Time for caution as stimulus is reined in

As policymakers and governments have grappled with the enduring economic and financial consequences of the preceding years of excess, policy intervention has become ever more heavy handed and experimental. 

Initially, their objective was to prevent the deflationary consequences of a private sector deleveraging, which they anticipated would have followed the crisis, by slashing interest rates and expanding central bank balance sheets. However, policymakers have become increasingly interventionist, ready to supply stimulus in response to a decline in asset prices or a downturn in economic activity, and seemingly following a ‘crisis, response, improvement and complacency’ framework. 

In a post-crisis world, such micro management is unique and arguably best illustrated by looking at the actions of central banks and policymakers in 2016.

 The actions of policymakers have not been without consequence. The Institute for International Finance reported that global debt grew by $7.6trn (£6.1trn) in 2016 to $215trn

Having painted itself into a corner, the US Federal Reserve hiked rates in December 2015 while global growth was in decline. The turmoil in markets that accompanied the start of 2016 prompted the Fed to U-turn on the pace of interest rate hikes and talk down the US dollar, which consequently saw a substantial easing in global financial conditions.

In China, the authorities began ramping up fiscal stimulus in late 2015 as the private sector flirted with recession. China’s political model enabled the authorities to implement a form of helicopter money that the market was also expecting to arrive in the West. 

The easing of global financial conditions combined with China’s colossal fiscal stimulus succeeded in reflating the global economy throughout 2016. Fears of deflation and recession have been almost forgotten, and instead talk is of reflation as the economic and financial problems of the past eight years are widely depicted as being eradicated. Having gone through the improvement phase, policymakers and global markets are now firmly in the realm of complacency. 

The actions of policymakers have not been without consequence. The Institute for International Finance reported that global debt grew by $7.6trn (£6.1trn) in 2016 to $215trn, with China alone, accounting for approximately $4trn of the additional debt.

Over the past 10 years global debt has risen by a staggering $72trn, with $40trn coming from emerging markets and the remaining $32trn from developed markets.

By inflating asset prices, the easy-money policies of central banks in the developed world have encouraged the misallocation of capital both domestically and in the rest of the world. In 2009, Gao Xiqing, the then head of Chinese sovereign wealth fund China Investment Corporation, warned: “The Fed should remember that when it makes monetary policy it should take into consideration the impact on the rest of the world.” 

He was referring to the detrimental impact that loose monetary policy in the US would have on emerging market economies.

For all the hope that the election of Donald Trump marked the beginning of a new era of pro-growth policies, the structural challenges of demographics, technological change and mounting debt burdens ensure that the world will remain structurally low growth. As president Trump is beginning to realise, complex systems riddled with vested interests are not willing subjects for reform, particularly when democracy is the prevailing political system. Change, if it comes at all, will come slowly and is unlikely to have radical impact.  

Complacency among policymakers has led to a winding down of stimulus across the world. China is tightening both fiscal and monetary policy, while the Fed is resolutely back in tightening mode. As a result of central bank actions, valuations are at or near all-time highs across virtually all asset classes, promising poorer returns for the long-term investor. 

While valuations offer no indication of when the cycle is going to end, the scale of the cumulative misallocation of capital that has taken place over the course of the cycle – as seen by the pervasive rise in leverage – means that risks within the financial system continue to be elevated. 

With the reining in of stimulus, particularly in the US and China, economic activity is likely to slow, increasing the probability that some latent financial risks will be triggered. Against such a backdrop, a cautious approach is appropriate while maintaining the flexibility to take advantage of attractive risk-reward opportunities when they present themselves. 

An absolute return approach to investment is one that, in this case, fits the bill. 

Brendan Mulhern is a global strategist at Newton Investment Management