27 June 2020 Viewpoint resize
June 29, 2020

CIO Viewpoint: Intangible Interference

27 June 2020 Viewpoint resize

Markets have arguably mellowed of late, but we believe that significant risks still remain to economic growth in the near to medium term. Moreover, financial markets are not exclusively representative of the economy. Key economic data, such as the Purchasing Manager’s Index (PMI), remain weak though are bouncing off the bottom; flash Eurozone June PMI looks promising at 47.5 vs. May’s 31.9. However, the real story is behind the ongoing rhetoric among central bankers, policy makers and market participants in respect to the probability of further stimulus measures. However, we feel markets are unduly asking for more simply because they can under the subconscious guise of a supposed rational and fitting economic explanation: Modern Monetary Theory (MMT). We outline below how the US Federal Reserve and the US Department of Treasury’s ‘lending and spending’ is likely influencing issuance, bond spreads, and general asset prices. We tie this into how MMT is coming back into vogue as a way to explain and substantiate such coordinated central bank and policymaker action. We think markets are likely to experience an undercurrent of ongoing macro monetary and fiscal action. (See CIO Viewpoint: Fiscal Policy in 2020.)

Fed Fluster: Outsized Issuance, Blunted Spreads and Inflated Prices

Specifically, we think that the Fed is acting as a static and incumbent market participant not only in its traditional domain of US Treasuries, as they did during Quantitative Easing (QE) from 2008 to 2014. But they are now doing so for corporate bonds of both high grade and high yield nature. Naturally this has influenced the run-down of trader’s order books. Mechanically, having a live bid lends to liquidity, 

Issuance

Accordingly, this has emboldened companies to issue record amounts of new debt in the market knowing that there is an active market despite the economic circumstances. After all, the Fed originally promised on April 25 to buy select bond ETFs comprising primarily of US based issuers. They then expanded this to corporate issuers which were investment grade as of March 22. On April 9 they expanded this to bonds which were downgraded to high yield; these are bonds considered as “fallen angels”. The Fed will also include primary issuances in their purchases. In fact, according to Dealogic, US dollar investment grade issuance is tracking higher in the first half of 2020 than in the first half of 2019, which were both periods of declining rates.

Spreads

Broadly, spreads have moderated since March but remain elevated historically, reflecting the underlying uncertainty of the economic outlook for the US and globally. Notably, spreads did not widen as much or reach the same highs as during the Global Financial Crisis (GFC) in 2008/2009. Spread, the difference in yield between issuances or versus a risk free instrument, such as the US 10 year bond, should normally indicate the premium or discount received for holding either a higher or lower rated instrument with a similar maturity or an instrument of similar rating but with different maturity. Theoretically, spreads widen when uncertainty increases due to a weaker economic outlook and when investors demand a premium for risker bonds. Therefore, typically spreads narrow when investors are feeling more optimistic about economic prospects.

While evidence to support these behaviours remains to be seen, we think the addition of a determined market player, the Fed, may likely keep spreads unnecessarily tighter than if there were not such a determined market participant. It’s no doubt that bond spreads will adjust day to day based on risk on or off sentiment in the market. This is a short term phenomenon. An on-going and transparent bidder is likely to instil a psychological sense of security in the market thereby reducing the width of spreads and ultimately keeping them range bound. While on the upside, this could reduce bond price volatility and yield volatility, in effect the market becomes unable to discover the “real” price due to such interferences.

Asset Prices

Fed intervention to ensure functioning and liquid markets is likely to impact the efficacy of price discovery. Incumbent to fundamental investors, traders and money managers is the ability to identify mis-priced risk or return and take advantage of these “edges” in the market to garner performance return. A market player with unlimited supply in the form of electronic cash and an unlimited balance sheet unequivocally affects the fairness of such price discovery; money talks. While regulation can eliminate greenfield opportunities, so too can temporary liquidity measures. For example, some equity indices have been in a bull run since March (NASDAQ + ~42% since March lows). Some stocks have been retouching all-time highs. Ultimately, asset prices are, in part, reacting to the psychological effect of the concept of an unlimited balance sheet. Investors claim “don’t fight the Fed”, which is likely true given the Fed’s apparent unlimited resources. This may require a fundamental rethink of coordinated monetary and fiscal policies, with asset price inflation as the long term collateral damage.

MMT and Lack of Fiscal Discipline

Modern Monetary Theory (MMT) posits that an economic system that creates its own money has the power to do so in an unconstrained fashion so as to pay for whatever program or initiative the policy makers fancy. Essentially, it allows ever more sovereign flexibility and power over money.

MMT has evolved from early days of studies of monetary and fiscal policies. Formerly, such approaches to managing economic growth were evaluated in isolation with limited expectation of the impacts of effective coordination. The new economic paradigm has demanded that central bankers and policymakers coordinate for the better interests of society. MMT throws out the idea of minimizing budget deficits. It further dismisses established concepts of the Classical theory of economics such as supply and demand, rational behaviour, limited resources and incentives. In fact, it even negates the impact of the Consumer Price Index (CPI) figures on policymaking however maligned the figures may be at any given point in the cycle. MMT is a derivative of Keynesian economics.

Proponents of MMT are commonly more economically progressive. Therefore, the simple concept of “balancing one’s check book” in effect becomes outdated under MMT. This is why MMT connects to the current Fed and Treasury programmes. Merely by the size of the US fiscal spending programme announced since March, it argues for MMT in that the tax base cannot support and should not support such spending. This raises the question of a long held US presidential candidate platform view: tax policy.

Convergence: Lawmakers, Central Banker and Politics

Historically, the Democratic Party in the US has supported a “tax and spend” fiscal approach to economic malaise. However, under MMT, if one assumes central banks can truly print unlimited money (unlimited balanced sheet), the need to tax citizens and businesses, at the levels they are now, becomes moot. (We’d caution though that in order to set inflation expectations for a rising period of inflation, money on main street is the real driver as shown in various forms of M2 and money multiplier metrics.) Economist and even the Fed have a number of times expressed doubt over the sustainability of continued budget deficits. While it’s easy to start and enter a programme such as unlimited debt creation through an MMT framework, it’s much more challenging to turn off those faucets without significant ramifications. It remains to be seen if MMT theorists will be successful in shifting the budget hawks’ view on the need to match spending with tax increases. 

What to Do

Policy makers will continue to evaluate the merits of fiscal stimulus no matter the persuasion of the administration. MMT is likely to only support the friction of differing views of tax policy. However, in the medium term, under the guise of the theory, but more reflective of the need to spend and lend to support a post COVID19 economic recovery, bond issuance is likely to increase and spreads are likely to stay narrow – economic uncertainty notwithstanding. Asset prices broadly are likely to be inflated due to central banks’ unlimited resources at the behest of policy makers.

For portfolios, we remain neutral on fixed income. Risk return is more attractive for equities on an equity risk premium basis albeit with increasing risks of late. There are pockets of value but identifying true mispricing is challenging and could only be a tactical trade than supportive of long term views.

The Fed’s intangible interference is likely here to stay. We are resolutely in a lower for longer rate environment. (See CIO Viewpoint: Lower for Longer.) Moreover, the Fed has returned to providing forward guidance and their projections show no significant rate increases until 2021. Consequently, seeking alternative yield instruments could prove a welcome distraction from the euphoria behind equities of late. See this quarter’s Focus: Renewable Energy Revolution, where we discuss an emerging asset class, Yieldcos.

Uncertainty remains. Broad and diversified portfolios, balancing both risk and reward across asset class, sector, region and currency will help to weather flash crashes. As always, active and prudent portfolio management to stay on top of the ever changing dynamics will help to preserve capital in portfolios.

Sources: Bank of America Private Bank, Bank of America Global Research, ETF Strategy, Federal Reserve Bank, Forbes, Frasier Institute, Goldman Sachs Investment Research, JP Morgan Investment Research, MarketWatch, Reuters, Seeking Alpha, The Wall Street Journal, Vox, and CIGP Estimates.