Multi-assetMar 24 2015

Implications of the ‘post-Goldilocks’ economy

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The story of Goldilocks and the Three Bears was originally written in the 1830s by the British poet Robert Southey.

Nearly 200 years later, the porridge that is neither ‘too hot’ nor ‘too cold’ serves as a good metaphor for the post-financial crisis economy.

Growth has not been sufficiently weak to undermine corporate earnings or drive default rates higher, but neither has it been sufficiently strong to put upward pressure on inflation or central bank policy rates.

The result is that holders of diversified portfolios have enjoyed an unusually propitious environment – rising equity multiples and falling bond yields have simultaneously bolstered returns.

In the aftermath of the oil price adjustment in the second half of 2014, the world is arguably moving to a “post-Goldilocks” economy.

Central bankers – especially in Europe and emerging markets – are responding to ultra-low inflation by loosening policy, and the boost to consumer discretionary income from cheaper fuel provides a fillip to economic growth similar to a tax cut.

The drop in oil prices has effectively transferred $2trn (£1.3trn) from oil producers with relatively high savings rates to oil consumers with relatively low savings rates. The net effect is likely to directly reduce global inflation by 1.5 per cent and boost global growth by up to 1.5 per cent in the next one to two years.

That combination of monetary and quasi-fiscal stimulus has the potential to have a profound impact on the outlook for both the global economy and asset prices.

The most important financial market implication is that it is likely to extend the “search for yield” of recent years.

The critical driver of that dynamic has been the ultra-low yields available on government bonds around the world. The average real (or inflation-adjusted) yield on 10-year government debt has been hovering close to zero per cent.

In the ‘post-Goldilocks’ world, central banks are firmly committed to keeping those rates low, and inflation risks seem remote. Somewhat higher yields may be likely as fears of outright deflation subside, but the global bond market is likely to persistently confound expectations of a meltdown.

Investors in such bonds therefore face a Hobson’s choice – stay in bonds and accept uncomfortably low real yields, or shift into other (ie non-fixed income) assets and accept the associated risks.

The latter choice is particularly encouraged by large-scale asset purchase programmes, otherwise known as quantitative easing. Via the so-called ‘portfolio rebalancing effect’, private sector investors are forced out of government bonds into riskier assets.

This effect has been particularly marked in the US, UK and Japan, and it seems reasonable to expect the same dynamic in the eurozone as the European Central Bank’s printing press is fired up this month.

Assets that are perceived as fixed income proxies are likely to enjoy the most persistent inflows in that environment. High dividend equities are one obvious candidate. However, with their predictable and long-dated income streams, commercial real estate and infrastructure assets also fall squarely into this category.

When viewed on a standalone basis, there are some legitimate concerns about increasingly stretched valuations in such assets. For example, the dividend yield on the FTSE Epra/Nareit European real estate index has dropped to 2.7 per cent from 5 per cent in 2011.

However, those valuations need to be understood in the context of ultra-low discount rates. The growing popularity of multi-asset income funds and cross-over investment from yield-starved bondholders have undoubtedly helped to sustain demand.

While the Goldilocks economy overwhelmingly benefited the bond market, in the ‘post-Goldilocks’ world it is the fixed income proxies such as commercial real estate that increasingly look ‘just right’ for investors.

Chris Jeffery is strategist, asset allocation at Legal & General Investment Management

CENTRAL BANK POLICY

US

The US Federal Reserve finished the tapering of its quantitative easing programme in October 2014. It is expected interest rates in the US will rise this year.

UK

Interest rates in the UK have remained at the record low of 0.5 per cent for six years, while the UK’s asset purchase programme sits at £375bn. In the latest minutes of the Monetary Policy Committee meeting it was suggested interest rates would “more likely than not” increase over the next three years.

Europe

On January 22 2015 the ECB announced an ‘expanded’ asset purchasing programme with monthly purchases of roughly €60bn (£42.8bn) starting in March 2015 and expected to last until “at least September 2016 and in any case until the governing council sees a sustained adjustment in the path of inflation”.

Japan

In October the Bank of Japan announced an expansion of its quantitative and qualitative easing (QQE) programme, where it boosted the monthly purchases of Japanese government bonds (JGBs) from ¥60-70trn (£334bn-390bn) to ¥80trn a month. In addition the bank warned it would “continue with the QQE, aiming to achieve the price stability target of 2 per cent, as long as it is necessary”.