Government can spend, spend, spend....
March 8, 2019

View from the Bond Market: by Chris Iggo, CIO, Head of Europe and Asia Fixed Income, AXA Investment Managers

Magic Money Trees

Solvency or inflation?  

Pricing inflation risk?

But no need at the moment

Growth sentiment is weakening

Which bonds for you?

The impossible dream  

Disappointment with growth and concerns about inequality pose challenges to conventional thinking on economic policy. This is exacerbated by the apparent inertia in political discourse in many countries. The US used fiscal stimulus but no-one else is seriously considering it. Whilst Central bankers are questioning whether they have done enough to generate better rates of nominal growth, some are questioning the policy framework itself. Investors should be aware of new policy proposals. Anything that deviates from the orthodox will require a risk premium. Modern monetary theory takes over where quantitative easing left off. It explicitly states that expansionary policy only faces an inflation constraint at the extreme of capacity utilization. I'd probably want to hold government liabilities that were linked to the inflation rate in such a policy regime.    

Magic money trees – It was inevitable that after a period of unconventional monetary policies that have largely failed to generate levels of nominal GDP growth that prevailed before the financial crisis of the last decade, that there would be a debate about the effectiveness of monetary policy in western economies. In the United States, there is a discussion taking place within the Federal Reserve about what should be the appropriate monetary policy target – a specific inflation rate or a price level that would allow periods of higher inflation to compensate for periods of lower inflation. In Europe, the European Central Bank gave up on its target of removing negative interest rates in 2019, admitting that both growth and inflation would not meet its previous forecasts. The downgrade to the outlook was sufficient for the governing council to agree to provide additional liquidity provision later this year as previous long-term repurchase agreement operations mature. This  in itself is not new easing but it is another sign that the normalization of monetary policy in the Euro Area is not happening. At the broader policy level, the debate has been added to by support, in some academic fields, for what is described as "Modern Monetary Theory" or MMT (not to be mistaken for Magic Money Tree – or perhaps it could easily be mistaken for that). I have not had enough time to really dig into MMT but my initial gut feeling, having been taught macroeconomics in the Keynesian-Hicks tradition, is that it is "tax and spend" dressed up to suggest that budget deficits and excessive money creation don't matter. I suspect that this is what people like Jay Powell, Larry Summers, and Ken Rogoff also think judging by their recent comments on the matter. However, in the political climate of today with the "establishment" and all its core ideas on politics and economics under threat from both the left and the right, we can't dismiss it. Academic cover for increasing state power in a mixed economy through central bank financed provision of public goods is likely to resonate with swathes of the electorate. Quantitative easing let the cat out of the bag in a way as "money" was created by central banks to essentially provide government bond funding (albeit indirectly). The fact that it has not yet led to an inflation problem has encouraged proponents of MMT. With monetary policy alone seen to be ineffective and with some countries, like Germany, having the potential to use fiscal policy more aggressively, one can see some Europeans also seeing the positives of a policy approach that could address some of the infrastructural and social deficits in the Euro Area (the one caveat here is that MMT is best explained within the framework of a sovereign monetary authority which Euro Area members no longer qualify as).

Solvency or inflation?  – MMT argues that macroeconomic policy does not face a financial constraint as governments can issue as much domestic currency to finance spending as it needs. Instead there is a real constraint on policy being too expansionary, as determined by the supply of labour and natural resources. In other words, there is an inflation constraint once the economy reaches full capacity. Budget deficits don't matter because the central bank can create reserves to accommodate funding while taxes can be used to control the overall rate of expansion. According to MMT, a sovereign government that is in control of its own currency can't become insolvent because it has an unlimited capacity to pay its bills. Orthodox theory that rests on the notion that a budget deficit is a constraint– because of the need to issue bonds and the supposed capacity of the private sector to buy those bonds. This "crowding out" constraint eventually raises the cost of capital for the private sector and reduces investment and productivity. MMT argues that government spending does not need to be financed entirely by borrowing from the private sector as the government, through its central bank agency, can create currency. In our world today, there is always an element of credit risk, although it is distant in countries like the US, the UK, Australia, and Canada where borrowing tends to be in the domestic currency. However, where governments borrow foreign currency there are more risks in terms of their ability to repay debts currencies other than their own. A country like Italy does not have control of its own currency so there is clearly a sovereign credit risk there as the government needs to rely on the private sector for funding, and thus faces a significant constraint. In the MMT world, the biggest risk is that the real value of fixed income assets could be eroded if there is not sufficient control of the inflation risk.

Pricing inflation risk? – The debate is academic so far. However, MMT has its supporters in Washington, especially on the left of the Democratic Party, led by Bernie Sanders and Alexandria Ocasio-Cortez. In the UK there have been discussions in Labour Party circles about increasing funding through government spending into some kind of MMT approach. Coming from the left, as the theory seems to, there is clearly a re-distributive element to it. Tax increases to control inflation would probably be quite progressive to complement the targeting of increased social provision of medical care, education, and employment. Clearly the US economy is close enough to being capacity constrained at this time to not warrant any additional stimulus – the announcement of the biggest trade deficit for years in 2018 being a clear illustration of the excess of demand over domestic output. Imagine if the Democrats got control of Congress and some of the MMT proposals – such as a "Green New Deal" became realistic. I suggest that the inflation risk premium in the US Treasury market would increase significantly as a result.

But no need at the moment – As Inflation is not driving monetary policy today. There has been a rowing back on policy tightening since the end of last year. This has allowed risky assets to perform well with credit spreads significantly lower than the levels they were at when the AXA Investment Managers Fixed Income team last underwent our strategic review of the market outlook. On a rolling 1-year basis, credit has started to outperform rates over the last month or so and the latest round of central bank easing probably supports that. However, I am starting to get concerned about valuations and the sustainability of the kind of returns we have seen so far. The additional spread in credit markets should underpin the outperformance but I can't see investors aggressively loading up on credit assets at this stage of the economic cycle. One exception to this, for the time being, seems to be in the European sovereign space with even Greece managing to attract billions of euros to its recent new issue. While there is no imminent existential threat to European sovereigns the reward for picking up the additional carry over the swap rate seems too hard to resist for many European fixed income investors. 

Growth sentiment is weakening – The non-tightening of monetary policy in 2019 reflects official concerns over the economic outlook. The OECD revised down its GDP growth forecasts for 2019 this week. The ECB had done the same for the Euro Area, although this was just catching up with where most of the private sector already was. Global manufacturing data, while still suggesting positive growth in the aggregate, has weakened markedly with European and Chinese indicators peaking in early 2018 and the US ISM peaking at the end of the year. There are additional risks (and it is boring to have to repeat them) from the US-China trade situation and Brexit. There needs to be some clarity on these issues and a stabilization of sentiment in the growth outlook to bring about any kind of upward revision to interest rate expectations.     

Which bonds for you? – So, if you are looking for higher returns in fixed income I would suggest looking at emerging markets and the US high yield market. In Asia, any good news on China's policy supports for the economy should help the higher yielding part of the Asian credit market perform. For carry the dollar market is again the most attractive, with the flatness of the yield curve meaning you can get carry without taking too much duration risk. For protection, the long end of Europe is the one sector that will continue to act as the risk-off diversifier. The bond market is a little more heterogeneous than the equity market even if, at face value, it does not look that attractive from a total return point of view. I would suggest, however, that interest rate risks are low now and credit risk is reasonably well remunerated for the most part. Another global growth shock would fall on equity markets more disproportionately. 

The impossible dream – I am writing this note on the Eurostar on the way to Paris. Sadly, for me, I was not in Paris on Wednesday evening to see the dramatic Manchester United victory against PSG. It was unlikely and sealed, in the end, by a controversial decision that allowed Marcus Rashford to score from the penalty spot in the last minute of normal time. It's been said many times what an amazing job Ole is doing and what a turnaround there has been since he took over. It's like some superstar CEO has gone into an underperforming company and suddenly turned around its profitability. In that case, the company's shareholders would benefit. In the case of United, it is the fans that are benefitting from the pleasure that is derived from, first of all, winning and, secondly, seeing the team trying very hard and really enjoying themselves. Ole was a cheap option when United hired him, today he is close to being in the money and a top four place alongside further progress in the Champions League would be a handsome payoff. That would of course raise the expectations for next season, if he were to get the job full-time. I, for one, can cope with that. As Rio Ferdinand said after the game on Wednesday, United are back. 

Have a great weekend,

Chris

 





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View from the Bond Market: by Chris Iggo, CIO, Head of Europe and Asia Fixed Income, AXA Investment Managers

Magic Money Trees

Solvency or inflation?  

Pricing inflation risk?

But no need at the moment

Growth sentiment is weakening

Which bonds for you?

The impossible dream  

Disappointment with growth and concerns about inequality pose challenges to conventional thinking on economic policy. This is exacerbated by the apparent inertia in political discourse in many countries. The US used fiscal stimulus but no-one else is seriously considering it. Whilst Central bankers are questioning whether they have done enough to generate better rates of nominal growth, some are questioning the policy framework itself. Investors should be aware of new policy proposals. Anything that deviates from the orthodox will require a risk premium. Modern monetary theory takes over where quantitative easing left off. It explicitly states that expansionary policy only faces an inflation constraint at the extreme of capacity utilization. I'd probably want to hold government liabilities that were linked to the inflation rate in such a policy regime.    

Magic money trees – It was inevitable that after a period of unconventional monetary policies that have largely failed to generate levels of nominal GDP growth that prevailed before the financial crisis of the last decade, that there would be a debate about the effectiveness of monetary policy in western economies. In the United States, there is a discussion taking place within the Federal Reserve about what should be the appropriate monetary policy target – a specific inflation rate or a price level that would allow periods of higher inflation to compensate for periods of lower inflation. In Europe, the European Central Bank gave up on its target of removing negative interest rates in 2019, admitting that both growth and inflation would not meet its previous forecasts. The downgrade to the outlook was sufficient for the governing council to agree to provide additional liquidity provision later this year as previous long-term repurchase agreement operations mature. This  in itself is not new easing but it is another sign that the normalization of monetary policy in the Euro Area is not happening. At the broader policy level, the debate has been added to by support, in some academic fields, for what is described as "Modern Monetary Theory" or MMT (not to be mistaken for Magic Money Tree – or perhaps it could easily be mistaken for that). I have not had enough time to really dig into MMT but my initial gut feeling, having been taught macroeconomics in the Keynesian-Hicks tradition, is that it is "tax and spend" dressed up to suggest that budget deficits and excessive money creation don't matter. I suspect that this is what people like Jay Powell, Larry Summers, and Ken Rogoff also think judging by their recent comments on the matter. However, in the political climate of today with the "establishment" and all its core ideas on politics and economics under threat from both the left and the right, we can't dismiss it. Academic cover for increasing state power in a mixed economy through central bank financed provision of public goods is likely to resonate with swathes of the electorate. Quantitative easing let the cat out of the bag in a way as "money" was created by central banks to essentially provide government bond funding (albeit indirectly). The fact that it has not yet led to an inflation problem has encouraged proponents of MMT. With monetary policy alone seen to be ineffective and with some countries, like Germany, having the potential to use fiscal policy more aggressively, one can see some Europeans also seeing the positives of a policy approach that could address some of the infrastructural and social deficits in the Euro Area (the one caveat here is that MMT is best explained within the framework of a sovereign monetary authority which Euro Area members no longer qualify as).

Solvency or inflation?  – MMT argues that macroeconomic policy does not face a financial constraint as governments can issue as much domestic currency to finance spending as it needs. Instead there is a real constraint on policy being too expansionary, as determined by the supply of labour and natural resources. In other words, there is an inflation constraint once the economy reaches full capacity. Budget deficits don't matter because the central bank can create reserves to accommodate funding while taxes can be used to control the overall rate of expansion. According to MMT, a sovereign government that is in control of its own currency can't become insolvent because it has an unlimited capacity to pay its bills. Orthodox theory that rests on the notion that a budget deficit is a constraint– because of the need to issue bonds and the supposed capacity of the private sector to buy those bonds. This "crowding out" constraint eventually raises the cost of capital for the private sector and reduces investment and productivity. MMT argues that government spending does not need to be financed entirely by borrowing from the private sector as the government, through its central bank agency, can create currency. In our world today, there is always an element of credit risk, although it is distant in countries like the US, the UK, Australia, and Canada where borrowing tends to be in the domestic currency. However, where governments borrow foreign currency there are more risks in terms of their ability to repay debts currencies other than their own. A country like Italy does not have control of its own currency so there is clearly a sovereign credit risk there as the government needs to rely on the private sector for funding, and thus faces a significant constraint. In the MMT world, the biggest risk is that the real value of fixed income assets could be eroded if there is not sufficient control of the inflation risk.

Pricing inflation risk? – The debate is academic so far. However, MMT has its supporters in Washington, especially on the left of the Democratic Party, led by Bernie Sanders and Alexandria Ocasio-Cortez. In the UK there have been discussions in Labour Party circles about increasing funding through government spending into some kind of MMT approach. Coming from the left, as the theory seems to, there is clearly a re-distributive element to it. Tax increases to control inflation would probably be quite progressive to complement the targeting of increased social provision of medical care, education, and employment. Clearly the US economy is close enough to being capacity constrained at this time to not warrant any additional stimulus – the announcement of the biggest trade deficit for years in 2018 being a clear illustration of the excess of demand over domestic output. Imagine if the Democrats got control of Congress and some of the MMT proposals – such as a "Green New Deal" became realistic. I suggest that the inflation risk premium in the US Treasury market would increase significantly as a result.

But no need at the moment – As Inflation is not driving monetary policy today. There has been a rowing back on policy tightening since the end of last year. This has allowed risky assets to perform well with credit spreads significantly lower than the levels they were at when the AXA Investment Managers Fixed Income team last underwent our strategic review of the market outlook. On a rolling 1-year basis, credit has started to outperform rates over the last month or so and the latest round of central bank easing probably supports that. However, I am starting to get concerned about valuations and the sustainability of the kind of returns we have seen so far. The additional spread in credit markets should underpin the outperformance but I can't see investors aggressively loading up on credit assets at this stage of the economic cycle. One exception to this, for the time being, seems to be in the European sovereign space with even Greece managing to attract billions of euros to its recent new issue. While there is no imminent existential threat to European sovereigns the reward for picking up the additional carry over the swap rate seems too hard to resist for many European fixed income investors. 

Growth sentiment is weakening – The non-tightening of monetary policy in 2019 reflects official concerns over the economic outlook. The OECD revised down its GDP growth forecasts for 2019 this week. The ECB had done the same for the Euro Area, although this was just catching up with where most of the private sector already was. Global manufacturing data, while still suggesting positive growth in the aggregate, has weakened markedly with European and Chinese indicators peaking in early 2018 and the US ISM peaking at the end of the year. There are additional risks (and it is boring to have to repeat them) from the US-China trade situation and Brexit. There needs to be some clarity on these issues and a stabilization of sentiment in the growth outlook to bring about any kind of upward revision to interest rate expectations.     

Which bonds for you? – So, if you are looking for higher returns in fixed income I would suggest looking at emerging markets and the US high yield market. In Asia, any good news on China's policy supports for the economy should help the higher yielding part of the Asian credit market perform. For carry the dollar market is again the most attractive, with the flatness of the yield curve meaning you can get carry without taking too much duration risk. For protection, the long end of Europe is the one sector that will continue to act as the risk-off diversifier. The bond market is a little more heterogeneous than the equity market even if, at face value, it does not look that attractive from a total return point of view. I would suggest, however, that interest rate risks are low now and credit risk is reasonably well remunerated for the most part. Another global growth shock would fall on equity markets more disproportionately. 

The impossible dream – I am writing this note on the Eurostar on the way to Paris. Sadly, for me, I was not in Paris on Wednesday evening to see the dramatic Manchester United victory against PSG. It was unlikely and sealed, in the end, by a controversial decision that allowed Marcus Rashford to score from the penalty spot in the last minute of normal time. It's been said many times what an amazing job Ole is doing and what a turnaround there has been since he took over. It's like some superstar CEO has gone into an underperforming company and suddenly turned around its profitability. In that case, the company's shareholders would benefit. In the case of United, it is the fans that are benefitting from the pleasure that is derived from, first of all, winning and, secondly, seeing the team trying very hard and really enjoying themselves. Ole was a cheap option when United hired him, today he is close to being in the money and a top four place alongside further progress in the Champions League would be a handsome payoff. That would of course raise the expectations for next season, if he were to get the job full-time. I, for one, can cope with that. As Rio Ferdinand said after the game on Wednesday, United are back. 

Have a great weekend,

Chris

 



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