Bring in the Clowns?

At the end of the last week, one of the Bank’s Deputy Governor spoke in Winnipeg on the benefits of well anchored inflation expectations and how inflation targeting has been a major contributor to anchoring these expectations.  

He explained the issues and challenges ahead for the central bank as they start the process of renewing the inflation target agreement between the Bank and the Department of Finance for 2021.  Very candidly, he spoke of the declining trend growth of developed economies and the dampening of cyclical recoveries that could be expected.  While greater stimulus will be needed to offset these structural changes in the next downturn, he admitted that the amount of firepower that central banks have at their disposal is declining.  Less space in G7 countries for borrowing to stimulate demand due to the overhang of debt resulting from the 2008 “fix” and a declining neutral rate will constrain the effectiveness of monetary policy in the next downturn.  As a result, optimal macro policy would now demand more coordination of fiscal and monetary policy.   Studies have shown that when interest rates are pinned to the bottom, countercyclical fiscal policy arising from the automatic stabilizers kicking in and discretionary spending, like infrastructure outlays are highly effective at supporting output.  As a result, one of the things that the Bank wants to explore ahead of the renewal is looking into ex-ante mechanisms to co-ordinate fiscal and monetary policies to deliver better outcomes.  Unlike what we see south of the border, fiscal and monetary policy should be pushing in the same direction.   

With monetary policy potentially less powerful, as a citizen and asset holder, it would be reassuring to know that Parliament Hill and Wellington Street had a framework in place to ensure they would be leaning in the same direction post the next crisis in a timely manner.  Unfortunately, the philosophical and practical hurdles, and their associated risks, attached to some sort of actionable agreement between the Bank and the government are extremely high.

From a historical perspective, if managing inflation is your goal, mixing politics with monetary policy has not worked well.  Canada is a poster child in this area with the resignation of the Governor in 1961 when he set tight monetary policy to counter expansionary fiscal policy.  For a long time, central banks, including the Bank of Canada (after the “Coyne Affair”), worked to get at arm’s length from their political masters to ensure rates were set by economic fundamentals, not set by the electoral calendar.  There would seem to be some risk associated with tampering with this arm’s length arrangement.  

It is probably also fair to ask if the commitment would be binding across governments.  Politicians tend to do what is politically expedient.  The commitment to the inflation target by the current government and the Bank cited in the speech as providing the genesis for an agreement to complementary monetary and fiscal policy in a crisis is only on a piece of paper that could be terminated by the stroke of a pen by the next government (may I introduce Jagmeet when he is confronted by “excessively” high rates that are necessary to quell inflation).  Moreover, this commitment has the Bank accountable to parliament to achieve the inflation target regardless of fiscal policy dictated ultimately by the electorate.  I doubt our elected representatives would want to be seen backing fiscal actions that are contrary to what their voters want; that were triggered by what many constituents view as an arbitrary target.

On the practical side, only in a text book could you come up with ex-ante mechanisms to coordinate policies.  It is difficult enough for unelected officials to enact policy based on their outlook of what will happen.  This is almost impossible for an elected official to risk his career on what may happen.  Political momentum to enact fiscal stimulus beyond the stabilizers almost always happens after the sh** hits the fan (or they feel they are overtaxed, their military is still too small and they don’t have enough debt outstanding).  Even if the triggers (whatever they may be) were correct in anticipating a time when coordinating policies was needed, the political process could easily derail the timing. Fiscal policy, apart from the automatic stabilizers, is not quick and nimble by design.  

Given that monetary policy will not have the same amount of ammo going into the next downturn, it makes sense that the Bank pursues avenues to enhance overall macro policy.  I am just not sure that relying on politicians to act in an appropriately sized and timely manner is the type of assurance the market would want to bet on.  The best bet would be to structure your portfolio knowing the next time things go sour, the safety net below you is now much lower.

The "New" Fed in the "New" Environment

If you own stocks, the last few weeks have been turbulent.  Everyone seems to have a story about why it happened and what it means for the market going forward.  I listen to some of the talking heads and hear how great it is to see volatility back in markets.  The recent dive has acted as a release valve and now we are back to a healthier market.  The captain is about to take the seat belt sign off so the rally can recommence.  The fundamentals, we are told, remain favourable for equities to reach new highs.  Party on, Garth!  

Then there seems to be the deeper thinkers who suggest that there has been a seismic shift under the markets.  Investors had been operating in an environment of slow and steady growth, low interest rates, dormant inflation and accommodative central bank policies which led to a period of extremely low volatility and a relentless bid in all markets, including  equities.  Now, this view has been rattled.  While expectations for economic growth do not seem to have been altered much even with additional US fiscal stimulus, the market seems to have suddenly become aware that we are now in an environment where central banks are reigning in liquidity, yields have jumped higher and there is growing evidence that inflation is not dead.  This “new” environment requires that portfolios need to reposition for higher inflation and need to lower their risk profiles given the expectations of increased volatility.  

Adding to all this is the question as to how the new leadership at the Fed will respond to this “new” environment. The market was well served by Yellen over her term.  Rates were kept low and any increases were well telegraphed and tempered.  Her decision to start unwinding QE was virtually ignored.  Her market-friendly actions and resulting dovish moniker were the result of her setting appropriate policy.  With inflation stubbornly low, she could err on the side of ease.  Now, with Jerome in charge, the market has to consider whether he will be more hawkish than Janet.  For him, his starting point includes firming inflation, with core measures already close to their assumed inflation target.  He also has the economy growing above potential and in an excess demand situation.  Unlike Yellen, who could afford to act slowly, it is doubtful Mr. Powell has the same latitude.  Hence, he will likely be seen as less market-friendly and viewed as more hawkish over his entire term than his predecessor.  

The market already has a number of hikes built in for the next year.  Asset market valuations will depend on whether Fed actions match this profile.  To answer whether they do or not, we are right back to our “old” environment conundrum.  You know the one where inflation remains surprisingly suppressed relative to a given output gap by technology, globalization and other factors.  Unless there is more proof that inflation is really gaining traction and accelerating, I doubt we will see a huge personality change towards more aggressive behaviour coming out of the Fed.  It may take some time before we see the “hawk” in Mr. Powell.   Party on, Wayne!

Groundhog Day

Friday’s plunge in the Dow seems to have finally rattled the complacency that has persisted in the equity markets for the past year.  Whether this is just a pause for the markets to catch their breath or the beginning of something more sinister, no one has a clue.  

What I found intriguing is that the “jarring” 2.5% decline (remember when a 20% drop in one day was considered life changing?) occurred on Groundhog day.  This seemed appropriate both in context of Punxsutawney Phil’s call on the beginning of spring and in context of the movie bearing its name.  

Up until this week, the last year has reminded me of the movie Groundhog Day, the one with Bill Murray where he is trapped living the same day over and over again.  In the market’s version, every day the equity investor goes to work and starts buying stocks in response to hearing that in addition to a global economy that is strengthening, the US tax cuts will immediately boost earnings, incite massive repatriation that will spur buy-backs, dividend increases and all sorts of manna from heaven.  Over the course of the day, this buying pushes the indices higher and the investor goes home.  The next day, it is tableau rasa, groundhog day all over again.  The investor goes into work the next day, with the indices at a higher level and hears for the first time that US tax cuts will be great for earnings and repatriation of foreign profits by US companies will rain cash down on the market and that the global economy is gathering steam.  Investors have to get on board, so they start to buy equities, regardless of valuations, pushing the averages higher again.  The investor then goes home, and then gets up and goes to work the next day and he hears for the first time exciting news about the impact of tax cuts and the global economy…You get the picture.

I know the market is suppose to be a forward-looking discounting machine, but is it possible the degree of good news being priced into global equities was overdone while participants seemingly were locked into an infinite loop with the same factors getting rediscounted again and again?

It is now possible that from these elevated equity valuations, there has been a subtle shift away from the sweet spot.  The good news of global economic growth mixed with ample materials for financial engineering that for the last year have signalled all systems ‘go’ may now be interpreted as increasing the risk of higher yields and hence lower expected discounted future earnings. All of a sudden, good news maybe not that good after all.  

Last Friday, up on Gobbler’s Knob, Punxsutawney Phil came out of his hole to be greeted by a perfect cold morning.  With no clouds to protect him from the rising sun, he was startled by seeing his shadow and scurried back into his abode, the omen being we are in for a long winter.

On the same day, at 8:30 am, the market poked its head out to see the US employment release.  The news was good and the resulting possibility of higher-than-expected yields startled the market and sent it reeling back under its desk.  Now we just have to figure out if this means a long winter ahead for the market as well.  Happy Groundhog day.