The age of fiscal austerity is over – which might have important implications for investors.
Governments in many developing economies are loosening fiscal policy. This is most obvious in the US, where the OECD expects that cyclically-adjusted borrowing will rise to 6.7 per cent of GDP next year, from 3.1 per cent last. And the OECD also expects a fiscal easing across the eurozone between 2017 and 2019 of 0.4 percentage points of GDP. The UK could well follow suit. Chancellor Phillip Hammond is under pressure to increase spending on the NHS in the forthcoming autumn Budget.
Granted, these policy relaxations are much smaller than we saw in 2008-09. But they are very different from those. Whereas they were a response to slumps in output, the current easings are occurring against a background of good growth and – in the UK and US – low official unemployment. They are pro-cyclical easings rather than counter-cyclical ones; readers might consider this to not be what Maynard Keynes intended.
Which poses the question. What does this mean for asset prices?
One thing is higher interest rates and bond yields. This isn’t because markets will take fright at the higher supply of government bonds. The global savings glut and shortage of safe assets should ensure continued demand for these.
Instead, it’s simply because looser fiscal policy, other things equal, adds to aggregate demand. Central bankers believe this will close output gaps (the difference between actual and potential GDP) and hence raise inflation. They might well be mistaken in this, but that doesn’t matter for now: as long as they believe this, they will respond by raising interest rates which will have knock-on effects on bond yields.
We’re already seeing this in the US. In the past six months two-year Treasury yields have risen while 10-year ones haven’t changed much. This tells us that investors expect higher government borrowing (among other things) to raise short-term rates, but that they are relaxed about the prospect of increased supply of bonds.
This combination of higher government borrowing and higher interest rates matters for exchange rates. Loose fiscal policy and tight monetary policy is traditionally considered to be the recipe for rising exchange rates. It caused the US dollar to soar in the early 1980s, for example, and contributed to a stronger pound in the mid-1990s.
This is more likely to favour the US dollar than other currencies. Japan is still tightening fiscal policy; the eurozone is still some way from the point at which aggregate demand will raise fears of inflation; and prospects for the pound are clouded by Brexit.
What does all this mean for equities?
It could be bad news even if, as economists expect, the changing fiscal-monetary policy mix does not much affect economic growth.
Perhaps the biggest danger is that rising interest rates will cause a reversal of the 'reach for yield' that has driven some investors out of cash and into equities. Flatter yield curves also pose two problems. One is that they might cause investors to worry about a looming recession: historically, inverted yield curves in the US has been by far the best predictor we have of recessions. The other is that flatter curves are bad for banks; they hurt anybody who borrows short and lends long, and higher short rates mean that some trading strategies become unprofitable.
There are, however, offsetting considerations. One is that a stronger US dollar would be good for the many UK companies that earn dollar revenues – although for miners this benefit might be offset by continued weak growth in China depressing commodity prices.
Also, there’s one sense in which rising interest rates, for a given rate of earnings growth, should actually raise share prices: they reduce the chance of a very nasty development. If we get a recession when interest rates are near-zero it could be very deep indeed simply because central banks don’t have the ammunition to fight it; the effect of quantitative easing is uncertain especially when bond yields are low and central bankers will be slow to adopt radical policies which might well work such as helicopter money. As interest rates rise, however, this danger recedes. Share prices should therefore rise as this tail risk diminishes; share prices, remember, are the probability-weighted average of all possible levels of the market, so reducing the probability of a low level should raise current prices by basic maths.
The net impact on equities of a shift in the fiscal-monetary mix is therefore ambiguous.
One thing, though, is clear. The combination of tighter monetary and looser fiscal policy is an unusual one. Since the 1990s the policy fashion has been for what George Osborne, a local newspaper editor, called fiscal conservatism and monetary activism; fiscal policy should focus on ensuring a sustainable level of government debt to GDP, while monetary policy should fight recession. This fashion is now changing. It would be odd if this has no effect upon asset prices.
