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October 2016 | Macro Insights

Focus: A Turning Point in Policy


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Recent policy decisions by the European Central Bank (ECB) and Bank of Japan (BoJ) suggest policy may be at a turning point, with monetary policy at its practical limits and fiscal policy as the best option for further easing. In this edition, we attempt to answer some of the questions that arise from this apparent turn: Is monetary policy at its limits? Can fiscal policy have a meaningful impact? What might the end-game look like? And where might investors find value as policy turns and the hunt for return continues?

Has monetary policy reached its limit?

We expect the Federal Reserve to raise rates in December, which would provide some room for future easing if needed. In Japan and the Eurozone, we think monetary policy easing is effectively at its limits. Incremental rate cuts by the BoJ or ECB would likely have little effect and significant cuts would probably be counterproductive. Both banks are also already buying government bonds at a pace that will become increasingly difficult to maintain as their holdings grow as a percent of the total market (Exhibit 1).

Exhibit 1: Central Bank Holdings as % of Outstanding Government Bonds Based on Current Pace

Source: Autonomous Research, based on the current pace of government bond purchases by the ECB and BoJ

Negative rates and massive asset purchases were intended as stabilizing shocks to the system that would change the dynamic on inflation. But the sprint has become a marathon. The Eurozone has had negative rates for more than two years now, and Japan is more than a year past the BoJ’s initial two-year target for inflation rising to 2%. As a result, we think the unintended consequences of extreme policy in Europe and Japan have grown, most notably on the financial system and savers.

Looking ahead, we think future changes are likely to focus on 1) avoiding the need to taper existing purchase programs due to limited availability of eligible bonds, 2) shielding the financial system from the effects of existing policy, and 3) encouraging fiscal policymakers to take advantage of this period of stability and low interest rates.

We think the BoJ’s recent shift—from targeting a specific path for the supply of money to targeting a specific level for 10-year rates—is a significant step in this direction. If the government increases fiscal stimulus and issues more debt, the BoJ can now absorb those bonds without any explicit change in policy.

What is the outlook for fiscal policy?

We expect modest fiscal easing in the year ahead, but we do not see this as a panacea for growth, for several reasons.

First, except for tax cuts, fiscal policy tends to have a gradual impact. In the US, for example, both presidential candidates have suggested the need for increased spending on infrastructure. These projects take time to approve and can take many years to affect growth. Either US candidate might be able to pass a significant fiscal spending program, but the gradual nature of infrastructure projects means the boost to growth is likely to amount to a few tenths worth of GDP spread out over several years.

Second, fiscal stimulus increases government debt. More government borrowing might ease the scarcity constraints on ECB or BoJ bond purchases, but debt growth creates other issues. In China, for example, fiscal stimulus has helped to stabilize the economy, but investor concerns about China’s growing debt burden have also contributed to de-stabilizing capital outflows.

Third, politics are likely to constrain fiscal easing. After years of austerity, Eurozone fiscal policy has loosened in 2016 due to spending related to refugees and security, and could loosen more ahead of upcoming elections. More overt stimulus, such as tax cuts, might provide a bigger, quicker boost. However, fiscal policy in several countries is already straining the flexibility of Eurozone rules and Germany appears to have little appetite for major stimulus. As a result, we think a crisis would probably be required to overcome the political barriers to significant stimulus in the Eurozone.

How does the policy experiment end?

We see three scenarios: growth, inflation or default. Default is not a very popular option, so we generally expect countries to fall along a spectrum: from growth that allows policy to gradually normalize to inflation that becomes difficult to control. Whatever the end-game might look like, we don’t see any clear, near-term catalysts that lead to more pessimistic scenarios, so the environment of low growth, modest global inflation and investor demand for yield could remain in place for a long time. 

What are we pessimistic about?

Japan, China and Europe appear to be on unsustainable paths and we see risks in combining fiscal and monetary policy. 

In Japan, the BoJ is effectively monetizing government debt while committing to overshoot its inflation target. We would usually expect investors to sell government bonds in this situation, leading to higher borrowing costs and unsustainable government debt dynamics. However, Japan is unique: most government debt is held domestically, Japan has significant foreign assets and Japanese investors tend to bring their money home in times of crisis. This could allow an otherwise unsustainable situation to continue. Longer-term, controlling an overshoot on inflation may be a challenge for the BoJ. 

In China, policy has helped to stabilize growth but has also contributed to bubble-like conditions in one domestic market after another, including equities, wealth management products, commodities, corporate bonds and real estate. We expect this to eventually lead to a rise in defaults and a need for bank recapitalization. But again, we see no near-term catalyst for a debt crisis in an economy where the government has significant ability to socialize losses.

Europe bears watching. The Eurozone appears to be following Japan’s path, but is less cohesive and more politically fractured. Modest fiscal loosening, enabled by ECB rate policy and bond purchases, may support growth in the near-term but is likely to create political challenges over the longer-term. Some of these challenges may be on the horizon with upcoming elections in Germany and France, and a constitutional referendum in Italy. When we look for potential catalysts that could lead to another crisis, a break-up of the Eurozone is probably the leading candidate.

What are we optimistic about?

With no obvious catalyst for the more pessimistic scenarios, we are optimistic that markets can navigate the turning point in policy for now, as central banks are likely to succeed in extending accommodative monetary policy and fiscal policy becomes somewhat more supportive. If slow growth reflects an extended recovery cycle, as Neill Nuttall discusses, accommodative policy might allow an economy like the US to grow its way out and avoid the most pessimistic scenarios.

Where are the opportunities in equities?

We see security selection opportunities across global equity markets, but in the context of the current policy environment, we focus here on two particular areas: emerging markets and bond-like equities.

Emerging market (EM) equities have attracted significant investor demand this year, helped by expectations that EM growth may have turned a corner and that monetary policy will remain accommodative in the developed world.

More recently, some of the biggest risks for EM equities, such as China’s industrial slowdown and low oil prices, also appear to be stabilizing, while valuations remain attractive versus DM equities.

However, we believe investors should remain active and highly selective in EM: not only are EM economies at different stages of recovery, the MSCI EM Equity provides poor exposure to what we believe are some of the best opportunities.

While investors looking for growth are increasingly turning to EM, those searching for yield have flocked to high-dividend-yielding stocks, including real estate investment trusts (REITs). As a result, many of these “bond proxies” look richly valued by equity standards. However, we think they are relatively attractive compared to bonds. 

Moving slightly lower along the yield spectrum in equities can also offer more value. For example, as shown in Exhibit 2, stocks with slightly lower yield potential may be more attractive on important metrics related to sustaining that yield, including lower debt, lower dividend payout ratios and stronger earnings growth potential.

Where are the opportunities in fixed income?

With no clear catalyst for sharply higher interest rates, we think it makes sense to maintain exposure to fixed income sectors that offer a spread over government bonds.

Many investors are familiar with corporate bonds, and the sector has seen strong demand among those seeking higher-yielding alternatives to low or negative yields in the government bond market. This dynamic has contributed to rising corporate leverage and deteriorating balance sheets. We see more value in spread sectors that investors tend to be less familiar with, such as high-quality collateralized loan obligations (CLOs) and bonds secured by mortgage credit or government-backed student loans.

Exhibit 2: Within the Highest Yielding Segment of the S&P 500…the 2nd Quintile May Offer More Attractive Value

Source: FactSet, as of Q2 2016.
1S&P 500 quintiles subdivides dividend paying stocks within the S&P 500 index into fifths with the first quintile representing the 100 highest yielding stocks and quintile five, the 100 lowest. Dividend yield is calculated using annual dividends per share divided by the share price as of the report date. 2Long term debt-to-capital ratio is calculated as long term debt divided by total capital. Dividend payout ratio is calculated as annual dividends per share divided by annual earnings per share as of the most recent fiscal period. Estimated 3-5 year EPS growth rate is calculated as the mean of all 3-5 year EPS growth rate estimates provided to FactSet by individual brokers using their own individual methodologies. Shown for illustrative purposes. Past performance does not guarantee future results, which may vary.

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