Regime shifts

Brandywine Global quarterly letter 4Q 2016

Regime shifts

History will be the judge, but in our opinion, the third quarter of 2016 has a very good chance of being the secular low for developed-country sovereign bond yields. Our position throughout the year...

was that most sovereign bond markets in developed countries offered no value —and in some instances were extremely overvalued. Yet until the fourth quarter, the trend-setting U.S. long-term Treasury bond yield continued to slide, the curve flattened, the Federal Reserve (Fed) balked at raising rates, and trillions of dollars of global debt traded with a yield of zero or less. The rallying cry for the bond bulls has been “secular stagnation,” the theory of a world short on spending and long on savings, proposed by Larry Summers of Harvard. According to this theory, underwhelming productivity and dwindling labor force growth condemned the world economy to perpetual low nominal gross domestic product (GDP) growth and yields below 1% for over 70% of the constituents of the most popular global bond benchmarks.

In the fourth quarter a major sell-off in the global fixed-income markets finally unfolded. Much of what has been written about this bear phase has been tied to the pro-growth economic agenda expected of the newly elected Trump administration. While certainly a factor, the change in U.S. leadership is only one of several regime shifts taking place —all of which may be connected.

The world economy also turned out to be a lot stronger than the expectation that was embedded in bond prices for most of the year. We made the case for a better cyclical outlook early in the first quarter of 2016. Chinese policymakers flipped the switch on fiscal spending to end their downturn, the Fed bought into secular stagnation and balked at increasing rates, and the dollar stabilized early in the year. Correspondingly, global growth ended the year on a strong note with the bulk of the marginal improvement coming from the developing world —especially China— which is what we had been looking for. Near the end of the year, growth in the developed countries also picked up, possibly a delayed reaction following the shock of the “Brexit” vote and uncertainty ahead of the American elections.

But our call for a better outlook for the world economy also hinged upon tentative signs of another regime shift, which we described last quarter as the “Stirrings of an End to Financial Repression.” We believe there is increasing evidence that the main propellants behind feeble post-2008 growth continue to lose momentum:

Household deleveraging in the U.S. stopped in 2016. Coincidentally, the growth of Chinese nominal GDP bottomed out as well. The synchronicity of credit-financed American consumption and Chinese production defined the pre-2008 world economy. As a result, the beginning of China’s growth deceleration coincided with the U.S. housing bust and the subsequent hole in household credit growth and spending. The collapse in U.S. household borrowing and corresponding downturn in Chinese economic growth have been the cornerstones of the post-global financial crisis (GFC) slow-growth environment. China boosted domestic credit growth in 2009 in order to contain the decline, but ultimately reversed course. This year’s realignment of U.S. household spending is more in line with domestic incomes and the bottoming out in China’s economic growth would remove a big source of the post-2008 subnormal “new normal,” if it can be sustained.


A shift in economic policy is also taking place. Central banks in developed countries have exhausted all means to reinvigorate growth. The baton is passing to fiscal policy, with the Chinese the first to lead the way. China’s credit impulse in the first quarter of 2016 was the biggest since 2009. In the United States, the agenda of the incoming Trump administration can be thought of in a narrow way of shifting the burden of growth from the shoulders of the Fed to fiscal stimulus. These are dramatic changes from what has dominated most of the last eight years.


• Lastly, productivity is probably not as weak as suggested by the secular stagnationists. Statisticians measure output growth per capita. This measure will obviously be slow if deleveraging and fiscal austerity have depressed economic growth. Correspondingly, this measure will rise once these factors lift. A more believable guesstimate of labor’s marginal factor productivity could be what businesses are willing to pay labor when the economy is at full employment, a status many observers believe the U.S. has achieved. Real wage growth is running somewhere between 1.5 and 2%, depending on what index you use. The implication would be nominal GDP growth ahead of closer to 4.5-5% in comparison to the 3-3.5% of the past several years.


Populism —another regime shift reared its head in 2016 partly in reaction to the years of post-2008 economic gloom. Voters laid the blame at the feet of the elites and their policies for the failure of family incomes to rise and for the growing income divide. The market failed completely to anticipate the Brexit vote, while most observers did not think Donald Trump would win the U.S. election. Contrary to the anxiety expressed ahead of these political developments, the British economy is stronger than many would have anticipated. In the U.S., capital markets are pricing in an economic boom. Stock prices and bond yields have been going higher since November 8. Similarly, commodity prices have been stronger despite a strong dollar, a combination only seen during periods of strong global growth. Dollar strength in 2014 and 2015 was more a sign of weakness in the rest of the world and led to a volatile U.S. equity market and a flattening yield curve. But since November, the market has behaved as if the Trump administration is going to light a fire under the economy, just as cyclical and secular factors also make the turn.

President-elect Trump has given every sign that he intends to reset American domestic and foreign policy through the lens of what he believes is in the nation’s commercial self-interest; tax cuts/reform and deregulation are priorities. “Globalism” is out. Bilateral treaties focusing on trade balance and fairness could usurp multilateral free trade. Cross-border tax reform proposals and a potential import tax have emerged as part of a possible mélange of carrots and sticks aimed at discouraging multinationals from outsourcing production for repatriation back to the U.S in an effort to help revive domestic manufacturing and jobs. But these plans also carry the strong whiff of protectionism.




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