In our view, the world economy has entered a period of stagnation that will at some point translate into a market correction. Targeted monetary and fiscal policies such as green monetary policy, rather than the current undirected accommodative monetary policies, are required to secure sustainable economic development. Since both are not expected to come in any time soon, we did not change our asset allocation and remain underweight in equities and neutral in bonds.
Persistent geopolitical risks
The most imminent geopolitical tensions are likely to remain a severe headwind for the global economy. So far, the ongoing trade war between the US and China has been the most important driver of recent worldwide uncertainty. After the trade war escalated at the beginning of August, with both countries imposing additional tariffs, equity markets temporarily dropped sharply. Although trade talks are scheduled to resume in October, we feel that the by now familiar cycle of escalation, followed by hints at a resolution, but ultimately no progress forthcoming, will continue at least until the US presidential elections in 2020.
Meanwhile, the uncertainty about Brexit also remains, with the deadline of October 31 rapidly approaching without any sign of a deal. In addition to this, the attack on oil production facilities in Saudi Arabia, escalating demonstrations in Hong Kong and the initiation of an impeachment inquiry against president Trump all resulted in an ongoing deterioration of global business confidence and stalled capital investments.
Germany seems to be heading for a recession, whereas consensus growth expectations for the US, eurozone and Chinese economies have been adjusted downwards. A global economic recession is still way off the mark, but stagnation is closer to reality than continued economic expansion.
In response to the economic growth slowdown and persistent geopolitical risks, the major central banks have implemented or hinted at looser monetary policies. Japanification of monetary policy has in our view definitively globalized: it is by far the most dominant force in driving financial markets. We are witnessing the ‘central bankification’ of the developed world. The US Federal Reserve (Fed) stopped quantitative tightening and cut interest rates twice last quarter, for the first time in over a decade. The European Central Bank (ECB) followed suit and cut its rate for the first time since 2016. It also announced the restart of its quantitative-easing scheme and eased lending terms for eurozone banks. The People’s Bank of China, China’s central bank, further eased its monetary policy by loosening the reserve requirements for Chinese banks, thereby increasing their ability to lend. And in their most recent statements, the central banks of England and Japan have both expressed their willingness to provide additional stimulus if necessary. All these (possible) easing measures have made the worldwide monetary policy environment even more accommodating. We probably haven’t seen the full depth of this trend yet.
The global trend in monetary policy is a strange phenomenon. Usually, central banks cut rates when economies have entered a recession. Now, only the mere probability of an economic slowdown is enough to set central banks in motion. There is but one explanation for this: our financial system is too fragile to handle any economic setback without monetary support. Yet, it is by no means certain that these additional measures will effectively sustain growth. So far, the excessive easing has led to unrealistic high returns on the financial markets, only benefiting investors and multinationals.
Urgent need for sustainable monetary and fiscal policy
Whereas the effectiveness of recent measures to sustain growth is disputable, it is a fact that current monetary policies are not designed to create a more sustainable economy. In this sense, monetary policies are ‘clueless’. Financial markets are expected to provide direction for investments and hence growth. The ‘market-neutral’ approach of the ECB’s corporate asset purchase program is a good example of this lack of vision. Through targeted purchasing of corporate bonds, the ECB could have fostered low-carbon production, thus stimulating and accelerating the transition to a low-carbon economy in the eurozone. But by proportionally buying a market portfolio of corporate bonds across all sectors, it also supports many fossil fuel companies, thus fully neglecting its (indirect) impact on climate change. This was acknowledged by Christine Lagarde, who is set to succeed Mario Draghi as president of the ECB. In her first public appearance as president-elect of the ECB, she called for a ‘greening’ of EU monetary policy, stating that climate change is one of the most pressing global challenges facing society today. According to Lagarde the environment and climate therefore “must be at the core of the mission” of any institution. Indeed, central banks around the world urgently need to rethink their mission. Instead of being part of the problem, they should play an important role in creating more sustainable economies.
Governments should also step up their game to stimulate sustainable development, for example by accelerating the energy transition. As it happens, last quarter showed some positive signs of that. The recently appointed president of the European Commission seems more ambitious in her climate policies than the outgoing president. In Germany, the government presented a 50-billion-euro plan to stimulate the transition into a carbon neutral economy, whereas the Dutch government is studying plans for an investment fund. Other countries may follow these examples, as the discussion in the eurozone about relaxing budgetary rules has started. But fiscal loosening, abandoning the famous German ’Schwarze Null’, would only make sense if the money is well spent: no general tax reliefs but investments, subsidies or tax breaks to create a more sustainable economy and incentivize private investors to step in.
Will investors touch base again?
The third quarter showed an overall increase in bond and equity markets. This contradicted with underlying economic indicators showing a global growth slowdown and was therefore not in line with our expectations.
The continued optimistic sentiment in global equity markets is mainly caused by more accommodative central bank policies. Investors clearly count on additional easing measures, following those taken during last quarter. Considering the relatively hawkish statements of the Fed that accompanied its interest rate cuts, they may be disappointed, however. In the meantime, resumed trade talks between the US and China are unlikely to resolve the global uncertainty that causes companies to stall capital investments. We expect a further slowing down of the world economy, which will keep earnings revisions into negative territory for most equity markets. We therefore remain tactically cautious on equity, since a more defensive sector allocation is the best way to guard against market corrections that so far have not materialised but are in our view inevitable at some point.
At the same time, the ongoing decline of government bond yields during most of the third quarter shows the persistent appetite for safe havens among investors. This trend clearly contradicts the optimistic view of equity investors about the future of the economy, which is largely based upon firm trust in central banks’ continued accommodative stance. Given the many geopolitical risks that may materialize and since the end of the business cycle is approaching, we position for a period of global economic stagnation. Our fixed income allocation therefore remains broadly neutral, and although the increase in liquidity makes defaults less likely, slowing growth makes us prefer credits with high-quality names.
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