PERSPECTIVES Trumponomics and the consequences for the policy mix December 2016 The election of Donald Trump as the next President of the United States is, in our view, a game changer. His economic programme provides for a substantial fiscal stimulus consisting of a portion of tax cuts and a portion of public investment. Whatever the magnitude of the stimulus, we believe this is a turning point in terms of policy mix for the United States and the developed world. Our analysis suggests that the monetary policy environment which has been so accommodative for such a long time will start normalising, while restrictive fiscal policies will start to loosen. This evolution of the policy mix will have major consequences in terms of asset allocation, with the theme of reflation replacing deflation and investors shifting focus from central bankers back to the politicians who control fiscal spending. We see this as a return to rationality after years of quantitative easing, with financial markets driven by careful analysis of economic data releases, and financial assets likely to show increased dispersion of returns as fundamentals come to the fore. In our assessment, this new landscape is likely to reward active investment strategies, with the potential both to benefit from the changing policy mix and avoid the pitfalls. Olivier Marciot Investment Manager The macroeconomic policy mix in perspective The overall policy mix has evolved considerably since the late 90s (shown as the triangle in the chart below), when both monetary and fiscal policies had no major biases, and a certain equilibrium existed between easing and tightening. Policy Mix in perspective (1998-2020) Guilhem Savry Investment Manager Source: IMF, Unigestion, as at Nov 2016 With the financial crisis of 2008, both central bankers and government reacted strongly to fight off recessionary pressures. Interest rates were cut aggressively and budget deficits widened. From 2010, quantitative easing was enacted to keep rates as low as possible and propel the recovery, but a wave of austerity was necessary to contain surging debt levels. We anticipate a new era going forward (shown as the dotted circle), with monetary policy back to some sort of neutrality and an increasingly supportive fiscal environment now that monetary policies have achieved their objectives and economic fundamentals have improved strongly. We anticipate a new era going forward, with monetary policy back to some sort of neutrality and an increasingly supportive fiscal environment. Read more of our latest investment thinking online: www.unigestion.com/publications/ Unigestion SA I 1/8
Job done: the quantitative easing cure has worked Since 2008, the monetary policies deployed in developed countries have played a major role in buoying economic growth and stabilizing financial markets. Thanks to aggressive interest-rate cuts, shown below, and an unprecedented expansion of their balance sheets, central banks have succeeded in achieving their objectives; stabilising the banking system, fighting the risks of deflation, and smoothing the negative macroeconomic effects of deleveraging. Number of interest rate hikes/cuts (since 31.12.2006) Source: Central banks, Unigestion calculations, as at Nov 2016 While their action has been successful, we believe that the phase of accommodative monetary policy is coming to an end. The forces of deflation have receded substantially. The negative side-effects of unconventional monetary policy have become increasingly important and are significantly reducing the benefits. Above all, the macroeconomic fundamentals are much better than five years ago. Comments from central bankers recently acknowledged this need for a change, highlighting the fact that economic support was reaching its limits. Central banker views about the limits of the easing cycle M. Draghi European Central Bank November 2016 M. Carney Bank of England June 2016 S. Fischer Federal Reserve November 2016 "Whether the economic recovery becomes more solid, and how quickly inflation dynamics become more self-sustained, depends not just on the current monetary policy stance, but also on other policies" "Monetary policy cannot immediately or fully offset the economic implications of a large, negative shock. The future potential of this economy and its implications for jobs, real wages and wealth are not the gifts of monetary policymakers." In my view, the Fed appears reasonably close to achieving both the inflation and employment components of its mandate. Accordingly, the case for removing accommodation gradually is quite strong. Our view is therefore simple: monetary support for financial assets is going to stop in the quarters to come. However, the end of the "easing cycle" must be distinguished from the end of the "easy money cycle". The end of easing does not mean tightening. As can be seen in the graphic below, there are six stages of monetary policy when unconventional measures are taken into account. Read more of our latest investment thinking online: www.unigestion.com/publications/ Unigestion SA I 2/8
The six stages of monetary policy 2.0 Source: Unigestion, Nov 2016. The Taylor rule is a guideline established by economist John. B. Taylor which stipulates how much the central bank should change nominal interest rates in response to changes in inflation, output or other economic conditions. Our central scenario favors the end of the easing cycle but without particularly sharp interest-rate increases outside the US. Looking at the graphic above, we expect a shift from stance 2 to 3 for almost all of the G10 central banks, while the Federal Reserve is already in stage 4. Our central scenario favors the end of the easing cycle but without particularly sharp interest-rate increases outside the US Macroeconomic nutrients for growth Monetary policy has been the main support for the increase in asset returns since 2008. A change in this bias is therefore a potential source of destabilisation for financial markets. This adverse scenario does not constitute our base case, however. Central banks have significantly improved the way they communicate since they introduced unconventional measures. We expect any change to be implemented gradually, as shown by the path to normalization adopted by the Fed since December 2015. We also think the macroeconomic fundamentals constitute a real support for risky assets and should replace monetary policy in this regard in the months to come. Our positive vision for the global economy comes from a significant reduction in overcapacity, as illustrated by the widespread decline in unemployment rates in developed countries. Our growth NowCaster, which aims to measure the probability of currently being in a recession, also indicates that the growth dynamics are improving and back to the growth potential. That trend is historically very positive for risky assets in general and world equities in particular. Additionally, we believe the need for capital renewal is extremely important. The investment of private companies, very low in recent years, should therefore restart. Unemployment rates changes across developed countries Source: IMF, Unigestion, as at November 2016 Read more of our latest investment thinking online: www.unigestion.com/publications/ Unigestion SA I 3/8
World NowCaster and MSCI World Index Source: Bloomberg, Unigestion, as at November 2016 Fiscal policy as a vitamin shot Along with monetary policy, fiscal policy has an important part to play in ensuring macroeconomic good health of the world s economies. It played a major role in stabilizing the global economy between 2008 and 2010, and we believe this tool will be used extensively in the years to come. The election of Donald Trump as the next President of the United States is, in our view, a game changer in the evolution of the policy mix. Indeed, the austerity era has left the United States and most developed countries with considerable room to increase their fiscal stimulus. As depicted below, government deficits have been reduced by 4% on average (and more than 6% in the US) since 2010. Change in public deficit across developed countries (as % of the GDP) The austerity era has left the United States and most developed countries with considerable room to increase their fiscal stimulus. Reduction in public deficits (Austerity) Increase in public deficits (Fiscal stimulus) Source: IMF, Unigestion, as at November 2016 The second element in favor of loosening fiscal policies is the unprecedented low level of interest rates, which allows countries access to inexpensive financing. Finally, central bankers have regularly warned about the increasing inefficiency of monetary policies when it comes to stimulating economic growth. A well targeted fiscal policy can achieve this objective in the medium term by stimulating private investment, which remains relatively low by comparison to recent history. Read more of our latest investment thinking online: www.unigestion.com/publications/ Unigestion SA I 4/8
Reflation: a side effect of changing the policy mix The change in the policy mix we anticipate will have important consequences in terms of asset allocation. The key one is that the deflation theme will be replaced by that of reflation. Most G10 countries have seen overcapacity shrink. What happens when fiscal stimulus is triggered in economies running close to full employment? Reflation. The chart below illustrates how reflation has taken over deflation in the investment imagination. Google search trends on reflation and deflation Source: Bloomberg, Unigestion, as at Nov 2016 Reflation describes the first phase in the recovery of an economy which is beginning to experience increasing prices at the end of a slump. Prices are still below where they would be expected to be, so not strictly regarded as inflation by economists, but it can be regarded as the first step on that path. The classical conditions for reflation are when inflation expectations are low, employment is firming and the outlook for growth is improving. An increase in inflation expectations is, therefore, often the first sign of reflation. An historical analysis of the Phillips curve for the US economy, plotting unemployment against wage inflation, shows that wage inflation at the current level of unemployment (4.9%) was 3.1% on average. As US consumer price inflation today stands significantly below that level at 1.6%, we expect a marked rise in US inflation in the years to come. We see early signs too in Japan and the UK. In most developed countries, inflation breakevens in the bond market have risen over the last six months even though wage growth has remained steady. US Phillips curve (inflation versus unemployment, 2000-2016) Reflation describes the first phase in the recovery of an economy which is beginning to experience increasing prices at the end of a slump. Source: Federal Reserve Economic Data, November 2016. The X-axis shows unemployment, and the Y axis inflation, as percentages. Read more of our latest investment thinking online: www.unigestion.com/publications/ Unigestion SA I 5/8
What does this mean for the bond markets? In our view, the change in policy mix will negatively affect the same factors that had been positive for the bond market over the last two years. Indeed, growth and inflation risk premia should increase, supported by the fiscal component. However, the amplitude of the expected rise in interest rates will differ between countries because the overcapacity reduction at work does not occur at the same pace everywhere, as shown previously. Our calculation of fair value based on potential GDP and potential inflation comes out at 2.80% for the US 10-year Treasury and 0.4% for the 10-year Bund. As inflation and growth edge up, these fundamental valuations should rise. The chart below illustrates the fact that despite the recent repricing, there is still room for a continued rise in bond yields. Moreover, if we add the Fed and ECB forecast for 2017 and 2018 to our model, the fundamental fair value is significantly higher than the current level. 10y bond yield fair value since 1990 in the US and Europe The amplitude of the expected rise in interest rates will differ between countries Source: OECD, IMF, as at November 2016 The return of the growth trade, but income assets may be more challenged Between 2010 and 2016, income assets have outperformed growth assets markedly. This outperformance should be reversed, at least partially, in the months to come. In our assessment, this could occur as previously crowded positions in bonds and bond proxies are unwound, and as investors appetite for duration diminishes in this environment. Read more of our latest investment thinking online: www.unigestion.com/publications/ Unigestion SA I 6/8
Asset performance by style (2010 2016) Source: Bloomberg, as at November 2016 Back to the fundamentals and increased divergence of returns Years of quantitative easing have left investors in a topsy-turvy binary world, where bad meant good and vice versa. Worsening economic data tended to be positive for both risk off and risk on assets, as the odds increased for either more monetary easing or less tightening from central bankers. With the focus gradually shifting from maintaining financial stability back to macroeconomic fundamentals, we expect financial markets to be driven by factors such as growth forecasts, the inflation outlook and public deficits. In a certain way, it will start functioning more traditionally, where correlations between the economic context and asset returns should be back to normality. Finally, the era of quantitative easing has strongly increased cross asset correlations, as depicted below. We expect divergence to increase and the dispersion of returns between and within asset classes to rise in this rational era as the influence of the central bank put that pushed the implied and realized volatility lower begins to diminish. In our assessment, this new landscape is likely to reward active investment strategies, with the potential both to benefit from the changing policy mix and avoid the pitfalls. Cross-asset correlation We expect divergence to increase and the dispersion of returns between and within asset classes to rise Source: Bloomberg, as at November 2016 Read more of our latest investment thinking online: www.unigestion.com/publications/ Unigestion SA I 7/8
What does this mean for the investment strategies we manage? With monetary policy set to normalise in the US and across much of the developed world, in our view, we are relatively cautious on the prospects for fixed income at the present time, particularly traditional government bonds. Where we are invested in fixed income, we have tended to shorten duration, an approach which has been beneficial in recent weeks. We still see opportunities to add value by allocating between different fixed income markets and by implementing our views on the likely steepening of the yield curve through derivatives. With fiscal stimulus potentially favourable for some areas of the US economy, particularly energy and domestically-oriented companies, we are looking more closely at credit, while this stimulus and the prospect of repatriation of US dollar assets should be supportive of the US dollar over time. Longer term, we believe the prospect of a return to a more traditional data-driven investment environment is one that should be welcomed by investors, while the prospect of an increased dispersion of investment returns and reduced cross-asset correlation, in turn, creates the potential for dynamic asset allocation to add significant value. In our multi-asset strategies, we are inclined favourably towards developed equities and other growth assets at the present time, away from emerging equities, and with an exposure to reflation-linked assets such as inflation break-evens and commodities. These should also act as portfolio diversifiers, mitigating the risk of having excessive exposure to equity market beta in multi-asset portfolios. We are inclined favourably towards developed equities and other growth assets at the present time, away from emerging equities and with an exposure to reflation-linked assets such as inflation breakevens and commodities Important Information This message has been prepared for information and for your personal use only. It must not be published, reproduced, distributed or disclosed (in whole or in part) by recipients to any other person without the prior consent of Unigestion. All information provided is subject to change without notice and should only be considered current as of the date of publication without regard to the date on which you may access the information. Past performance is not an indication of current or future performance. Data and graphical information in the attached document are for information only. No separate verification has been made as to the accuracy or completeness of this data which may have been derived from third party sources. As a result, no representation or warranty, express or implied, is or will be made by Unigestion as regards the information contained herein, and no responsibility or liability is or will be accepted in this respect. Read more of our latest investment thinking online: www.unigestion.com/publications/ Unigestion SA I 8/8