Policy Agnosticism
“Wisdom is knowing what you don’t know.”
The macro narrative at time of writing seems focused on “no landing” vs. “soft landing” vs. “hard landing.” My view is the lagged effects of tightening will inevitably result in a “landing” of some sort. The economic cycle has not been cancelled. But how “hard” this landing ends up being will depend mostly on how quickly and aggressively global (especially US) policymakers (both monetary and fiscal) respond. When making Asset Allocation decisions, this seems to me the most important question to consider right now.
There is a risk of setting up a straw man at this point — but I think it is a fair observation that when I discuss this topic with other investors, they usually have a strong opinion on how policymakers will react when the next crisis occurs. Market commentators and sellers of investment products appear to have even stronger conviction, inevitably in alignment with whatever narrative or product is being sold. These strong views are often motivated by a meta-narrative of some kind that encourages belief in an inevitable “End Game.”
One perspective emphasises how over recent decades, each crisis led to a more extreme policy response than the previous one. Exponential credit expansion is required to both refinance the hangover from the previous intervention, as well as stimulate incremental economic activity. The Pavlovian conditioned belief that this will inevitably repeat is rationalised by a valid assumption that policymaker incentives are aligned with repeatedly kicking the can down the road — passing the (now worse) problem to their successors. Looking beyond the next sugar high, a longer-term “End Game” involving hyperinflation is often envisaged.
At the other extreme, there are those who interpret the exponential credit expansion as part of a cycle that cannot go on forever, and conclude it therefore must end. This perspective tends to assume policymakers are not as effective as the hype suggests, with monetary policy influencing credit cycles only indirectly via sentiment, while fiscal stimulus is slow and dependent on unpredictable political winds. Once the curtain has been lifted and sentiment turns, debt-deflation and depression is the inevitable “End Game.” Looking beyond the short-term pain, many who subscribe to this view hope for renewal via creative destruction.
These opposing perspectives appear to agree on initial conditions, but then construct polarised narratives that justify diametrically opposed “End Games.” Which is most convincing? My view is neither, and for the same reason. Consider a “policy decision tree” branching out into the future. To get to either of the “End Game” end-point scenarios, it is necessary for policymakers to keep making decisions that push in the same direction, despite increasingly strong negative feedback as they travel further along that path. When inflation is high, policymakers would have to maintain an accommodative stance. The recent episode of high inflation instead resulted in political pressure that led to tightening. When debt-deflation dynamics start to take hold, policymakers would have to keep tightening, or at least wait on the sidelines. As the pain of this scenario escalates, it is difficult to imagine policymakers resisting pressures to intervene.
Does this mean it is impossible that we get either hyperinflation or debt-deflation? Concluding that this is the case would suggest a lack of imagination, and we have seen both play out historically more than once in the past century. Fiscal authorities could respond to high inflation with stimulus to try to offset the impact of declining living standards. This brand of economic folly is historically associated with left-wing politics, but it is not inconceivable that right-wing populists might also follow this path. Meanwhile, if debt-deflation dynamics took hold too quickly, policy might be pushing on a string. And the growth of shadow banking since the GFC might place the epicentre of a crisis outside policy mandates and visibility. But being able to construct scenarios where extreme outcomes occur is not the same as them being likely, let alone inevitable. Most future paths turn back towards moderate scenarios due to the political economy of strong negative feedback.
This is not the same as saying that inflation, growth, debt, policy, and the overall economic and financial system will become more stable over time. Indeed, as imbalances have worsened due to can-kicking, the amplitude of swings in all of these appears to be increasing. This likely does increase the risk of “something breaking” at some point and the cycle breaking out in one or the other extreme direction. However, policymakers seem as likely to learn from recent experience by moderating their own reaction functions. This might then dampen the cycle and lead to less wild swings in both directions. Indeed, we might consider there are five outcomes: hyperinflation; debt-deflation; cycle continues; wilder-swings; and less wild swings.
The ideal outcome seems to be for policymakers to dampen the magnitude of these cycles by stepping in, but with significant restraint, during the next downturn. This would involve achieving a difficult balancing act of preventing outright debt-deflation dynamics while permitting the beneficial effects of an economic winter: creative destruction; reallocation of resources to more productive uses; and restructuring of excessive debt. It would be cynical to dismiss entirely the possibility that policymakers will act in accordance with what appears to be the “correct” answer. However, there are many reasons why they may fail to do so. Firstly, their incentives and political pressures. Secondly, ideology (in either direction). Thirdly, because a downturn is a confusing and frightening situation in which data is unreliable and usually outdated. Finally, the tools at the disposal of policymakers are mostly indirect, generally act with a long lag, and are difficult to size correctly. They will be shooting a cannon of unknown size, in the pitch black, at a moving target.
Taking all of this into account, I think it is a mistake to hold a strong view on what policymakers will do in the next downturn, and therefore what type of “landing” will occur. I can imagine many scenarios, which play out over varying lengths of time. Longer term, many future paths seem to involve oscillation between inflation fears on one hand, and debt-deflation fears on the other, with policymakers essentially reacting. I do not think it is possible to predict whether policy will become more restrained (dampening the cycle) or more extreme (increasing volatility). Adopting a worldview of “Policy Agnosticism” seems sensible to me.
What does this imply for Asset Allocation? Tactically, gradually lengthening Duration makes sense into the end of the cycle, subject to exposure limits consistent with uncertainty around how high interest rates can rise first. Reflexivity and Convexity make this an attractive short-term position. However, from a longer-term Strategy perspective, Policy Agnosticism makes deployment very challenging. Investments de-correlated with the broad credit cycle / liquidity seem most sensible — these will be the focus of my next blog post.
Disclaimer: The content in this blog post should not be taken as investment advice and does not constitute any offer or solicitation offering or recommending any investment product.