Despite being exceptionally aggressive, monetary policies do not bear fruit as hoped anymore. As a result, fiscal policy as a means of stimulating the economy once again gains popularity worldwide. Should the concept find support in general, it will also have noteworthy consequences for the financial markets.
On closer examination, one thing cannot be denied: Economies and financial markets have diva-like characteristics. They constantly need to be kept in a good mood by some kind of action. Without it, they sulk and slip into recession or a bear market. The job of entertainer was mainly left to the central bankers in recent years. They used much more of their firepower than in the past, with the only goal to keep the economy and the stock market running.
Unfortunately, the positive response seems to subside more and more. This is not surprising. Bank of America Merrill Lynch has counted nearly 700 rate cuts globally since 2008.
Despite these massive efforts, the world economy is expected to grow by less than 3 percent in 2016. That would be the lowest growth rate since the last financial crisis. For political leaders, that is not sufficient, as confirmed by the wording of the final declaration of the recent G20 summit in Hangzhou, China. In their communiqué, the leading industrial and emerging countries classified growth worldwide as still weaker than desirable.
Fiscal policy as a tranquilizer
The search for more growth momentum, however, is limited by a lack of alternatives to stimulate the economy. Reforms are certainly the best choice. But this is usually connected with steeper cuts, and therefore politicians most commonly want to make use of that tool only when it is really unavoidable. Compared to that, it is much easier to open the cornucopia of the state and to hand money to the people through an expansionary fiscal policy.
The reason why this option is preferred in the current situation is explained by Julius Baer chief economist Janwillem Acket: “The combination of central banks running out of options to stimulate growth and governments simultaneously imposing fiscal austerity measures has fuelled concerns over globalization pressure in more and more economies. Frustration levels among private households are rising, which is challenging the legitimacy of the ruling political parties and spurring radical factions. Instead of prioritizing structural reforms, which tend to hurt many in the short term, the ruling authorities are increasingly eroding fiscal austerity for deficit and even debt-financed spending.”
The pressure increases
The enthusiasm in terms of expansionary fiscal policy, however, is often slowed by empty state coffers. The debt of the industrialized countries is expected to reach 107 percent of annual economic output this year, the highest level since the end of World War II, cites Stefan Scheurer, capital markets expert at Allianz Global Investors, in data from the International Monetary Fund. But that does not stop influential institutions, such as the IMF, the Federal Reserve or the European Central Bank, as well as leading investment banks, from calling for new government stimulus.
It seems as if their proposals are met with approval with increasing frequency. China has already implemented such measures. Japan and the U.K. are on the verge of doing it. In Europe, the austerity provisions are already interpreted less strictly, once again the authorities work on an EU infrastructure fund, and for the first time in five years EU fiscal policy will turn expansionary in 2017. In addition, in the United States the campaigns of the two presidential candidates include infrastructure spending to the tune of 1.5-2.5 percent of GDP.
Separate from the funding issue, there is undoubtedly a need for action. In terms of government spending, U.S. public fixed investment as a share of GDP is running at a 60-year low, while in the eurozone a ratio of private capital expenditure to GDP reached record lows in 2014 and has not improved since, J.P. Morgan writes in a research paper.
“Today, the 20 largest economies in the world, grouped together in the G20, face an infrastructure spending gap of about US$20 trillion over the next 15 years,” adds Joachim Klement, head of thematic research at Credit Suisse. That is a big chunk of money, and without government involvement not easy to stem. In summary, all of that ultimately makes a new wave of fiscal stimulus measures quite likely.
Whether the upcoming fiscal spending will make a difference depends on sensible use of these resources. The way it should not be done can be seen in China. According to a study from the University of Oxford’s Saïd Business School, more than half of China’s infrastructure investment has destroyed economic value instead of generating it. Furthermore, the slow progress of implementing these projects has to be taken into consideration too. The proposed plans have to be passed by legislation and put into practice – a process that can drag on for years.
Stock market has smelled a rat
Nevertheless, the consequences of the emerging realignment of economic instruments should not be underestimated. No one knows this better than the investment banks. How much they have already picked up the scent is reflected in the numerous research reports they have published on this issue in recent weeks. But of course the masters of money do not only act as paper tigers. If they write something currently about fiscal policy and infrastructure spending, then sooner or later capital also flows in that direction, either because they invest themselves or because customers implement the recommendations made in these research papers.
In the current case, the consequences could be serious and extend to all segments of the financial markets. It therefore makes sense for all investors to deal with the issue. The problem is various scenarios seem to be possible and this means it is unclear how it will eventually play out. There is some disagreement, for example, about the impact on the bond market. On one side, Jeffrey Gundlach can imagine a sustained upturn in bond yields. The “king of bonds,” as the founder of the investment firm Doubleline Capital is called by media, underpins his view with the following explanation: “There will be two effects of an increase in fiscal spending and both will push rates higher. The supply of bonds will increase, and GDP growth will be higher.”
On the other side, Patrick Artus, the chief economist of the French investment bank Natixis, simply cannot imagine a more expansionary fiscal policy without continuously low interest rates. That has to do with his belief that most countries cannot afford higher borrowing costs. Both approaches sound plausible, which is why prudent market participants do not jump to hasty conclusions. They prefer a wait-and-see approach and observe closely which forces will finally become prevalent.
Construction, infrastructure and industrial benefit
Less controversial is the question which sectors would benefit most should the future really bring more public stimulus. Should that happen, construction companies and building materials manufacturers would profit, as well as industrial companies and infrastructure service providers in general. Also, some commodities, such as base metals, can expect a certain positive impact.
Merrill Lynch says in reference to the “Greenspan Put” (former U.S. Federal Reserve Chairman Alan Greenspan responded to every crisis by cutting interest rates) from a
“Keynesian Put.” This in turn refers to the economist John Maynard Keynes, who is considered the mastermind of economic and fiscal policy. Compatible with this, Chief Investment Strategist Michael Hartnett advises to switch the investment strategy:
“Cyclically, we recommend investors rebalance portfolios away from the “QE winners” and toward assets and sectors that should benefit from more fiscal largesse, such as companies with exposure to Main Street, infrastructure, defense, and real assets.“
His advice which sounds reasonable, especially if investors concentrate on companies in the mentioned sectors that are in a good shape now. These stocks have proven to be able to cope well with the status quo, and if expansionary fiscal policy was added on top of that, it would be a welcome addition. Then the existing upward trends in earnings and stock prices of these companies should be prolonged further.