Last week brought arguably the most important event in the monetary policy calendar, as central bankers and economists from around the world converged on Jackson Hole, Wyoming, for the Kansas City Fed’s annual economic policy symposium.
Two of the most powerful central bankers – U.S. Federal Reserve Chair Janet Yellen and European Central Bank (ECB) President Mario Draghi – both gave momentous speeches, but neither one gave attention to the key topics on investors’ minds with regard to their economies.
In the case of the U.S., Chair Yellen didn’t discuss balance sheet normalization or persistently low inflation. And in the case of the EU, President Draghi did not discuss tapering of the ECB’s quantitative easing program – nor did he talk down the euro. Instead, both used the Jackson Hole platform to argue against some of the most powerful trends spreading around the world: deglobalization and deregulation.
Yellen’s speech: Defending regulation
In Ms. Yellen’s speech, she defended regulatory reform. She argued strenuously that the increased regulation that has occurred in the wake of the global financial crisis (GFC) helped prevent another crisis. She recognized that the regulation wasn’t perfect, however, and that some aspects of the Volcker rule – intended to stop the type of speculative banking activity that contributed to the GFC – could be changed in order to improve liquidity. She also admitted that there is room for deregulation of smaller banks, recognizing that there is unnecessary complexity in their regulation. However, she cautioned against any broad rollback of regulation: “Any adjustments to the regulatory framework should be modest and preserve the increase in resilience at large dealers and banks associated with the reforms put in place in recent years.”
Draghi’s speech: Promoting productivity
In his comments at Jackson Hole, Mr. Draghi noted that the global economic recovery is accelerating, but that Europe and Japan are in the early stages of their recovery – suggesting they need continued monetary policy accommodation. I would argue that his speech was far more important than Ms. Yellen’s in that he tackled the difficult topics of demographics and productivity.
Mr. Draghi warned that the cyclical recovery that many countries are now enjoying could deteriorate without stronger potential growth. And stronger potential growth requires either higher population growth or greater productivity. Since demographics are not working in developed countries’ favour, Mr. Draghi made it clear that “the burden of raising potential growth must fall on productivity.” He believes this can be encouraged in a variety of ways from a policy standpoint – supporting competition, research and development, and especially free trade.
In short, Mr. Draghi made an impassioned – and timely – plea against protectionism, just as both the North American Free Trade Agreement and Brexit negotiations are underway. Understandably, free trade and globalization are currently under attack in a variety of areas around the world as industries and employment opportunities have changed over time. In particular, some countries are lamenting the loss of jobs in certain industries such as manufacturing. That Mr. Draghi focused his comments on free trade suggests to me how concerned he is about the deglobalization movement and its potential negative impact – and with good reason, given that protectionism exacerbated the Great Depression of the 1930s. The question is whether nations will take heed.
Fitch expresses concern over U.S. debt ceiling
In other news, debt ratings agency Fitch Ratings gave a rating warning for the U.S. as concerns grew that the country will not be able to raise its debt ceiling in a timely fashion. Fitch expressed its concern that if the debt limit is not raised with adequate time before the U.S. runs out of available money, it would review the country’s debt rating, suggesting “potentially negative implications.” Fitch added that prioritizing debt payments is unlikely to be enough to protect its rating: “We have previously said that prioritizing debt service payments over other obligations if the limit is not raised – if legally and technically feasible – may not be compatible with ‘AAA’ status.”
Recall that in the summer of 2011, Standard & Poor’s not only gave the same warning, but in fact lowered the U.S.’ rating from AAA to AA after Congress’ deadline came and went – but also after it had approved the lifting of the debt ceiling. Fitch’s warning is a red flag; it is clearly worried that Congress will not lift the ceiling in time. And it’s a reminder that a similar scenario – a stock market sell-off – could result if Congress is unable to lift the debt ceiling in a timely fashion. We will want to follow this situation closely as Congress prepares to return from its summer break.
U.K. reports sluggish economic growth
Finally, we learned last week that the United Kingdom’s economy grew at a tepid 0.3% pace in the second quarter – half that of the eurozone. Weakness came from business investment and household spending. This suggests that economic policy uncertainty is stifling both business and consumer spending – which is not surprising, given that historically there has been a negative correlation between economic policy uncertainty and business investment.
And the recent release of the U.K.’s Brexit position papers does not seem to have allayed any concerns over uncertainty. The customs paper could be described as “aspirational.” In particular, the U.K.’s expectation of maintaining the same trade relationship with the EU through a transition period seems unrealistic, especially as the U.K. would like to utilize the transition period to negotiate trade deals with other countries. Because Article 50 was invoked in March, the U.K. has only two years to negotiate this complicated exit as well as its future relationship with the EU – and therefore runs the risk of falling off a cliff with no post-Brexit arrangement in place.
Key takeaways for investors
As you may recall, one of the key themes I have underscored this year is disruption – and geopolitical risk can of course lead to disruption. And disruption can create volatility and place pressure on asset prices. I believe investors should consider an adequate allocation to alternative investment strategies that have the ability to take short positions, which can profit from a fall in an asset’s value. These strategies can potentially deliver positive returns in falling markets, which means they could help offset losses incurred by other assets in an investor’s portfolio. In particular, a market neutral strategy may help with this objective. In addition, several types of alternatives – such as those that invest in currencies, commodities and real estate – have historically had low correlation to traditional stocks and bonds, giving them the potential to help lower overall portfolio volatility as measured by standard deviation.