Download Post-Monetarism and the New World Order: Executive Summary

Fourth Quarter 2016
STRATEGY INSIGHTS
Post-Monetarism and the New World Order:
Executive Summary
As a result of quantitative easing (QE), total assets
of the Federal Reserve (Fed), Bank of Japan (BOJ),
and European Central Bank have swelled since
2000. The proliferation of negative-yielding debt
throughout the globe is another example of how
monetary policy has been called upon to shoulder
the burden of the weakest recovery since 1949. In
this issue of Strategy Insights, we approach the
monetary policy discussion from a different angle —
the Post-Monetarism theory — and present a more
nuanced view of some inherent challenges in the
current policy environment, including interaction
between U.S. bank capital regulations and the Fed’s
current monetary policy stance.
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Symptoms of Post-Monetarism
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Monetarism Theory versus
Post-Monetarism Theory
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1
Monetarism is an economic theory that
postulates the best way to control the pace
of the economy (and inflation) is through
slow, steady control over the growth in
money supply.
Monetarism suggests an increase in M2 (the
Fed’s preferred method of measuring
money supply) should lower interest rates,
which in turn should spur increased
investment and, ultimately, consumer
spending. Businesses respond by increasing
production to meet the increased demand,
which in turn increases the demand for
more workers (that is, job creation).
However, since roughly 2000, these cyclical
relationships have begun to decouple and
break down to varying degrees. One possible
explanation for this is a theory called “PostMonetarism,” a theory coined by David
Malpass, founder and president of Encima
Global LLC. This is an approach to central
banking in which “commercial bank
leverage and balance sheets are controlled
by direct government regulation rather than
indirect monetary tools.” 1
Mr. Malpass suggests federal and state
level regulatory agencies and the Fed have
effectively impaired the normal functioning
of the credit markets by their increasingly
vast reach and influence.
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Symptoms of post-monetarism include
sluggish economic growth, decelerating
velocity of money, and weak credit growth.
Sluggish economic growth: The Fed’s current
approach to policy has persisted far too
long, in our view, and has now turned
contractionary in nature rather than
expansionary. The extensive regulatory
controls imposed on commercial banks with
respect to liquidity, leverage, and reserve
requirements have constrained overall
credit growth in an attempt to avoid another
financial crisis. Unfortunately, Mr. Malpass
suggests the unintended consequence of
post-monetarism may ultimately be a
slower/flatter trajectory of economic growth,
as evidenced by the Fed’s consistently
lowered annual economic growth
expectations ever since the financial crisis.
Velocity of money: Although the absolute
level of M2 has been rapidly accelerating
since the late 1990s, velocity (that is, the
rate at which money changes hands via
David Malpass, “Post Monetarism: The Fed’s Growth Options,” CATO Monetary Conference (November 12, 2015).
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transactions) has dropped significantly. Mr.
Malpass posits that what is preventing all of
this “extra” money in the system from freely
circulating are the regulatory constraints
imposed following the financial crisis, which
are essentially controlling the amount and
allocation of capital within the banking
system. Current Fed policies are reinforcing
this misallocation of capital, concentrating
most of it in the hands of large bond issuers
instead of smaller business owners who
should theoretically be more willing and
able to stimulate growth.
Credit growth: Private sector credit growth
slowed to only 4.3% year over year in the
second quarter. Although well off the trough
of the financial crisis, “credit growth has
been stalled at a slower rate than the trough
rates suffered in the 1970, 1975, 1982, and
2001 recessions.” 2
The sustained strength of the corporate
bond market has been impressive, but these
pools of capital seem to be primarily
directed toward anti-growth endeavors. We
think this behavior is actually symptomatic
of a much larger and more complex issue –
a lack of clarity, certainty, and overall
confidence in our current political, financial,
and social frameworks
Post-Monetarism Flaws
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2
A protracted period of near-zero or even
negative interest rates is actually
contractionary policy, not accommodative,
when accompanied by the massive
deleveraging process that has been
underway since the end of the financial
crisis. Mr. Malpass believes credit is being
substantially underpriced and, therefore,
rationed at near-zero interest rates. Credit
is underpriced to high-quality borrowers
that could pay more and unavailable to risktaking job creators.
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What has also resulted from the very low
interest rate environment is an implicit
transfer of wealth from so-called “Main
Street” (individual investors, small
businesses, employees, and the overall
economy), which is dis-incentivized to save
more due to the depressed level of interest
rates (or worse, forced to save even more
despite low rates to make up for a shortfall),
to “Wall Street” (the financial/investment
community and corporations), which is
incentivized to issue more debt.
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We think the Fed is likely to raise interest
rates 25 basis points (bps) at its December
2016 committee meeting and follow with
subsequent increases in 2017. An alternative
option we have heard explored recently is to
increase interest rates once (by a more
material 65 bps) and then hold at that level
for approximately two years. We believe
maintaining the currently very depressed
level of interest rates seems like the wrong
answer at this juncture.
The Fed’s asset purchases have also
become a contractionary force. By buying
only very long duration, highest-grade credit
instruments, the Fed has effectively
provided a subsidy at the expense of more
job-growth-oriented credit instruments like
working capital loans.
The Fed’s greater than $4 trillion bond
portfolio shows no signs of shrinking any
time soon. In fact, there have been some
concerns following comments made during
the recent Jackson Hole annual meeting
that the Fed may consider purchasing other
types of fixed income and/or equity
investment either in an effort to alleviate
some of the acute pressure on certain credit
markets or to diversify its portfolio or both.
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Time for an Exit Strategy
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The Fed’s balance sheet contains assets and
investments it acquired coming out of the
David Malpass, “Credit Growth Slows in Fed’s Flow of Funds Data,” Encima Global (September 16, 2016).
financial crisis. As a result, the Fed’s balance
sheet is now more exposed to both credit and
interest rate risk than ever before.
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The Fed has been borrowing at short-term
interest rates to buy long-term bonds in
order to just reinvest the principal that is
maturing and still maintain the existing size
of the balance sheet—effectively lengthening
the effective maturity of its bond portfolio.
This continues to put significant downward
pressure on real yields and stresses on the
short-term credit markets.
The Fed has said it plans to begin tapering
once a path toward higher interest rates is
well underway/established, but that still
seems rather far off absent a sweeping
change in the current thinking/approach to
monetary policy.
Mr. Malpass sees tapering new asset/bond
purchases and slowing the maturing
principal reinvestments as absolutely
critical to supporting economic growth.
potential for recurring, sustainable earnings
growth. We also think proactively raising
cash balances to meet short-term spending
obligations makes sense.
Emerging Markets
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Investment Implications
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3
Our business cycle framework/analysis is
signaling to us that the economy is in the
later innings of the current cycle. At the
same time, market valuation multiples are
stretched by almost all measures we track.
To the extent the Fed shifts policy gears
toward more growth-oriented activities, we
think these actions have the potential to
extend the current cycle.
The market has continued to grind higher,
but it has certainly not been a straight line
trajectory over the first three quarters of
2016. Fourth-quarter 2016 and full-year
2017 earnings expectations at 5.8% and
13.4% year over year, 3 respectively, look
optimistic to us, with risks skewed to the
downside. We continue to think it prudent to
take a more cautious approach to managing
portfolios at current levels by considering
asset classes with attractive yields and the
Monetary policy has been a critical driver of
emerging market (EM) outperformance
throughout 2016. We have been underweight
EM equities since early 2014, and our view
remains cautious despite the recent runup
in many of these markets.
With a favorable backdrop, EM stocks have
posted over 14% total return year to date.
Over a two-year period, EM stock
performance has still been quite poor, at 15.2%, but recent strength is worth
exploring, especially as it relates to the
interaction of policy and underlying
fundamentals.
Monetary policy is hard to predict, and we
believe any change in policy expectations
could lead to a dramatic reversal in the
robust flows into EM assets. Therefore, we
continue to focus on the fundamental
drivers of EM economic growth and
profitability, leading us to believe that risks
are still quite high. We believe this may not
be an opportune time to add broad EM index
exposure to portfolios.
Japan
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Japanese stocks have underperformed the
broad index of developed international
stocks since we initiated a small currencyhedged tactical allocation to the region in
spring 2015.
As was the case in the United States, we
believed aggressive monetary easing would
combine with more attractive relative
valuations to propel Japanese stocks higher,
while a weakening yen would be beneficial
https://www.factset.com/websitefiles/PDFs/earningsinsight/earningsinsight_9.16.16
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for the trajectory of the economy and
corporate profits.
However, aggressive monetary policy easing
is having counterintuitive effects on
Japanese asset prices and currency values.
There has been a divergence between
Japanese stock prices and the level of the
BOJ balance sheet.
Why have the BOJ’s policy actions had such
perverse impacts on the market? Simple
policy fatigue and skepticism may have set
in, with investors watching other global
central banks as they fail to spark a
significant growth reacceleration in their
respective economies. Clearly, policy has
not had the desired effect.
Even as the BOJ pushed rates further into
negative territory, the yen rallied over 18%
versus the dollar.
Ultimately, we believe structural reform in
Japan is the key to long-term progress.
However, structural reform can take many
years, if it happens at all. We think
additional monetary and fiscal stimulus is
likely in the shorter term.
The larger question is whether these efforts
will spark an upturn in growth and asset
prices. Recent history would suggest this is
not possible, but we think an argument can
still be made that valuations in Japan look
attractive and the BOJ is unlikely to tighten
policy any time in the near future; perhaps
these are elements that will result in better
equity performance, but over a much longer
horizon. For now, we believe it is prudent to
remove our tactical allocation to currencyhedged Japanese equities and look for
opportunities elsewhere in the market.
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Strategy Views
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We remain in a difficult market to forecast,
particularly regarding the complex
interactions between what we see as the
weak fundamental backdrop and how
current monetary policy might affect the
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dollar, interest rates, and investor risk
preferences.
Stocks and bonds are expensive relative to
history, growth remains sluggish, and
corporate earnings have been unable to
gather sustainable momentum. Conversely,
many investors are still being compelled
into equities by the extreme monetary policy
environment. These opposing dynamics
make it difficult to be decidedly too bullish
or too bearish over the shorter term, in our
view.
Regarding equities, we continue to believe
that average annual equity returns are likely
to be well below what investors have come
to expect as average. This view is purely
valuation-based and therefore longer term.
Equity markets will likely experience periods
of rising prices in the short run, but the risk
of steep drawdowns may make mediumterm price appreciation extremely slow.
Regarding fixed income, we continue to
recommend below-benchmark duration
positioning in fixed income portfolios. Yields
and duration are inversely related, making
bond prices more sensitive to moves in
interest rates when interest rates are low.
We think this is an important concept to
understand, since the price sensitivity in
bond portfolios is certainly elevated with
interest rates at such low levels; rates do
not need to increase all that much to see a
significant decline in prices.
High-yield bonds have had excellent
performance so far in 2016 despite our
cautious view toward the asset class. We
believe performance has been mainly driven
by a reach for yield amid speculation the Fed
would continue to delay any additional
interest rate increases. We think high-yield
bonds are at risk of a swift reversal in
capital flows if the probability of a Fed
interest rate hike rises materially.
On the international front, the fallout from
Brexit is starting to filter through some U.K.
economic data. Thus far, however, the data
are not quite as grim as many investors had
feared, causing some to moderate their
pessimistic growth forecasts. Still, our view
is that England may undergo a significant
slowdown, if not recession, and the extreme
dip in PMI survey data in July is still a
potential warning sign. For now, the Bank of
England has aggressively stepped in to dull
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any Brexit-induced economic pain, and the
rest of Europe appears largely insulated.
From an investment perspective, growth
across Europe is still slow but has remained
largely in line with expectations. We remain
comfortable with our allocation to currencyhedged European equities.
Jeffrey D. Mills
Hawthorn Investment Strategist and Senior
Investment Advisor
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