The perceptions of divergence of monetary and fiscal policies are likely to shapeinvestment performance of all asset classes for the balance of 2017.
In the modern world of computer generated trading & ETFs and a veritable floodof zero cost information, marginal news is all that matters and public sector hasbecome the key driver of both news and fundamentals. Hence, politicaleconomy is the only decision framework that is rooted in reality of public sectordominance. Instead of focusing on mitigating extremes of ‘climate’ shifts(‘avoiding severe winters or scorching summers’), we believe that state andpublic sectors are likely to continue to ‘micromanage weather’. The key questionfor investors therefore is ‘what would states do and when would they do it’.
As a result, investment returns critically depend on a relative mix of fiscaland monetary policies. As discussed (here), China’s stimulatory and monetarystance is the single most important factor driving global reflation. However, thereis also a question over likely path of the Fed’s tightening and the degree ofdivergence with ECB and BoJ. It is a complex game with multiple conflictingand binary outcomes. ‘Healthy reflation’ scenarios envisage improving growthtrend and globally co-ordinated but gradual rise in interest rates that confirmsstrength rather than weakness, leading to convergence of monetary policieswithout any disruptive fiscal impact. This would be a recipe for lower US$ andhigher �/￥, boosting EMs demand and investment performance. However,another scenario argues for fading reflation and a growing divergence of fiscaland monetary policies, leading to FX/bond market dislocations and erosion ofEMs demand and liquidity. There is also a possibility that fading reflation and‘black swans’ could prompt China to stimulate again, causing policy confusion.
What are the key signals that investors should focus on? We highlight four:(a) extent of reflation, as determined by commodity prices, core inflation andsteepness of the yield curves; (b) monetary and fiscal divergence, as reflected inFX moves; (c) China’s attempts to curb domestic excesses while avoidingincremental stimulus; and (d) the US ability to inject incremental demand andUS$ supply. There is a possibility that despite uncertainties, 2H’17 might still endup as a ‘muddle through’ with limited disruption, but there is also a considerablescope for policy errors and mistiming. As in Greek Titanomachy, the ‘Olympians’(disinflation due to technology & overfinancialization) are stronger than ‘Titans’(protection & reflation), though ‘Titans’ can occasionally win a few rounds.
Our core belief remains that ‘Titan’s’ latest reflationary pulse had alreadypeaked and will weaken through ‘17, as neither China nor the US would bewilling or able to inject incremental demand; supply of US$ is likely to remain lowwhile it would be difficult to converge monetary policies. At the same time, thereis considerable evidence that reflationary wave is already weakening. Althoughour base case scenario does not assume significant disruption, we maintain that‘healthy reflation’ is highly unlikely. We therefore continue to avoid extremesof country selections and focus on Asia ex markets that are local, liquid andwith lower degree of external vulnerability (India, China, Philippines & Taiwan). If‘healthy’ reflation was the predominant theme, then clearly EMs outperformancewould significantly strengthen, with emphasis shifting to more vulnerable markets(such as Indo or Mal) while severe disruption would leave China as the EM’sonly ‘safe heaven’. In terms of stocks we maintain a non-mean reversionarystance, which continues to work, with all portfolios (global and regional; qualitysustainable & thematics) up strongly YTD (absolutely & relative to benchmarks).
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