“It was the best of times, it was the worst of times…”
Charles Dickens’ famous comment from A Tale of Two Cities is a fitting description of the mindset of investors these days. First, there is the jarring juxtaposition of a stupendous global equity market rally and an unchecked pandemic accompanied by the worst global recession in nearly a century. And second, just under the surface, a decade of assaults on liberal democracy and free markets, exploding national debt, massive monetary expansion and potential leadership changes in the US, Japan and Germany swirl like a maelstrom, assuring that no matter how high the stock market may be, anxiety is not far behind.
So, how should investors contextualize today’s dynamics of change in politics, fiscal and monetary policy?
The three national pillars of the postwar establishment – the US, Japan and Germany – all now face monumental political shifts. In Japan, change is certain, following Prime Minister Abe’s decision to resign for health reasons. In Germany, long-serving Chancellor Merkel has announced she will step down ahead of national elections, which must be held between August and October 2021. And, in November US voters will choose their president and may opt for new leadership on Capitol Hill as well.
In the long run, changing political leadership in Europe, Japan and the US could have enormous implications for market fundamentals. Consequential decisions about taxation, spending, structural reforms, environmental and health policies will be required in all major developed economies, given current unsustainable trajectories of indebtedness, social unrest, challenging demographics and climate change.
Counter-intuitively, however, in the short term politics may not matter too much. Japan has witnessed seamless prime ministerial transitions in its postwar history, mostly without consequential policy change. The same can be said for Germany, where despite the rise of the far right, a large centrist majority that spans Germany’s main postwar parties ensures that change is gradual and seldom disruptive.
If there is outlier among the three it is the US, where the Trump Administration has represented the biggest shift in postwar western political history. In the past four years, the US has rebuffed allies and embraced historic adversaries, while undermining confidence in the Bretton Woods architecture. At home, tax cuts have been large and deregulation extensive, while social, political and economic divisions in the US are at their greatest extremes in generations.
Yet it would also be simplistic to assume a possible Biden Administration will simply re-establish what may no longer be sustainable. US flagging interest in foreign affairs, in the Atlantic alliance and in promoting freer markets was palpable during the Obama Administration and its predecessors. The fabric of postwar western unity began to fray once its chief adversary, the Soviet Union, disappeared three decades ago. Common values exist between the US and its allies, but their bonds are seemingly not strong enough to prevent continental drift.
Moreover, for much of the first term of a possible Biden Administration the main task will be to address the Covid-19 pandemic and its economic fallout. Public finances, stretched by recession and political irresponsibility, leave little latitude for expensive new social programs. Some de-regulation may be reversed, and higher corporate income taxes will be re-instated, but the effects are more likely to be at the company or industry level, with relatively little impact on broader stock and bond markets.
Indeed, across all major developed economies the room for maneuver is constrained. Budget deficits have exploded, yet high rates of unemployment, social unrest and low rates of inflation will likely thwart efforts to pursue fiscal tightening over the next few years. Whatever adjustments are made, they will be marginal.
This means that more of the burden for macroeconomic management will fall to monetary policy. Central banks have already stepped up by slashing interest rates and buying unprecedented quantities of assets. They have even partnered with governments to financially backstop private sector balance sheets via public sector guarantees.
This past week, the Federal Reserve went a step further in declaring that its policy now has an asymmetric bias. Fighting low inflation or deflation is now more important that rigidly adhering to a 2% inflation target. Inflation overshooting is not just possible, it has become the stated aim of the Fed. This is a fundamental change for the world’s most important central bank.
Still, investors should recognize that for all of these central bank actions and new policies, monetary policy may be more consequential for near-term market outcomes, yet less consequential for the long-term.
For the foreseeable future, the promise of very easy money and super low interest rates will continue to support investor flows into global equities. There is no alternative, as long as we don’t have a re-run of pandemic-induced economic closures. The Fed’s decision is also likely to further weaken the US dollar in the months ahead, particularly against the euro and gold. Emerging currencies, however, won’t benefit too much, given that their economic and fiscal positions have been put at considerable risk by the pandemic, global recession and the collapse of world trade.
In the long run, however, monetary policy (even its extreme variant) is unlikely to be so consequential. There is little reason, for instance, to believe that central banks will allow runway inflation. Their decisive actions today reflect appropriate responses to genuine risks, but they are not a categoric rejection of sound monetary economics over time. Moreover, sound monetary policy can only alter the course of growth, employment and living standards in the short run. Human ingenuity coupled with sound economic policies, a solid legal foundation of property rights, equality of opportunity, social cohesion and environmental protection is the only combination of factors that can drive sustainable increases in living standards.
In the long run, the political process that either delivers those preconditions, or doesn’t, is what truly matters. Thus, the choices voters will make in the US this November, next year in Germany and at some point in Japan, could not be more consequential. No less may be at stake than the fate of liberal democracy, the nature of market economies, and the health of humanity. But for the financial markets, which like to focus on the short run, the only story that really matters for the current moment is the continuing willingness of central bankers everywhere to do whatever it takes.