Fiscal and monetary policy could shift and that could bring big changes.
by Jurrien Timmer, Director of Global Macro, Fidelity Investments
Key takeaways
- An era of coordinated industrial policy, executed through fiscal expansion and “funded” by monetary policy, similar to the policies during World War II, is a possibility. If it came about, it could affect the market for years.
- The structural change could be ushered in by the combination of factors produced by 2020: COVID, the election, and the fiscal/monetary policy experiment which spiked the money supply to a new record high.
- Rising inflation could be the result of a structural shift in fiscal and monetary policy. If so, it could mean a rotation from growth to value, from large caps to small caps, and from stocks to commodities.
- The shift from an era of deflation to one of inflation could have implications for long-term investors. It's too soon to tell but if the tide shifts, investors should be ready to go with the flow.
Sometimes it’s hard to see through the clouds, but as investors that’s exactly what we need to do.
There are so many things in flux this year, from COVID-19 (including a now unfolding second wave in Europe and parts of the US), to a possible political regime change in Washington and what that might mean for fiscal policy, to a real-time experiment in fiscal/monetary mixology, to questions about the prospects for the 60% stocks/40% bonds paradigm, to the possibility of a career-making (or breaking) secular rotation from growth/large/US/financial assets to value/small/ex-US/real assets.
For investors there’s plenty to unpack here, so let’s break it down into themes.
Will next week’s election bring about a new fiscal/monetary regime?
Needless to say, the election could produce a number of market-moving changes. While a possible change in tax policy may be front of mind for many investors, that’s only part of the picture.
In my view, the possibility of an era of coordinated industrial policy, executed through fiscal expansion and “funded” by monetary policy, is something that could affect the markets for years to come.
Ironically, the scenario that historically has been most favored by the market (a divided Congress) might potentially throw cold water on a market that is primed for a fiscal/monetary cocktail. But then again, this is 2020.
Regardless of the election’s outcome, I believe we are looking at the prospect of rising debt levels as far as the eye can see.
I continue to use the 1940s as the most likely policy playbook for how the Treasury and Fed might navigate the years ahead. The period from 1942 to 1946 (when the US mobilized the economy to enter World War II) produced sharply higher debt levels. The debt levels increased from 41% of GDP to 115% of GDP within the span of a few years and were fully monetized by a Fed that increased its balance sheet 10-fold and kept both the policy rate and market rates well below the inflation rate.
When debt levels are high and there is no ability to grow out of them (because of demographics; i.e., the wave of people at or near retirement age), inflating or devaluing your way out of debt becomes the only option. Since less and less of US debt is owned by foreigners (at least in percentage terms), inflation may well be the only way to get out of debt. All the Fed has to do is peg rates at below the inflation rate through a combination of quantitative easing and forward guidance.
Part of this reflation playbook is a lower dollar. Back in the 1940s the dollar was on the gold standard, but this time around it is free to fall as the Fed absorbs the increase in debt with balance sheet expansion and zero rates. With all major economic powers facing the same problems of aging demographics and high debt burdens, and with rates already at zero, currencies have become the final frontier. And the Federal Reserve is in a unique position to win this race.
A career-making (or breaking) rotation?
So the question is whether such a policy cocktail will prove to be inflationary. This is certainly one of the most important issues facing investors today (along with the capital vs. labor pendulum).
The COVID-induced growth in the money supply (minus inflation) is at an all-time high of +22%. That is greater than even the increase from World War II—the money supply spiked +18% during the 1940s. It’s so 2020.
If this liquidity spike is a one-and-done response to the pandemic, then I believe it will likely not produce a lasting inflation regime. But if this is just the warm-up for a more structural shift toward fiscal/monetary expansion (and from capital to labor), then I wouldn’t bet against a rise in inflation.
If inflation is at an inflection point, commodities could well enter a new long wave. If that is the case, history suggests that this could also produce a new long wave for value vs. growth, small caps vs. large caps, and real assets vs. financial assets.
But the caveat here is that the commodity super-cycle spans several decades, so it’s easy to be right on the big picture while being very wrong in its timing. Timing inflection points on a 30-year cycle can be both career-making or career-breaking!
Until this year there was not really a catalyst to produce a regime shift (remember, you always need a catalyst to spark a mean reversion), but now we have one in the form of the election and COVID-19, and the real-time experiment in fiscal/monetary mixology that it has produced.
We’ll see how it all turns out, but cyclically speaking the setup is there.
What becomes of the 60/40 paradigm?
With bond yields approaching zero back in March, and with now the specter of rising inflation and repressed nominal rates, many are wondering whether the 60% stocks/40% bonds framework will continue to work if the above scenarios unfold. It’s a good question.
The chart below shows that the negative correlation between equity returns and bond returns has indeed gotten smaller in recent months. A negative correlation between 2 investments, like stocks and bonds, means that when one goes up, the other goes down. The 12-month correlation spiked to −47% in March as rates plummeted, but it has since risen to −18%. It’s still negative, but not nearly as negative as before.
If we took a longer view, we would see that the peak in negative correlation was −78% back in 2015.
The next chart shows a longer history, and this time I am showing the correlation between equity returns and changes in the inflation-adjusted 10-year yield in the bottom panel (using yields instead of returns flips the correlation from negative to positive). It’s the same story, with the (now positive) correlation peaking in 2015 at close to 50% and falling to almost zero earlier this year before spiking a bit in March.
The chart also shows that the current era of positive correlation between equities and bond yields (or the negative correlation between equities and bond returns) has been around only since 2000 or so. Before then, equities had the opposite correlation to bonds.
That opposite correlation lasted from 1961 to 2000. Back then, rising yields were bad for stocks, and falling yields were good. That was the inflation era. The current deflation era, on the other hand, has meant that falling yields are bad (deflation) and rising yields are good (reflation).
What does it all mean? I don’t have the answers, of course, but what is clear to me from the charts above is that we could well be at a pivotal moment in investing history, and that we need to be ready to go with the flow if the long wave does end up turning.
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
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