrowing costs, along with the emerging markets that took the brunt of the Fed-related upheaval. However, some of the more fragile emerging markets have narrowed current account deficits in the intervening years, and may be better able to withstand shocks. In Japan, we think the BoJ’s policy of yield curve control will probably keep downward pressure on the yen, though we see limited downside for government yields.
From a quantitative perspective, monetary easing has driven valuations across both equities and bond portfolios to high levels, but dispersion with these markets remains historically wide. As the policy balance shifts in favor of fiscal easing, we see potential for this dispersion to narrow in 2017, which may benefit value-oriented investment strategies.
The Path of ECB and BoJ Bond Buying Is Unsustainable
Source: Autonomous Research. As of Dec. 9, 2016.
Trump’s First Fed Picks
Since the crisis, the Fed’s bias toward easier monetary policy—and more recently a gradual tightening—to support US growth has been relatively uncontroversial. That may change under Trump’s administration. While the Fed’s independence is a cornerstone of its credibility, the board is composed of political appointments. The Fed has two open seats that Trump can fill soon and Chair Janet Yellen and Vice Chair Stanley Fischer could leave when their terms come up for renewal in early 2018. Trump will have significant ability to re-shape the Fed and his early nominations for the two vacant Board seats could be an important indicator of the direction of the Fed in years to come.
One idea popular with some Republicans is that Fed policy should be more rules-based. If Trump appoints candidates that support such an approach, the market could price in a more hawkish Fed outlook. The Taylor Rule, which models the appropriate level of interest rates primarily according to changes in inflation and output, suggests rates should be higher than they are now.
The President-elect wants to spend money on a significant infrastructure package and tax cuts, increasing the deficit, and he needs low rates to do that. A Fed appointee favoring a more discretionary approach could mean Trump considers his policy priorities better aligned with the Fed’s current stance. Moreover, the proposed fiscal expansion is in line with the government spending boost that Yellen has been advocating for years to complement the Fed’s monetary support. If this fiscal expansion boosts US growth and inflation as intended, the economy should be able to support higher rates, allowing policymakers to find a compromise between “lower for longer” and “higher in haste.”
US government bond markets may be underestimating the potential for Fed rate hikes over the coming year. Although government bond yields have increased since the US election, we expect the market to continue adjusting to a somewhat steeper path of Fed rate hikes in the coming years. We also see relative value opportunities in the contrast between tightening US financial conditions and looser conditions elsewhere. Broadly speaking, an orderly increase in inflation should be beneficial for corporate profits, supporting the outlook for US equities.
A Taylor-Rule Approach Suggests US Interest Rates Should Be Higher
Source: Bloomberg. As of Nov. 30, 2016. The Taylor Rule is a model for adjusting policy rates based on actual inflation relative to the central bank’s target, actual employment versus an estimate of full employment and an estimate of the “neutral” policy rate consistent with full employment.
A Global Fiscal Big Bang?
The economic impact of infrastructure spending will manifest years down the road and will not be as significant as one might expect. We think it’s positive, but not transformational.
—Collin Bell, Client Portfolio Manager, Fundamental Equity
Since the financial crisis, many economists have criticized the lack of fiscal spending to support the recovery. Years of austerity have helped correct the worst of Europe’s deficits, and now the tide seems to be turning—the European Commission already has plans for infrastructure spending in place. A similar shift seems likely in the US, as President-elect Trump has pledged massive spending on infrastructure, funded by repatriation taxes and with possible tax credits to boost private spending. The question remains: will his Republican colleagues reverse their opposition to deficit spending to allow a meaningful stimulus through both Republican-controlled houses of Congress? And if they do, can the benefit to growth offset concerns about debt sustainability?
Ideally, government spending creates a multiplier effect across the economy, stimulating confidence and spending among businesses and households and boosting productivity. We would look for positive signals in consumer sentiment and budget estimates for business investment as signals. Allocation is key—for instance, new building projects will be more stimulative than repairs— and funding can be optimized by harnessing private sources in public/private partnerships.
The multiplier effect is easiest to achieve in a low rate, low growth and low employment environment. The current conditions are conducive for fiscal stimulus in our view, and under our assumptions the proposed US tax cuts and spending policies could add about 0.8% to GDP over up to two years, probably starting from the second half of 2017. That said, we believe the US’ comparatively tight labor market could stoke inflation. And the positives of fiscal spending for the US economy may be offset by adverse trade and immigration policy (see “Globalism to Populism”). Moreover, inefficient or wasteful government spending poses risks to debt sustainability, and in the US, debt is already higher than it has been at the outset of prior fiscal expansions.
In emerging markets, infrastructure spending has generally been more substantial, given that many countries are at an earlier stage of economic development. China, in particular, has employed infrastructure spending as a driver of economic growth. But we do see a risk of indirect impact on emerging markets if a heavy US fiscal expansion drives rates and inflation meaningfully higher, inviting the Fed to tighten policy more sharply than is currently anticipated.
Sizable US fiscal spending, coupled with tax measures to encourage companies to repatriate foreign profits, could have a significant effect on US inflation, given the economy is close to full employment. As a result, fiscal policy expectations have favored the reflation trade, benefiting assets correlated to growth and weighing on government bonds. We think the actual impact will play out over several years with different effects across sectors. We expect that near-term beneficiaries will likely be the “builders” of infrastructure, specifically the engineering, construction and basic material companies that supply them. Longer-term, “owners” of infrastructure should also benefit, starting with those exposed to higher government ownership. Over an even longer horizon, we see potential benefits for assets geared to increased inflation, including inflation-linked bonds, real assets beyond infrastructure, and equities.