In 1964, Bob Dylan expressed social unease and the hope for change during a period of political turmoil and economic transformation via his third album, ‘The times they are a-changin’.
Over some fifty years following its release, globalisation, technology and the rise of financial capitalism and central banks as primary drivers of economic policy became the dominant features of the investment landscape.
Today, the world faces environmental, rather than nuclear annihilation, a shift in global economic power from West to East, and the erosion of political and economic liberalism.
Globalisation is currently under profound challenge from the rise of populist policies and nationalism that exploits discontent with the status quo and the stagnation of real incomes in the aftermath of the global financial crisis.
GLOBALISATION, TRADE % OF GLOBAL GDP
Source: World Bank; latest annual data for 2016
The vehemence of political discourse disguises an emerging ‘anti-globalisation’ consensus of populism from the left and right, emphasising a nationalist economic policy agenda and rejecting multilateralism.
- President Trump’s economic policy agenda is explicitly anti-globalisation
- Brexit is a rejection of European multilateralism
- The populist Five Star and League coalition governing Italy is railing against the eurozone’s fiscal ‘rules’ and common immigration policies
- Nationalist populist leaders from left and right are gaining high office across EM economies
- Even China, a key beneficiary of globalisation, is becoming more assertively nationalist and is reducing its reliance on foreign investment and trade
- China, along with the rest of the world, must confront the profound challenges arising from climate change and environmental degradation that have economic as well as social consequences
Goldilocks and the three bears
A combination of volatility, political uncertainty and higher interest rates scared away the ‘Goldilocks’ environment (above-trend growth, below-trend inflation) of steadily rising investment returns.
In contrast to 2017’s soporific (though rewarding) markets, 2018 has been characterised by several episodes of volatility including:
- the blow-up of ‘short volatility’ strategies at the start of the year
- the sell-off in EM assets and Italian government bonds
- multiple global equity market ‘corrections’ (falls of 10%+)
Very few asset ‘betas’ have generated positive total returns in 2018 and despite the episodes of volatility and equity drawdowns, core fixed income has offered little compensation, reflecting the regime shift from quantitative easing (QE) to quantitative tightening (QT).
QE anchored ‘very low for very long’ policy interest rates and the commitment of central bankers to provide additional monetary easing in response to episodes of weaker growth and volatility.
More than USD9 trillion of central bank asset purchases created a tide of liquidity that lifted all asset prices, suppressed dispersion and volatility and elevated cross-asset correlations. Rewards from asset and security selections were eroded with returns dominated by the QE-induced ‘beta’ rally that favoured passive investment strategies.
In the era of QT, central banks are no longer net buyers of financial assets and the most important of them, the US Federal Reserve (Fed), is shrinking its balance sheet and steadily raising interest rates. The European Central Bank (ECB) will stop buying bonds at the end of 2018 and the Bank of Japan (BoJ) is scaling down its asset purchases and allowing bond yields to rise, albeit very modestly.
Global monetary policy has a tightening bias and in the language of options, the ‘central bank put’ (the commitment of central banks to put a floor on asset prices) is much more deeply ‘out of the money’.
During the QE-era, the correlation between core fixed income (high-grade government bonds and short-term interest rates) and equity (or growth) risk was strongly negative and relatively stable. Central banks were more worried about deflation than inflation and soothed jittery markets with a monetary sedative. But with growth above potential and little in the way of economic ‘slack’, inflation is a greater risk than deflation and central banks are reversing the extraordinary monetary policies of the QE-era.
- For the first time, the aggregate balance sheet of the world’s major central banks will shrink in 2019, marking a decisive shift from the quantitative easing (QE) to quantitative tightening (QT) era.
- The reversal of QE – quantitative tightening – implies more frequent volatility episodes and greater reward from security selection and less stable correlation between equity and traditional fixed income.
- QT is unchartered territory for investors; favour alternative approaches to fixed income that are not solely reliant on interest rate duration to drive returns and diversify equity risk.
EQUITY & BOND CORRELATION LESS NEGATIVE & LESS STABLE
Source: Macrobond; BlueBay calculations; latest data 19 November 2018