Fiscal or Monetary?
Both, Please (and the Case for Commodities)

The DNA team present an anatomy of a potential inflation paradigm shift, a checklist of confirmatory signals, and the portfolio moves investors could consider.

 

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The last 20 years have seen negative correlations between stock and bond prices. This is against the precedent of history: for the preceding 250 years the correlation was consistently positive.

 

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Introduction: The State Is Back

The historian AJP Taylor once observed that “until August 1914 a sensible, law-abiding Englishman could pass through life and hardly notice the existence of the state, beyond the Post Office and the policeman”. How times have changed. Leaving aside the fact that he overlooked 50% of the population in that breezy statement, the state has expanded dramatically. Back then tax was less than 8% of GDP in the UK (not England!). This year, the Office for Budget Responsibility expects it to be 37% of GDP. Next year it could go higher still, potentially setting the pattern for the years to come under a Conservative government with aspirations to Build Back Better, whose leader has bluntly stated that austerity is not for him. After decades of laissez-faire, free market policy, we can clearly say that “the state is back”. And it’s not just in the UK, it’s everywhere.

Figure 1. IMF Estimates of Fiscal Stimulus in Response to Covid

Source: Database of Country Fiscal Measures in Response to the Covid-19 Pandemic; and IMF staff estimates; as of 31 March 2021.

The wrinkle is we can’t be sure for how long and to what extent ‘the state is back’. After the publication last year of Stephanie Kelton’s Modern Monetary Theory bible The Deficit Myth and the subsequent election of a US president bent on delivering an enduring fiscal boost paid for by government borrowing, the momentum is clearly with the fiscal spend crowd. But for how long? In the UK, for example, are we to take Boris Johnson at his word and believe he has structural change in mind, with large state-funded investment programmes designed to ‘level up’ the rest of the UK to the living standards and productivity levels of the southeast of England? Or will his enthusiasm fade; will fiscal hawks in HM Treasury insist on balancing the national books and so curtail the durable, monetary-policy-enabled fiscal boost that we believe will be required to bootstrap the UK out of its sluggishness? The story in Japan over the last 30 years has been one of stop-start stimulus, with the Ministry of Finance (fiscal authority) often seeming to be acting in opposition to the Bank of Japan (the monetary authority), and vice versa. Which way will it now go?

Well, our answer to that one is, it remains to be seen. We shall only know over time, so there’s not much point speculating at this early stage. As we set out in Inflation Regime Roadmap last year, we think all the pillars are in place for an enduring regime change to a more inflationary environment but that will only happen if policy makers keep their foot firmly on the monetary and fiscal accelerators at the same time. But as we warned last year, the consequences of a more inflationary outcome on current asset allocations could be very significant, even seismic, so it’s well worth preparing for what may be ahead if policymakers do as we suggest they might.

In this article, we dip our toes into the age-old fiscal versus monetary debate and ask, what works, fiscal policy, monetary policy, both or neither? And we provide some basic analysis of how multi-asset portfolios might properly prepare for any eventual inflation.

Fiscal Versus Monetary Policy

We should emphasise at this point that we are asset allocators, not economists, but a cat may look upon a king, as the ancient saying goes, and it matters greatly that asset allocators form a view of what the impact of all this fiscal spending might be.

Complications to the debate include big questions such as: can government investment raise total factor productivity; are there threshold levels for debt/GDP beyond which future growth slows; will higher money supply growth cause generalised inflation; or will higher monetary velocity cause inflation; will money printing cause FX volatility which could cause episodic, country-specific inflation?

For a good review of the literature, we were pointed by our friend Gerard Minack to the IMF’s World Economic Outlook (April 2020) which summarised multiple academic studies in many jurisdictions (Figure 2) and concluded that:

• Spending-based fiscal multipliers average about 1 in year one, and remain there for three or four years – that is, one unit of increased government consumption or investment will produce one unit of increased real output in year one – with “that for public investment slightly higher than that for public consumption”;
• Tax cuts generate multipliers of around 0.25, they say;
• When interest rates are at the effective lower bound, as they are now, the IMF says that multipliers are likely to be substantially higher since there is no interest rate penalty entailing from increased government borrowing;
• Consequently, they advise policymakers “to consider adopting rules-based fiscal stimulus measures” ideally in a co-ordinated multi-country push “that would entail even greater gains”;
• Against this, we read respected market economists, such as Zervos and Hoisington Investment Management’s Lacy Hunt, who flatly state that multipliers are close to zero in the short term and negative in the medium to longer term. They cite Milton Friedman’s empirical studies (with Anna Schwartz and others) which found no relationship or a negative relationship between fiscal spend and subsequent economic output and inflation. This is held to be especially the case in highly indebted economies such as those of today.

Figure 2. IMF Estimates of Fiscal Multipliers

Source: Gechert and Rannenberg (2018).

Our View Today

While we are not economists, nor are we politicians, so our views on what should or could be done is irrelevant. What is relevant is what we think the political narrative might be, and therefore which policies might be pursued.

We think the narrative goes something like this. There is a growing consensus that we are faced with an under-employed global economy; where declining trend growth has almost kept pace with falling interest rates thus reducing the ability of rate cuts to stimulate demand; and where there is a glut of savings which goes to unproductive use in financial markets and not the real economy; which could therefore really use a large dose of fiscal stimulus to bootstrap it out of its torpor.

In a more fully employed economy with scarce resources, the narrative goes, one should strongly lean towards more supply-side reform and a smaller role for the state. But that’s not where we are now and the policy prescription of at least the last 13 years since the Global Financial Crisis (and before) has done very little to address the growing imbalances of wealth and income or to stimulate productivity enabling investment. Central bank support is vital to facilitate this investment surge for both the private and public sectors in order to keep a lid on market interest rates, without which already high debt loads would produce crippling debt service bills. Thus, where we are today requires both monetary and fiscal support in large size.

The Case for Commodities

Which brings us to look at commodities. Over the long run, they have weak real returns and drastically underperform paper assets. As people say, if you are long commodities you are short human ingenuity, and we agree. However, in our academic paper The Best Strategies for Inflationary Times (co-authored with Professor Campbell R. Harvey from Duke University and Man AHL’s Otto van Hemert), we examine 34 inflationary episodes since 1926 in the US, the UK and Japan to see how asset prices fared when inflation accelerated from 2% to 5% or higher. The results are quite comprehensive. Total annualised real returns to 10-year Treasuries in inflations was -5%; to US equities -7%; to US investment grade -7%; to US high yield -7%. Paper assets have consistently failed to hold their value in inflations. Commodities, however, are a different story. They prosper in inflations, very consistently and very broadly. Our commodity aggregate¹ was on average up 14% in real terms in inflations; and every commodity subcomponent had positive real returns, ranging from 7% annualised for agriculture and livestock to 19% for industrials and even more for energies. Precious metals also do very well.

Interestingly, we found, most commodities had negative real annualised returns in non-inflationary periods, and this is most likely why they are so unpopular among institutional investors. We just haven’t had much inflation during the working lives of most money managers around the world, so there has never been a role for commodities in portfolios that have generally prospered from their large bond and equity allocations.

This prompted us to do a little exercise to see just how unpopular commodities are among big money managers and the results were (to us!) fascinating. Looking at the 20 largest asset owners in the world – mainly sovereign wealth and very large pension funds – we found published asset allocations for 13 (Figure 3). Just one large plan has an explicit commodities exposure – and that was a 2% allocation. True, seven of 13 plans have a ‘Real Assets’ allocation, but as far as we can tell, in six of those seven cases, that was an allocation to real estate, which we find has a decidedly mixed track record in protecting against inflations (we find average real annualised returns for US residential real estate in inflations is -2% with positive real returns just 25% of the time). Against this, the asset weighted average allocation to equities is 47% and to bonds 37%. This group clearly has very little fear of inflation but if that changed for any reason the buying power would be massive.

Figure 3. Holdings Breakdown of World’s Top 20 Asset Owners

Source: 20 largest asset owners – Institutional Investor, November 16, 2020; Asset allocations – asset owners’ websites; data compiled by Man Group. Note: Shading indicates asset allocation data not found for these asset owners.

There’s not space here to develop the supply-demand case for commodities but suffice to say large scale global infrastructure rollouts are commodity intensive, and a 10-year low (last year) in commodity prices has caused very large capex cuts from the mining and energy majors such that many commodities are already in supply deficit and likely to remain so for several years. This, remember, is before the infrastructure roll out.

Conclusion – Watch Policymakers and Start to Prepare for Inflation

In wrapping up, we would simply say that Covid has accelerated a process that was already under way with a shift from a largely monetary response to secular stagnation, to a largely fiscal response supported by monetary policy. This latter has a decent chance of turning out to be inflationary. Given that risk, we believe multi asset portfolios should start to prepare strategies that can protect them from inflation better than their existing allocations to equities and bonds. Commodities are one strong candidate, in our view.

1. An equally weighted, monthly rebalanced portfolio of front-end futures in copper, gold, silver, platinum, wheat, corn, soybeans, cocoa, cotton, coffee, sugar, cattle, hogs, Brent oil, WTI oil and heating oil.