On the Road to Japanification

by Eric Knutzen, CIO, Multi-Asset Class, and Robert Surgent, Senior Portfolio Manager, Neuberger Berman

Sentiment around monetary policy, fiscal policy and a host of other factors can swing markets, but can anything return us to sustained growth and inflation?

Our Asset Allocation Committee (AAC) was back on videoconference for its quarterly meeting last week. As always, we’ll bring you the details in our regular Outlook early next month.

In the meantime, we wanted to highlight the difference in perspective depending on time horizon: the sheer weight of uncertainty that we face in the very short term; the AAC’s broad consensus in favor of riskier assets on a 12-month view, as the result of continued accommodative monetary and fiscal policies following the U.S. election; and a deep concern that the massive stimulus programs implemented in response to the COVID-19 crisis may not be able to truly generate the kind of sustainable growth and inflation that would likely be required to drive markets over the longer term.

Even as policymakers have gone all-in on monetary and fiscal stimulus, we are grappling with whether there will be any turning point on the road to worldwide “Japanification.”
Progress

Joe Amato set out the formidable array of short-term stumbling blocks three weeks ago. Chief among them are the path of coronavirus and the upcoming U.S. election.

When AAC members looked beyond the next several months, however, they were broadly in favor of riskier assets, with a moderate tilt to quality high yield, more cyclical segments of the stock market, and assets that are likely be sensitive to a near-term recovery in inflation. Uncorrelated strategies may help absorb some of the volatility of the next three to six months, put option writing could be a way to monetize it, and a modest cash buffer might enable investors to benefit from it by adding to risk on the dips.

Regarding the virus, while there is general concern that markets have become over-optimistic in recent weeks about a vaccine and treatment, we have confidence that real progress will be in sight on a 12- to 18-month timeframe.

Regarding the election, the headline view is that uncertainty about how quickly a final result will be available will be a likely source of elevated market volatility (and it is something we will watch closely over the coming weeks), but that the ultimate economic impact of a “blue wave” sweep, a Biden win with divided Congress, or a status-quo outcome would take time to unfold and may not be as significant as projected in the short term.
Punches

Ultimately, however, this 12- to 18-month view is about sentiment. It’s about renewed expectations for growth and inflation against a lower level of uncertainty. But what could be the engine for actual, realized growth and inflation?

As we wrote a couple of weeks ago, when we asked who you’d bet on in the epic title bout between the “Japanifier” and the “Stimulator,” in our view this is really the key question for any asset allocator with a long-term horizon. The result is likely to determine fundamental things such as whether government bonds can ever be used for income again and whether asset correlations will ever go back to normal.

The Stimulator, trained in the Modern Monetary Theory Gym, sees ever-growing government debt rewarded with ever-lower bond yields, and concludes that he can just keep on throwing fiscal-spending punches, powered by central bank liquidity, until the reflationary knockout is achieved.

But the Japanifier, defending his post-GFC title, does not look beaten. He can boast of years of disinflation and below-trend growth no matter how low unemployment goes or how high the debt piles up. He’s convinced that central banks are no match for demographic forces and the march of technology.
Disruptive Shock

On this secular question, looking beyond the next 12 months, the AAC was more split: Some point to a decade of policy failure to generate inflation; others counter that we’ve never been all-in with both fiscal and monetary stimulus before now. Policymakers might stimulate cost-push inflation by debasing their currencies, say others, but they cannot create the more constructive demand-push inflation we need.

Financial markets are split on this question, too. Since the massive policy response to the COVID-19 pandemic in March, cyclical and reflationary indicators such as the 10-year U.S. breakeven inflation rate, the Goldman Sachs Cyclicals Versus Defensives Index, the Australian dollar and copper are all up sharply. Despite all this, the 10-year Treasury yield has refused to get up from near its all-time lows.

The discrepancy could be an expression of how the impact of current stimulus on market sentiment for the next year or so contrasts with skepticism about our ability to return to sustained growth and inflation. The way that discrepancy resolves itself over the next six to 12 months may begin to tell us how justified that skepticism is.

For asset allocators, it’s a huge call to make. Maybe the disruptive shock of the coronavirus on our working and living patterns, together with the shock and awe of our response to it, will be our exit off of the road to Japanification. Or maybe Treasury markets are telling us that there is no exit. A year down the road, maybe we will be reining in our pro-cyclical tilts and thoroughly reassessing return expectations and asset allocation principles for the years ahead.

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