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Is ‘monetary magic’ dead?

At the end of a tumultuous decade for the global economy and markets, central banks’ monetary policies are still firmly centre-stage. However, with global economic growth set to slow in 2020, a new report from Deutsche Bank Wealth Management has questioned whether we are close to seeing the end of monetary policy dominance.

An erosion of central bank power?

This morning, the Bank of England meets for its final monetary policy meeting of the year, which will include a vote on whether to maintain or adjust interest rates. At its previous meeting, two of the nine monetary policy committee members voted to cut rates as a response to a slowdown in the UK economy. Interest rate decisions are one of the key tools of monetary policy in the arsenal of a central bank - but is this influence on the wane?

The global financial crisis of 2008 set the ball rolling on the question of central bank monetary policy dominance. More recently, interest rates in both the eurozone and the US have been where the battle has been fought.

Back in 2014, the European Central Bank took the decision to cut its deposit rate to -0.1%, a step into negative rate territory in an attempt to boost the region's inflation rate which was lagging behind targets. Yet almost six years later, the rate remains in negative territory, at -0.5%, while the region's inflation rate is at 1% and still below targets.

Speaking to the European Parliament's Committee on Economic and Monetary Affairs in September as part of the process to her appointment as the new president of the ECB, Christine Lagarde made her famous "I'm not a fairy" statement, referring to the fact that monetary policy on its own from a central bank cannot fix collective problems. 

"The real economy has reached that level of globality and in response to that, in order to avoid the feeling that people have that their destiny is no longer in their hands and that their national responsible representatives cannot deal with the issue, we have to collectively find the responses to those challenges..." Lagarde commented.

In the same address, Lagarde was clear to point out who she thought should be sharing some of the load with the ECB... some of the continent's politicians:

"When you look at the list of euro-area countries and those that are virtually at zero deficit or within 0.5% of deficit, it’s a majority of countries in the euro area, so, certainly, there is not a lot of room, but there is room that can be used in terms of fiscal policies."

Over in the US this year, the Federal Reserve has itself been cutting rates, particularly in the second half of 2019, albeit not into negative territories as yet. The final rate decision of the year actually saw the Fed leave its funds rate unchanged at 1.5-1.75%, while it signalled no plans to change rates in 2020 - in part due to the US presidential race which will be fought next year. This is an admirable sign of impartiality on the part of the Fed, bearing in mind the searing attacks it has come under from 'Tweeter-in-Chief' president Trump throughout the year, which we've covered here on CTMfile.

New world, new rules?

Speaking on the opening plenary of Sibos 2019 in London, Dame Minouche Shafik, Director of the London School of Economics and Political Science (LSE) and potential replacement for Mark Carney in the Bank of England hot seat, noted the 'new monetary theory', which argues that as long as your country's growth rate is higher than your interest rate, you can keep borrowing. "Numerically that is true, as long as your growth rate is higher than your interest rate, and that argument has been used to make the case for why even highly indebted countries in Europe can afford to borrow more," Shafik said. 

"But of course, you have to be prudent because at some point, the interest rate may be higher than your growth rate, in which case your debt becomes unsustainable," Shafik continued. "There is room to borrow. I think it's vital that the borrowing that's done creates new productive capacity, investing in things like infrastructure and skills so that the productivity and investment opportunities in those economies increases over time. And if there's more borrowing for that purpose, I think markets would see that as credible." 

Refine for robustness and sustainable income

Under attack indirectly from adverse macro economic conditions and more head on from politicians and others, there is a question to be asked as to the role central banks will play in the new year and decade ahead of us. The newly-released Deutsche Bank CIO's annual outlook takes a good stab at answering that question.

“Whether we like it or not, central bank 'magic' will continue to play an enormous role in both economic policy - and markets,” said Christian Nolting, Global Chief Investment Officer for Deutsche Bank Wealth Management. “The evolving investment environment will remind us of the importance of strategic asset allocation for portfolio robustness.” 

The DB report includes six themes for 2020 that highlight the key implications of likely economic and policy developments for investors to pay attention to:

  • Policy pressures need prudent response. As global economic growth slows there will be a growing realisation that monetary policy can’t do it all alone, but policy change will take time and a sustainable investment process will be key.
  • Living with a low-yield world. With monetary policy still centre stage for now and yields unlikely to rise appreciably, investors should reassess holdings of non-yielding bonds and investigate how to capture returns from illiquidity premia in private markets.
  • Find new income harbours. Looking beyond US Treasuries, some other developed market fixed income areas are still appealing. But keep an open mind about other possible sources of yield - for example, in corporate as well as sovereign emerging market bonds.
  • Balance your style. Equities could register further albeit more limited gains in 2020, but market dynamics will be shifting. At an equity style level, “growth” stocks’ premiums over “value” could be reaching their peak and high-quality value stocks could offer opportunities.
  • Politics tops policy. For foreign exchange, 2020 could be a year when political developments often prove more important than fundamentals: look for currencies to act as portfolio diversifiers. Geopolitics alone won’t drive oil prices higher but gold maintains its allure.
  • Tech meets ESG. Two new long-term investment themes are launched. 5G Fast Forward looks at the broader implications of faster communications for industry and “big data”. The Environmental, Social and Governance (ESG) theme of Resource Stewardship focuses on waste management and recycling.

Clearly monetary policy will continue to have an effect of the financial markets in 2020. But to expect it to right the economic ship in isolation is asking a lot, possibly too much.

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