Market Turbulence and Policy Reversal Shouldn’t Cow Investors

Rick Rieder and Russ Brownback argue that despite the market turbulence witnessed in the past several months, as well as a dramatic policy reversal, we find ourselves at a moment of remarkable economic stability. That fact, along with greater policy accommodation and capacity, argues for healthy and sensible risk taking.

Resilience in the face of worry

On the eve of World War II, the British government propagandized the iconic slogan keep calm and carry on, described by Wikipedia as “evocative of the Victorian belief in British stoicism–the “stiff upper lip,” self-discipline, fortitude, and remaining calm in adversity.” We’ve adopted a similar mantra in 2019 as we endeavor to keep calm in the face of stubborn Brexit drama, and more importantly in the face of a persistent hyperbolic financial market narrative that unnecessarily emphasizes global economic left-tail risks.

Financial markets have endured significant turbulence in recent months as the market-implied forward monetary policy path pivoted from overtly hawkish late last year to ambitiously dovish more recently. The irony is that despite some modest ebb and flow in aggregate global economic indicators during this period, the global economy is enjoying some of the greatest stability in history, notwithstanding specific pockets of weakness, like European manufacturing and emerging markets. Thus, there is enough core economic stability overall to warrant holding higher-quality risky assets, in our view, so we are positioned to “keep quality and carry on.”

Policy prescriptions support the weakest link

We think the dramatically dovish U-turn in the market-implied monetary policy path is rooted in the growing realization that policy makers are increasingly faced with the dilemma that their tools are remarkably blunt, at least relative to the incredible dispersion of real economy performance within their jurisdictions. Specifically, given global secular dynamics that dictate an asymmetric distribution of risk to the deflationary tail, central banks are forced to calibrate jurisdiction-wide policy postures in order to accommodate the weakest economic link, not the broad economy overall, as is commonly believed.

So while the Federal Reserve looks at solid nationwide growth driven primarily by a handful of states, it must consider the inherent weakness in states with poor demographics, or onerous tax policies. Similarly, the European Central Bank(ECB) must consider double-digit unemployment rates in the periphery of the region, even though Germany is flirting with full employment. These dynamics are at play globally too as the marginal layer of policy posture has enormous influence on both the domestic policies of countries with managed currency regimes as well as the ebb and flow of global liquidity. To wit, two-pronged Fed tightening last year dictated liquidity-sapping U.S. dollar strength and pro-cyclical tightening in emerging markets (EM), which fed directly into severely tightened financial conditions. We are heartened that global policy has evolved toward a more pragmatic embrace of a marginally easier policy stance in deference to these economic realities.

Policy and secular economic transformations

As for the remarkable global economic stability we’re witnessing, relative to history, we’ve been very vocal about the powerful secular evolution away from a dependence on the production and consumption of goods, to a far more services-dominated global economy. The inelasticity of supply at the right side of the goods cost curve is what has historically exaggerated the amplitude of the business cycle. In contrast, a services-led economy enjoys ample elasticity on the expansionary side of its supply curve because the marginal cost of production is limited to the marginal price that the marginal worker is willing to pay. Ultimately, this is represented by their marginal disposable income. Thus, a services-dominated economy is structurally less volatile than one that is goods-dominated (see graph).

Goods vs. Services GDP Growth: 5yr Rolling Volatility chart

At the same time, in an environment of cyclical global growth deceleration, our enthusiasm in underwriting a diverse portfolio of quality yielding assets is enhanced by the knowledge that global policy makers have the requisite ammunition to fend off any unexpected increase in the probability of the deflationary left tail becoming a reality. Indeed, China, the U.S., and the emerging markets, which combine to generate roughly 86% of global growth, all have convincing prospective policy tools to ward off an existential growth scare.