Central banks are from Venus: They would like to assure price stability, avoid or mitigate harmful effects to the economy and – in some cases – even support growth. In harsh contrast, the real economy is from Mars: it is in a reckless Darwinian process of the survival-of-the-fittest business model, in a constant state of ‘creative destruction’ with industries dying while new ones arise.
All this is driven by changes in population, economic policies and – most disruptively – in technology. The history of financial markets since the beginning of the century has been shaped by an ever-greater divergence of the two – Mars and Venus – as the real economy shifts its shape in a breath-taking manner, yet the monetary policy response stays the same. At the core of the discrepancy is the change in the world economy’s structure. The integration of China into the global economy and technological shifts proved to be a major rebalancing act of almost any economy on the planet.
To take the US, still – for now – the largest economy in the world, as an example: the change in economic data could not be more dramatic. Taking employment as a proxy, in 2001 the US had a balanced employment of about 16 million people each in manufacturing, retail, education and healthcare, and professional and business services. Fifteen years later, only 12 million are left in manufacturing (down by more than 25 percent). At the same time, the education and health service sectors added 6 million jobs (roughly a third more than in 2001). All in all, the US is left with twice as many people in health and education as in manufacturing today.
Yet the Federal Reserve, coming from Venus, applies the same policies to assure price stability: it eases the monetary regime when prices are falling – seemingly due to economic weakness – and tightens when prices and growth rates stabilise. So it is about ‘reflation’ of the economy, which is a long-term investment position that the world economy will rebound, driving up interest rates and commodity prices, as central banks and governments act to rescue the struggling economy. Funnily enough, when looking at price patterns, after all the efforts of the Federal Reserve, US core inflation fell to near all-time lows (except for recession periods) in autumn 2015. But financial assets are at all-time highs (such as the S&P 500 and the US bond market). It seems as if all the central banks can produce is asset inflation.
I came across a ‘happy depression’ concept when talking to investors about Japanese depression economics. Nobody coming back from Japan would describe daily life as depressed as the economic aggregates would imply. Similar to Japan, the global economy seems to need lower prices − let us say, due to global demographic, technological and trading pattern changes − but central banks would not allow it and make asset prices skyrocket.
So what about 2016? The fact that only investors care about calendar years would also imply that a lot of the deflation patterns in the real economy and the asset inflation in financial markets will continue in the year ahead. While we would fully subscribe on a fundamental basis to this view, the only thing that would make us more cautious is the fact that a lot of this is already reflected in asset prices.
If we look at the reflation measure (commodity versus government bond returns), it is at an all-time low by the end of 2015. So a rebound of inflation concerns would not come as a surprise. Yet over the next 12 months, we think investors are better off taking the deflationary stance and bank on asset inflation. This means looking for some stabilisation in portfolios with long-duration government bonds, not taking major currency bets (hence mature-market investors should stay in their home currencies) and adding anything that grows sustainably in the current low-growth environment.
European equities are included here as they are exposed to domestic Europe and will benefit the most from a normalisation in European growth rates.
Digital disruption is another important area of consideration as companies create new industries and close established ones, and this has very much been visible amongst software companies. Investments in emerging markets should also be restricted to those that have growing consumer bases, such as in Chinese healthcare. At the same time, there will be more overall pain for emerging markets next year, before a final capitulation that will possibly open a ‘buy of a generation’.
Christian Gattiker, chief strategist and head of research at Julius Baer.
Follow us on
