“In a dark room you move with tiny steps. You don’t run, but you do move. Or in other words, you try to be proactive rather than reactive to contingencies because, for a variety of reasons, the situation can then unfold in an unforeseen and unwanted way.”
– Mario Draghi, ECB President, 7 March 2019
In a world increasingly populated by economic risks, central bankers have often been the only sheriffs in town, keeping extreme events at bay, and using unconventional policies to do so. As geopolitical tensions rise and domestic policies become more one-sided, central bankers are looking increasingly alone in their fight.
Since the 2008 recession, central bank stimulus and QE have been relatively successful in the United States, in part thanks to structural advantages – including the ability to restructure private balance sheets quickly and externalise losses through bond markets. Instead, central banks in the Eurozone, the UK, Switzerland, Australia, New Zealand and of course, Japan, appear to have missed the window to normalise policy (The Silver Bullet | Have Central Banks Missed the Exit Train?, May 2018).
As the cycle slows, many have been debating whether central bankers should continue to defend the economy, potentially even changing their mandate to allow for more easing, or if they should save ammunition for the next crisis. ECB board member Bini-Smaghi recently compared this to a Sergio Leone western: “The best way for central banks to keep their powder dry is to shoot as much as they can right away, and avoid a recession”.
Mr Draghi’s approach appears much more cautious than the gunslinger with no name in The Good, The Bad and The Ugly. This is probably because the ammunition available is scarcer, with rates already at record lows and increasing signs that liquidity may have contributed to inflating asset bubbles, thereby increasing the economy’s sensitivity to fluctuations in financial markets. The lukewarm recent price action following this month’s ECB press conference and TLTRO-III announcement is a case in point. Against a very sharp growth downgrade by the ECB, a two-year extension of existing liquidity facilities was taken negatively by investors, who perhaps expected the ECB President to unveil a new weapon.
There is no other “whatever it takes” moment on the horizon – rather, a prolonged environment of loose policy which will help to reduce tail risks for the cycle, but without fixing structural economic issues. And while there is more awareness of the collateral effects of low rates from our conversations in Frankfurt, the sense of urgency to change policy remains low, absent fiscal policy and reforms from European governments.
For investors, this means preparing for slowing trend growth and potentially Japanification risks, particularly in Europe and China, and trading cycles of stimulus and fear around it.
The game-changer and counter-argument to this view could be fiscal policy. However, the US has already implemented its largest peacetime stimulus on record; China is about to re-enter stimulative policy, as announced at this months’ National People’s Congress, but this year’s stimulus will be a fraction vs the one started in 2009. Germany remains on the side-lines, with new CDU leader Kramp-Karrenbauer sceptical on European fiscal consolidation.
Investing in a Japan-like Environment
Are Europe and China on the edge of a prolonged period of dovish QE infinity policy and low growth, like in Japan’s lost decades? The odds are increasingly pointing in this direction:
First, Europe has rapidly ageing demographics, a trend similar to Japan’s in the early 90s. In Europe, over a third of Italy’s and Spain’s population may be over 65 by 2050. Eastern Europe is anticipated to have amongst the most rapid population decline by 2050. Second, Europe is pursuing a very accommodative monetary policy with lack of reforms, this continues to support bank liquidity while stifling productivity and creating misallocations of resources in the economy. The result is ultimately a lack of efficiency and productivity. China is on a similar path. China’s demographic shifts over the next 25 years will likely mirror those of Japan in the 90s, despite the abolition of the one-child policy. China too is pursuing accommodative monetary policy, however, with a long term plan to diversify the economy towards new engines of growth, like technology and innovation. Last, while banks in both regions have stronger capital positions than before the 2008-crisis, their balance sheets remain bloated by a long period of high lending growth and are still saddled with non-performing loans. Therefore, like Japan in the 90s, the banks remain incentivized to extend-and-pretend on their existing loan book rather than lend to new businesses. This will further weigh on productivity. Unlike Europe, however, China may be able to partly offset this risk by relaxing capital rules and attract foreign investment.
When we launched our Macro Credit Fund three years ago, we had the risks of Japanification on our mind: our aim was to provide alternative returns for fixed income for investors in a low or negative rates environment. Since then, we experienced a tentative normalisation in nominal interest rates in the US, but we have largely returned to historical lows elsewhere. Meanwhile, real interest rates remain near zero or negative in most developed markets. In some cases, like governments which plan to increase public spending even in the face of rising debt sustainability issues, risk-free assets are increasingly becoming less risk-free.
Once again, today’s environment calls for diversification into alternatives and into credit risks which may represent a better source of yield than sovereign credit and traditional strategies. In particular, we believe markets are still providing a good opportunity set for investors willing to deploy capital, due to the combination of the following factors:
1. Recession fears are still elevated, as reflected by credit spreads in high yield markets, particularly in Europe and some Emerging Markets.
2. China’s stimulus is picking up steam. Although we do not expect a large-scale stimulus package, the U-turn by Chinese policymakers from de-leveraging to credit expansion will likely push growth to rebound from the technical recession experienced last year. However, the recent factory-output growth data (5.3% year on year growth, the weakest reading since 1995) suggests that tariffs could outweigh the economic stimulus measures from the Chinese government and that the stimulus may have a more domestic impact.
3. Monetary policy is likely to remain dovish for longer. As discussed in our latest Silver Bullet (Throw in the Powell, January 2019), this will reduce tail risks for credit investors.
4. Positioning remains very underweight. Only in Emerging Markets, mutual funds received enough inflows in 2019 to make up for the outflows of last year. More broadly, investors have remained short or underweight during this year’s moves, especially in some pockets of the credit markets – like Europe and some EMs.
5. Much-feared binary events may not translate into tail risks. US-China trade negotiations will likely reach a temporary deal, transforming future negotiations into a framework to monitor China’s compliance with trade and intellectual property policies. Even though there remains a lack of preparation around Brexit, it is possible that an extension agreement will be reached by month end. European elections are likely to translate into a warning sign for current policymakers, not an outright victory for populist parties. Put differently, while investors often shy away from events which may be interpreted as complex or binary, these risks often can spread out for much longer in reality, and are less binary in nature.
We believe there’s substantial value in credit markets. While the major benchmark indices have moved, some areas remain attractive and can benefit from the pricing out of growth and political risks emerged in Q4 last year and from a still-wide liquidity premium. This is particularly true for European and selective EM assets.
We believe this opportunity has persisted in part due to the mispricing of political risks in Europe and some EM countries, as well as the exacerbation of recession fears, compounded by the inability of bank trading desks to warehouse inventory in the latter part of 2018.
Put differently, what was just a growth scare for the economy, was priced like an outright recession by credit markets. We were indeed cautious about 2018, although we did not expect markets to react so abruptly.
Today, the bonds we held in 2018 and the ones we bought in Q4 are recovering, as our views on dovish policy and the absence of an actual recession are proving correct (The Silver Bullet | 2019: Populism and Volatility, but no Recession, December 2018). Going forward, our base case scenario is for a cyclical recovery within a structural period of around-trend growth and persistent dovish policy. In this context, credit and rates risk should continue to perform well.
Our fund is positioned to benefit further from the pricing out of negative risks and potential upside risks into the rest of the year.
Alberto Gallo is Head of Macro Strategies at Algebris (UK) Limited, and is Portfolio Manager for the Algebris Macro Credit Fund (UCITS), joined by portfolio managers/ macro analysts Aditya Aney and Pablo Morenes.
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