Given limits on credit availability, the authorities need to find an alternative way to increase households’ real disposable income. In the medium term, the best method of doing this is, of course, through jobs growth. However, this can take a while to have an impact.
A faster, though less sustainable way, is through tax cuts – both to households and businesses. The big tax cut route is limited, however, by fiscal deficits and by the fact that the banking sector’s liabilities need to be covered before “clean” lending can resume in the global economy. This involves adding big numbers to the already big amount of government debt.
Net savings nations, such as Japan, can much more easily use tax cuts than net debtors. They can simply divert domestic investments into government bonds. However, the US and UK are net debtor nations, with foreign investors owning approximately one-third of US Treasuries and UK Government bonds.
As a result of the difficulty in stimulating US consumer demand, we have been reducing our equity exposure to Western economies and tilting investments toward Asian companies with strong cashflow generation and those undergoing structural growth.
Given that a proper recovery cannot even begin until the banking system is fixed and the banking system cannot be fixed without a genuinely global solution (which does not look to be immediately available), the US authorities’ very short-term priority will be getting money into the household sector. Tax handouts and employers’ incentives designed to encourage spending and job creation are the order of the day. When the Obama stimulus plan finally gets enacted, it is very likely to encompass these core characteristics.
These measures are likely to help slow the pace of deterioration in the real economy and, hence, we expect to see improved macro indicators by the middle of the year. However, it is important to keep in mind that, compared with the near immediacy of credit-fuelled recovery, the positive impact of tax and employment incentives only becomes evident over a longer period. Thus, in our view, a recovery which is prone to setbacks seems more likely than in any previous cycle.
This has led us to reduce exposure to equities and to increase to asset classes such as gold, which is expected to relatively outperform given its safe haven status, and to property, where the valuations are at an extreme level.
Government bonds are delivering positive absolute returns again, particularly index-linked bonds. This has been largely aided by government agencies manipulating the price partly through buying their own paper in the market.
The US and UK authorities are over-supplying money and will continue to do so until it “sticks”. However, it is worth reminding ourselves that in the history of the bond market, there has never been a sustained statistical relationship between government supply and price/yield.
More recently, the experience of Japan tells us that it is eminently possible to have government yields as low as 0.5 per cent in the face of supply well over 100 per cent of GDP. Despite concerns over supply, we maintain a positive view on government bonds, particularly index linked bonds, given their ability to act as a hedge against inflation.
David Jane is head of multi-asset at M&G