On top of the regime shift at the BoJ, the ECB now also seems willing to add more stimulus, while the Fed and the new leadership at Bank of England would also not hesitate to do more if their economies would weaken significantly again. Obviously this leads to ample liquidity support for global markets.
Given that both equities and treasuries did well recently, it does make sense to assume that is has been a liquidity driven rally. At the same time are some elements in recent market behaviour very different from previous periods in the year when easy liquidity conditions triggered cash rich investors to push markets higher in their search for income and stable growth assets.
These forces largely explain why commodities lagged so much and why (stable dividend paying) defensives outperformed cyclicals in the equity markets during the first quarter of the year.
Cyclical shift
Both the recent rebound in commodities and the cyclical nature of the equity market rally (e.g. IT and materials outperforming) provide tentative evidence that underlying drivers of the market are shifting. This hints at the possibility that it is not only higher expectations about central bank easing that are behind the recent move.
In this respect it was also noteworthy to see the Euro appreciate against the dollar over the week as an increased likelihood a rate cut by the ECB would normally create downward pressure on the currency.
In the search for alternative explanations it seems wise to not only look at the monetary side of the policy equation, but also consider what is happening on the fiscal front. It is certainly too early to talk about regime changes on this front, but it seems that a moderate wind of change has started to blow in recent weeks.
Given that fiscal policy has been one of the most significant headwinds for global growth in recent years, a change of stance could materially impact market expectation about future growth.
Out with austerity
Admittedly it is early days and in many parts of the developed world the Austerity agenda is still preached by many political leaders. At the same time, intellectual support, popularity and actual implementation are all clearly in reversal at this point.
Most eye-catching has been the remarkable research errors that have been exposed in the work of two well respected economists (Reinhart and Rogoff) who had provided the most intellectually influential academic backing for the strong, near-term focus on debt and deficit reduction. Many politicians in favour of austerity have quoted their work in recent years to justify their positions.
With that support now almost eliminated and the fairy tale of expansionary austerity (on the back of magically improved confidence) being completely contradicted by the facts on the ground over the last three years, the ability of those remaining Austerians to “sell” their story to the public has been seriously damaged.
Obviously the politicians in the South of Europe had already noticed that very clearly and recent development in both Spain and Italy suggest that they will pursue a less stringent austerity agenda going forward. Spain demanded (and got!) a two year delay in their fiscal targets from the Troika and the new Italian government has already made clear that they will not overlook to most important message from the last election (Austerity: NO!) and will look for a more balanced approach for structural reform and fiscal consolidation.
On top of this it seems that also the European Commission is beginning to wake up and smell the coffee as both President Barrosso and its Commissioner for Economic and Monetary Affairs, Olli Rehn, have made public statements that hinted at a softening in stance towards austerity.
Time to loosen
Meanwhile, it is important to note that even without further changes to fiscal policy we have now clearly passed the peak of tightening. In Europe that peak was reached in 2012 and while still being a drag on growth in 2013, fiscal policy will roughly turn neutral next year. In the US the peak is now with the payroll tax hike and the sequestration creating a strong fiscal headwind in H1’13, but will gradually moderate in the quarters thereafter in terms of impact on growth. At the same time however Japan is switching gears as the fiscal part of Abenomics will kick in from Q2’13 onwards to provide stimulus rather than tightening.
All in all it could well be that more constructive views on the impact of fiscal policy on economic growth over the next year or two is starting to play a role in investor behaviour. Especially if one adds the recent fall in oil prices, which has a comparable impact to a tax cut for global households, it can be understood why markets have not only been willing to look through the weak data that describe the past, but also adapted to a more cyclical state.
Income to growth
Low central bank rates, ample liquidity and lower tail risks justify a cautious relocation of cash into the markets and will gradually “force” investors up the risk curve. That has basically been happening since the Summer of last year. In such an environment it still remains highly uncertain how much traction in the real economy the policy mix will generate as the fiscal pillar of the mix remains constrained. And indeed this is what the evidence has shown as global growth remained remarkably modest for a recovery period.
If the fiscal pillar has now finally started to move in the “growth”-direction that could change things a lot. If perceived credible and substantial enough it will probably cause the relocation from cash to markets to morph into a relocation investors across the risk curve, whereby defensive assets will be switched into growth assets. Both the behaviour of markets (bonds continuing to do well) and the uncertainty still surrounding the fiscal policy future suggest that a genuine rotation from bonds to risky assets and from “income” risk (credit, real estate, dividend equity) into “growth” risk (high beta equity, emerging markets, commodities) is still not ongoing.
Still, the seeds have been sown and with some fragile green shoots emerging in the policy equation investors need to open their mind to the possibility that the current wind of change will blow the global economy towards a healthier growth environment and markets towards a more growth oriented regime. This keeps us tilted towards risky assets (equities and real estate) and on the lookout to growth risk once more confirmation on policy direction and shifts in investor behaviour become visible.
