Why investors must beware of 'unforced errors' by central banks

Portfolio manager says outlook hinges on policymakers navigating mid-cycle transition

Why investors must beware of 'unforced errors' by central banks

Ask any fan or manager of a sports team and “unforced errors” destroy your chances. Breath-taking, well-coached attacking prowess can be negated by a lack of concentration in defence or by making the wrong decision. And so it is with central banks as we head into a new economic cycle.

With the worst of the economic downturn behind us, policymakers in developed countries face a heightened risk of missteps and wrong calls. They need to avoid providing excessive stimulus for too long, stoking inflationary pressures and financial instability, while also avoiding withdrawing stimulus too aggressively, slowing job creation and the recovery.

Todd Mattina, chief economist, portfolio manager, and team co-lead Mackenzie Multi-asset Strategies Team at Mackenzie Investments, said: “Strong growth with inflation expectations under control would be a constructive environment for risk assets, such as global stocks. However, the outlook hinges on policymakers avoiding ‘unforced errors’ in withdrawing pandemic-era support.”

He added: “As policy blunders would have negative impacts on asset prices, investors need to keep an eye on shifting macro policies in the mid-cycle transition.”

Mattina expects growth to moderate in this emerging mid-cycle phase from its unsustainable double-digit pace while long-term inflation expectations stabilize. The Bank of Canada, Bank of England, Reserve Bank of Australia, and the Reserve Bank of New Zealand have already started tapering, with the US Federal Reserve expected to start in the fourth quarter.

In this context, Mattina expects policy rate hikes beginning in 2022-23, barring a sharp economic slowdown due to the Delta variant. Investors expect this hiking cycle to be limited based on Eurodollar futures with US policy rates rising to about 1.5% over five years, supporting the recent decline in long-term bond yields.

Meanwhile, fiscal support has also moved beyond its peak pace of accommodation and may start subtracting from demand growth in coming quarters. This includes several major events and possibilities for slip-ups, including the phasing out of supplemental unemployment insurance benefits in the U.S.before they expire nationally in September. In Canada and the UK, job retention programs will expire early in the fall. Deferred tax and interest payments as well as moratoriums on evictions are also set to expire in some markets, setting the stage for increased pressure on cash flows and balance sheets.

Of course, these are offset by the US$2.5 trillion in excess savings accumulated over multiple lockdowns, allowing, in theory, for a smooth hand-off from declining fiscal support to higher consumer and business spending.

Mattina said: “Maintaining strong economic growth will be important not just to recover from the pandemic but also to ensure long-term debt sustainability. However, with the worst of the economic crisis likely behind us, fiscal policymakers may shift their focus toward reigning in unsustainable budget deficits.

“A key downside risk is a sharp decline in budget deficits without a full hand-off to sustainable private sector-led growth. We will be looking for growth-friendly fiscal adjustments that credibly delay deficit and debt reduction, supporting current demand conditions.”

Avoiding these unforced errors is, therefore, critical and Mattina said he is looking for several key characteristics from policymakers in a growth-friendly fiscal adjustment:

  • Implementing a medium-term policy framework over five years that anchors reductions in the budget deficit (or government spending) to a sustainable debt level
  • Avoiding cuts in public investment, especially in infrastructure, to support productivity growth.
  • Targeting program spending and tax deductions to achieve long-term efficiencies.
  • Reforming tax policies to focus on consumption and environmental impacts rather than income and savings.

He added that the multi-asset strategy team is overweight equities as stock markets are expected to continue outperforming in conditions of strong growth and stable long-term expected inflation. It also plans to continue being overweight in sovereign bonds to provide some sensitivity to downside risk scenarios, such as an unexpected decline in growth momentum due to new variants, policy blunders or other unexpected events.