Volatility stirs as fears grow over a ‘second wave’ and IMF downgrades global growth outlook

Key points:

• Market sentiment has turned negative on concern that the spreading coronavirus could force policy makers to slow the pace, or reverse, business re-openings.
• The International Monetary Fund downgraded its outlook for the world economy, projecting a significantly deeper recession and slower recovery than it anticipated just two months ago.
• We expect trade tensions to re-emerge between the European Union and the U.S as Washington launches a consultation on new tariffs on $3.1bn of European products — ranging from German camera lenses to British biscuits and French wine — in a move that would broaden a transatlantic dispute over aircraft subsidies.

Volatility looks here to stay as markets wrestle with an extraordinary faith in the ability of policymakers and central banks to navigate a path through the crisis and potential ‘second waves’ of the COVID virus. These are a real risk given stubbornly high infection rates in certain US States and renewed outbreaks in Beijing, and high rates of infection in India and Latin America.

Geopolitical risks abound:

• Tension between China and the US (and the West more broadly). Of course we’ve had trade tensions elevated for the last year or two and the Huawei issue but relations between China and the West have ratcheted up further in the wake of COVID. Unrest in Hong Kong just adds fuel to the fire.
• Heightened tensions between China and India
• Global politics were already dysfunctional: the US was characterised by “gridlock” and a polarising Presidential campaign; Europe has its share of problems with political polarisation; and, as mentioned, China had a Hong Kong problem.
• Heightened tensions on the Korean Peninsula.
• Cyber ‘cold war’ tensions are escalating.
• Governments were wrestling with deep-seated structural issues such as climate change, inequality and “oligopolisation”.
• Additionally, investors also need to contemplate potential longer-term pitfalls relating to exit strategies from extraordinary stimulus. The “moral hazard” issues attaching to those measures loom large.

With those uncertainties as background, the “extraordinary faith” in policymakers, combined with what were arguably elevated levels in risk markets in a valuation sense, means that risk markets get shaken by the sort of news flow we saw overnight.

More volatile conditions are ahead as risk tolerance remains sensitive to the nature of the “news flow” both good and bad. But with market levels optimistically (but not necessarily implausibly) priced, risks are still weighted to the downside.

RBA inflation target / Changes to monetary policy objective

It was reported earlier in the week that RBA Governor Phillip Lowe opened the door to reviewing the three decade old inflation targeting framework, albeit in a “few years”. Dr Lowe said the existing monetary policy framework, including the 2-3 per cent inflation target, had served Australia well and should not be changed immediately.

However, the current framework smacks of “fighting the last war”. In the current environment returning inflation to the 2-3% band would require more monetary stimulus. Whichever way one cuts it, that requires more private sector leverage to encourage economic activity. However, the fundamental cause of the GFC was excessive private non-financial leverage, yet every remedial monetary policy measure since the GFC has done nothing to quell that leverage.

The onset of COVID-19  has seen a raft of monetary measures also designed to encourage leverage in the non-financial corporate sector but it is the build-up in non-financial corporate leverage that is the clearest area of potential financial imbalance. In this context, there are obvious limitations to what monetary policy can achieve. To try and hit the inflation target runs the risk of exacerbating financial imbalances and causing some financial instability.

If there are changes what form should they take?

Change the inflation target to 2% or 1-3%?

• I can’t see how it adds to the central bank’s credibility when after an extended period of missing its inflation target it changes the target to one that it currently (passively) meets. It’s about as credible declaring one has climbed the mountain at the halfway point to the summit. And it doesn’t get around the problem of a disconnect between the inflation objective and the problems of excessive leverage.

Switch to a nominal GDP target?

• It is difficult to believe that central banks would be any more successful in hitting such a target given that inflation is a key component of any nominal GDP target. And again it doesn’t get around the problem of a disconnect between the objective (in this case nominal GDP) and the problems of excessive leverage.
• It also overstates the omnipotence of monetary policy. In any case nominal GDP growth depends on many more variables than monetary policy. It depends heavily on the underlying flexibility and functioning of the myriad of labour, goods and services markets – the microeconomies –  that make up the macroeconomy.

What then?… Good question!

• Perhaps a more flexible mandate is in order with the emphasis varying according to existing exigencies. Locally that might be something akin to the original Reserve Bank of Australia Act focussing on inflation (“stability of the currency”), the “maintenance of full employment” and “the economic prosperity and welfare of the people of Australia” (which implies a growth element as well as a financial stability element). If that were also somehow quantifiable (admittedly easier said than done), so much the better.
• Such an independent central bank should also be enabled to transparently articulate what it sees as barriers to the achievement of those objectives, but leave it to the legislature to judge the merits (societal or otherwise) of those barriers.

It is clear that the most efficient form of marginal stimulus is likely best delivered through thoughtfully crafted fiscal measures. Central bankers themselves, from Powell to Lagarde to Lowe have said as much. Indeed, it was the overarching message from Fed Chairman Powell in his recent Congressional testimony when he urged lawmakers not to pullback on fiscal support measures.

Gold

Gold prices are hitting levels not seen since 2012 when concerns around the European debt crisis were at their most elevated.

Gold is perceived as somewhat of a safe haven, but recent elevated prices are perhaps boosted by:

• Uncertainties associated with the COVID-19 crisis, including:

• • Record low interest rates and bond yields lowering the ‘opportunity cost’ of holding gold, particularly as a part of a defensive portfolio.
  • Concerns about ‘exit strategies’ attaching to the current extraordinarily accommodating global monetary policy settings. These concerns are multi-dimensional and range from medium term inflation concerns to the consequences of ‘moral hazard’.

• Geo-political concerns ranging from:

• • China’s relationship with the West and India and its own HK issues.
  • Tensions on the Korean Peninsula.
  • Escalating ‘cyber Cold-War’ tensions.
  • Political polarisation and a potential breakdown in the post-war ‘liberal/social democratic consensus’.
• Maybe at the margin, at least until last night, a weaker USD (gold in EUR is at an all-time high). A stronger USD overnight saw some retreat in gold prices that nevertheless remain close to 8 year highs.

In that sense, perhaps investors are hedging their risk bets with gold exposure, particularly given low rates and the issues around the medium-term consequences of current monetary settings.

By Stephen Miller, Investment strategist