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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. Symptoms of Post-Monetarism Monetarism Theory versus Post-Monetarism Theory 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. 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). 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 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. 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. 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. Time for an Exit Strategy 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. 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 Investment Implications 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 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 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. Strategy Views 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 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 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 The PNC Financial Services Group, Inc. (“PNC”) uses the marketing name Hawthorn, PNC Family Wealth ® to provide investment, wealth management, and fiduciary services through its subsidiary, PNC Bank, National Association (“PNC Bank”), which is a Member FDIC, and to provide specific fiduciary and agency services through its subsidiary, PNC Delaware Trust Company or PNC Ohio Trust Company. Standalone custody, escrow, and directed trustee services; FDIC-insured banking products and services; and lending of funds are also provided through PNC Bank. This report is furnished for the use of PNC and its clients and does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation, or particular needs of any specific person. Use of this report is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client’s individual account circumstances. Persons reading this report should consult with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in this report was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness, or completeness by PNC. The information contained in this report and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. 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