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An Equity Investor's Guide to Modern Monetary Theory

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An Equity Investor's Guide to Modern Monetary Theory An equity investor’s guide to Modern Monetary Theory RWC Equity Income 2020 For Professional Investors and Advisers Only RWC equity income The team Ian Lance has thirty years of experience in fund management and started working with Nick at Schroders in 2007 before joining RWC in August 2010. Whilst at Schroders he was a senior portfolio manager managing the Institutional Specialist Value Funds, the Schroder Income Fund and Income Maximiser Fund together with Nick. Previously Ian was the Head of European Equities and Director of Research at Citigroup Asset Management and Head of Global Research at Gartmore. Nick Purves joined RWC in August 2010. Nick worked at Schroders for over sixteen years, initially starting as an analyst before moving in to portfolio management where he managed both Institutional Specialist Value Funds and the Schroder Income Fund and Income Maximiser Fund together with Ian Lance. Prior to Schroders, Nick qualified as a Chartered Accountant. John Teahan joined RWC in September 2010. He was previously portfolio manager at Schroders where he co-managed the Schroder Income Maximiser with Nick Purves and Ian Lance. In addition he co-managed the Schroder Global Dividend Maximiser, Schroder European Dividend Maximiser and Schroder UK Income Defensive funds, all three of which employed a covered call strategy. During his time at Schroders John also specialised in trading and managing derivative securities for a range of structured funds. Previously he worked as a performance and risk analyst for Bank of Ireland Asset Management UK. John is a CFA Charterholder. 2 RWC equity income Introduction We are sometimes told that value investing will never work again because interest rates are going to stay permanently low thus favouring bonds and, by extension, bond-like equities. Ignoring the fact that there is no long-term evidence of a correlation between interest rates and relative performance of growth versus value, and also ignoring the fact that interest rates appear to have hit a floor, these claims seem to assume that inflation will never be an issue again. That certainly seems to be the view of most investors looking at the chart of inflation expectations below. Source: Bloomberg, 11 May 2020 In response to the economic damage caused by the UK lockdown, the last few weeks have seen the introduction of fiscal and monetary stimulus on an unprecedented scale that must at least increase the probability of a rise in inflation at some stage. This note looks at what new measures have been employed, their theoretical origins, and why they could stimulate inflation in the future. It should be clear that this is not a prediction but merely an attempt to challenge the prevailing wisdom that the world will remain locked in permanently low inflation or deflation. The conclusion is that investment portfolios built for a world of low inflation and falling interest rates might struggle if that economic backdrop changed and that investors might want to hedge for such a scenario. The search for a new type of economics Just as the failure of economic policy to avoid the Great Depression gave birth to Keynesian economics, and Keynesianism gave way to Monetarism in the 1970s after the former was unable to explain simultaneously high inflation and high unemployment, so the failure of economics in recent years has left the environment ripe for considering new ideas such as Modern Monetary Theory (MMT). No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. 3 RWC equity income Failure of Monetary Policy Central bank’s post-financial crisis policy of cutting interest rates and quantitative easing is largely deemed to have been a failure. It has: • Failed to generate sustainable levels of growth Source: Bloomberg, 11 May 2020 • Failed to generate inflation above 2%, which is the objective of most central banks Source: Bloomberg, 11 May 2020 • Has created a series of asset bubbles that are now in the process of unwinding Source: Bloomberg, 11 May 2020 No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. 4 RWC equity income • Increased inequality by boosting the prices of assets which were mainly owned by the wealthiest and hence fuelled the rise of populism Source: Wid.world, Morgan Stanley Research • Finally, although these policies were originally justified as being a temporary response to the Great Financial Crisis, they were not unwound before the latest downturn. This meant that central banks had nowhere to go when the latest downturn struck and went into this crisis with interest rates near zero (or negative in some cases) and with bloated central bank balance sheets. Source: Bloomberg, 11 May 2020 Source: Bloomberg, 11 May 2020 No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. 5 RWC equity income Failure of Fiscal Policy • Among other things, the global financial crisis was largely considered to be a problem of too much debt making the financial system extremely fragile. Governments have responded by taking on even greater levels of debt, albeit that much of it shifted from the private to the public balance sheet. This has led some to suggest that there are negative consequences of continually increasing debt to GDP1. Source: Bloomberg, 11 May 2020 • This debt has not created economic growth but instead has slowed it. In the past 20 years, the ratio of federal debt to gross domestic product has leapt to 105% from 60% and GDP has grown at 1.2% a year, 37% below the long-term average. As Lacy Hunt of Hoisington Investment Management observes, “large indebtedness eventually slows economic growth as resources are transferred from the highly productive private sector to the government sector”. Ultimately, more and more debt is required to finance every dollar of GDP. • The deficit is not self-financing as much of it is not put into productive assets, but rather used to fund welfare programmes. Source: US Treasury, 30 April 2020 1 See for instance: ‘This Time is Different: Eight Centuries of Financial Folly’ by Reinhart and Rogoff No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. 6 RWC equity income Given these failures of post-crisis economic policy, it was not surprising that a new type of doctrine would be considered, and Modern Monetary Theory (MMT) is one such innovation. What is Modern Monetary Theory? In a nutshell, MMT is the financing of government deficits via money printed by the central banks. For anyone who wants to dig deeper into the subject, I have put a reading list in the appendix but for the moment I will summarise the core tenets of MMT. • Money is a creation of the state and therefore sovereign governments cannot run out of money as they can always print more. This also means that a government will never default on its debts since it can always print money to meet the debts that are coming due. • One critical caveat of MMT is that a government can borrow as much as it likes if it is not owed to other nations. It is feasible to keep bond yields in check if your central bank is buying most of your debt, but if you are reliant on the ‘kindness of strangers’ then you are at risk of a buyers’ strike in government debt and a sudden surge in bond yields. • Fiscal spending should be disconnected conceptually and practically from its financing. Spending should be focused on achieving full employment and should not be limited by deficits. • MMTers believe that the only constraint on spending are the real resource constraints of the economy, and that inflation will result if spending is increased to a level beyond the productive capacity of the economy. Basically, anything (Universal Basic Income, Medicare for All, Green New Deal etc.) can be financed by printing money so long as it doesn’t trigger inflation. This necessarily means that the government takes a greater role in the allocation of resources in the economy and reduces the influence of the private sector. • Taxes are not used to finance government spending (as this is financed by money printing) but instead are used to slow the economy down. How likely is it that MMT will be implemented? MMT has the potential to be immensely popular with the public and politicians alike since it effectively removes any limits on spending and allows the financing of projects likely to be popular with voters. In the current crisis, this enables governments to order workers to remain at home whilst paying them 80% of their salary. In the longer term it can finance just about anything from ever increasing amounts of spending on the NHS to universal basic income. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. 7 RWC equity income Direct monetary financing of the government spending by the central bank is currently not allowed in most jurisdictions (central banks can only buy and sell government bonds on the secondary market). Whilst I find it unlikely that full scale MMT is ever going to be implemented given its inherent flaws, I do believe that a version of it is currently being trialled as central banks start to finance (implicitly if not explicitly) the ballooning deficits required to deal with the coronavirus crisis. Fiscal Response to the Coronavirus Crisis In the UK, economists at Citi estimate that the Treasury will borrow £273b this year taking the deficit to 14% of GDP which is not far from the 25% in the Second World War, and it is expected to remain above £100bn until 2024/25.
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