Running out of ammunition?

Perpetual Investments

Matt Sherwood

Head of Investment Strategy

The world is not out of policy ammunition, but during the recent market volatility it has become clear that policy needs to be much better co-ordinated around the world. Over the past eight years global interest rates have been cut to record lows, but fiscal policy in nearly all major economies has been tightened which has weighed on a global economy struggling to achieve average growth. Matt Sherwood, Perpetual’s Head of Investment Strategy, Multi Asset concludes that the world economy, financial markets and central bank policy are all indicating that the forces that brought interest rates to zero still have the upper hand and that increased fiscal stimulus is needed in 2016 to increase household income or fund infrastructure, or both. If fiscal policy is managed to boost spending and monetary policy is aimed at preventing deflation the world can escape its current demand deficiency and provide a considerably stronger and more stable backdrop for global risk markets.



  • One of the many issues confronting the world is that the advanced economy savings glut (as households deleverage) has sparked a demand deficiency which means that not only is growth lower, but that the seven-year surge in emerging market investment spending is now facing a very low rate of return. This combination has culminated in global excess capacity, higher non-performing loans and a weaker world economy. The subdued nature of global growth can be resolved, but policy needs to be better co-ordinated between central banks and government across all major regions. The sole aim of monetary policy should be preventing deflation and financial crisis, whereas government spending should be aimed at boosting spending, directly and indirectly.


  • The world economy is structurally slowing due to the state of regional balance sheets, the aging demographics and a lopsided distribution of wealth, but the latter two of these issues cannot be resolved by central banks. Many believe that monetary policy is exhausted and while it is depleted, institutions in Japan and Europe have resorted to negative rates in an attempt to lower currencies and boost export performance. However, this policy option is not well thought through as global trade growth in 2015 was the second lowest since 2001 meaning that these organisations are targeting a diminishing growth source. In addition, economic growth is not overly sensitive to exchange rates with the Japanese Yen down by -33% against the US dollar since 2012, but economic growth there is barely positive.


If asked in 2007 what would global conditions be like if rates were cut to zero around the world and China had doubled in size, most would have said that growth and inflation would be very high, regional

sharemarkets would be at record levels and global authorities would have to hike rates. Fast forward nine years and every one of those predictions would have been diametrically wrong. Indeed, 2015 saw the second weakest year of nominal global growth on record (on a rolling three-year basis only 2008 was lower), few regional sharemarkets are close to all-time highs and most central banks are considering how to further ease policy.


While the nominal global economy was soft in 2015, this is only the latest chapter of what has been a 30 year story as the fading impact of the IT revolution, emerging market industrialisation, labour productivity, falling interest rates, declining inflation and waning demographics, weighed on output growth. Indeed, since 1980 the three-year average growth rate has risen in only 16 of the 35 years with 2015 growth the second lowest over the entire period and inflation is at three generational lows (see Chart 1). This tells us that the forces slowing the global economy have been a persistent and long lasting trend with the 637 interest rate cuts around the world since 2008 and the USD12 trillion spent on bailouts and QE programs doing little to halt the slide.


Perpetual Investments


One of the many issues confronting the global economy is that the savings glut in the advanced economies (as households deleverage) is now so large that it has sparked a deficiency in aggregate demand which is having two key effects. Not only is advanced economy growth lower as slowing household spending growth crimps business investment, but the seven-year investment surge in the emerging market (to boost industry capacity) is facing low rates of return and chronic excess capacity, which has culminated in sustained corporate deflation and higher non-performing loans for banks.


Given, this backdrop, some believe that policy stimulus is exhausted because rates have been cut to zero, QE is ineffective and government debt is already very high. However, central banks may simply have to use more unconventional policy, with negative interest rates already having gone from a theory to a reality in recent months in the Eurozone, Japan, Sweden, Denmark and Switzerland in an effort to boost export performance. However, this policy option is not well thought through as global trade growth in 2015 was the second lowest since 2001 meaning that these central banks are increasingly targeting a diminishing growth source.


Central bank policy appears ineffective in stimulating aggregate demand as most economies are in liquidity traps, but pushing rates into negative territory to weaken their currencies is dangerous. A lower exchange rate does generate inflation but it’s the wrong kind of inflation – it is not the inflation which leads to higher wages, increased profits and eases debt burdens, but rather it generates inflation which lowers disposable income through higher import prices which lowers economic growth as fewer goods can be purchased with remaining household income. Although traditional central bank policy won’t have the usual effect on demand, it should be solely aimed at preventing deflation.


The next step is for government to use fiscal policy to boost demand, which is the only realistic escape route from a liquidity trap. This stimulus can be implemented indirectly through measures to increase household spending (such as permanently lower tax rates) and directly through infrastructure investment which has an economic payoff of higher productivity and efficiency. While government debt is very high, there has been no penalty from global investors with some of the most indebted governments in the world having low cost of borrowing and few G20 countries paying a higher bond yield for higher debt since 2007 (see Chart 2). In addition, lower commodity prices and subdued wages growth indicates that there are no material cost-side pressures to inhibit government stimulus.


The important thing is having monetary and fiscal policy working together. Given only a handful of G20 countries have government debt to economic output ratios at sustainable levels (60% of GDP) the key question is how can governments fund their stimulus without sparking market dislocation and some may need direct monetary support from central banks. The idea of this ‘helicopter money’ has been proposed by economists including Milton Freidman and Ben Bernanke and involves central banks printing money (like they did with QE programs) and then giving it to governments to spend in exchange for bonds. This approach could restart economies by stabilising demand and easing deflationary pressures and this notion is likely to be increasingly debated this year. 


Perpetual Investments

Beyond this, the only other central bank tool left is a global debt restructure, where they would print money and directly buy the debt of the public and private sector to facilitate deleveraging. This would directly tackle the biggest world problem, namely the debt stock.


The key question for investors is where helicopter money would be used first. Monetarising debt is outlawed in the US (which could admittedly change with an act of Congress) and given Europe does not have a fiscal union it could not be implemented there quickly, especially if the Germans are opposed. Conversely, given the close relationship between the Abe Government and the Bank of Japan, the subdued nature of the Japanese economy and the recent rise in the Yen, helicopter money would most likely to be implemented there. If implemented it would certainly be more efficient than current QE policies which require a lot of money creation with very little growth delta. It would also be faster than infrastructure programs which take years to build.


Despite the subdued investment climate, global economic growth remains positive and, contrary to popular wisdom, there remain several policy options available to boost growth. Admittedly, outside increased fiscal spending most of other options are unconventional, but the key at present is having monetary and fiscal policy working together for the first time since 2008. If both policy arms can collaborate then the global demand deficiency can be resolved, but the policy co-ordination needs to be global. Fiscal policy should be aimed at boosting spending through direct and indirect channels, and monetary policy should be aimed solely at preventing deflation and financial crisis. Although market valuations are back to historic averages in equities, investors still need to have some defensive assets in their portfolio and the key here, whether investors are multi asset, credit or equity holders, is the quality of the assets that they hold, with securities which can deliver sustainable growing cash flows likely to see increased demand from investors, especially if global growth continues to disappoint.

This analysis has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426 for the use of financial advisers only, it is general information and is not intended to provide you with financial advice. The views expressed in the article are the opinions of the author at the time of writing and do not constitute a recommendation to act. Any information referenced in the article is believed to be accurate at the time of compilation and is provided by Perpetual in good faith. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.