Rights,Wrongs &Returns:2017–State reflation or stagflation?

The state is emerging as an economic driver rather than just a policy facilitator.

After almost a decade of experimental monetary policies, there is a palpablefeeling of change in the air. Whilst no CB would dare to unwind monetaryaccommodation (~1/3 of GDP), monetary stimulus is now finally recognized ascounterproductive. As we were anticipating for the past two years, economistsare priming investors for the forthcoming fiscal stimulus. It is being dressed-up infamiliar ideas of public sector multipliers and productivity improvement via publicsponsored investment. The fact that there is tenuous evidence the multiplier isactually positive and that most countries no longer need infrastructure is left out(productivity is now driven by knowledge and social capital, rather than bridges).

The key question is not whether expansionary fiscal policies are on the horizon(we think this can be taken for granted), but its quantum, timing and how will itbe funded. Whilst rhetoric is becoming strident, at this stage, most countriescontinue to operate within the confines of ‘prudent management’ that can be bestcharacterized as a ‘drift’, rather than a significant shift. The new USadministration has more aggressive plans, but it is likely fall prey to the sameforces that ensure delays, inefficiencies and precludes recovery of private sector.

Also, today’s world is radically different to Reagan’s. It is more interdependent(particularly finance) and globalized. It also a world that carries 3x as muchleverage (hence lower capacity to absorb volatility and higher cost of capital) andunlike ‘80s it is wrecked by tectonic technological shifts. ‘80s task was to shakeoffthe state. Today’s objective seems to enshrine the state as a growth driver.

Having said that, there is no doubt that eventually (in fits and starts) fiscalpolicies are likely to become ever more aggressive and independent of country’sdebt carrying capacity, with distinction between fiscal and monetary policiesdisappearing and two arms merging into one potent weapon. The question iswhether one needs a ‘jolt’ to the system first. Our view remains that policymakers are unlikely to embrace more radical solutions, until they have nochoice and it is unclear that ’17 would bring the required ‘jolt’. We maintain thathealthy reflation (rising real GDP and higher but moderate inflation) remains theleast likely outcome, whilst state-driven stagflation (overheating without muchreal growth) is more likely. Periods of stagflation could morph into disinflationbefore flipping back. Neither bonds nor equities are likely to be unidirectional; noris it certain that bond yields will be higher. In the absence of a robust merger offiscal and monetary policies and tighter global co-ordination, it is not clear thatthe cost of capital can actually go up without causing disorderly volatilities.

It is likely to be an important transition year. Although disappearance of CBindependence; merger of fiscal and monetary policies and global coordination toavoid disruptive currency shifts are yet unlikely, investors should see the firstsigns of the state emerging as a driver rather than facilitator. Should we join‘healthy reflation’ trade? In a healthy reflation (state spending leading to re-startof private sector vigour), commodities and equities (cyclicals and financials) dobest, whilst gold and safety would be losers. In stagflation, gold and real estatewin with poor results for equities and bonds and uncertain ones for commodities.

A return of disinflation would benefit gold, ‘safety’ and growth plays. We expect‘17 to be four seasons rolled into one. There are far too many cross-currentsto second-guess risk trades. Hence we view tactical macro calls to be as risky asrelying on pollsters. In this ‘fog of war’, we continue to ignore rather thanembrace the state, and highlight non-mean reversionary & secular growthstrategies. In terms of countries, we prefer everything local & liquid to global.