Running Out of Ammo

What’s in store for 2020? In our view, with monetary policy makers out of ammunition, we may just get government-funded euphoria until the lights go out.

This year’s rally has been driven by six ‘puts’, in our view. All show how far policymakers could go to avoid disruption. None are a solution.

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Before the bull market dies, the conditions are ripe for a late-market surge.

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While trade wars have been the story of the last few months, we believe that the tail risks – rather than either the US or China – lies in Europe, particularly within the banking sector.

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Our key reflection of 2019 has been an analysis of the 'Six Puts' that we felt were supporting markets around the world. After a troubled 2018 fourth quarter, it felt like there were existential threats to the stability of markets, the Federal Reserve’s rate hikes being most important. These threats were contained in the short term by our puts, which reassured markets and allowed the conditions for the equity revival we are now in the midst of. In fact, around this time last year, the watchwords on the Man Group trading floor were “bad news is good news”; in other words, the worse things got, the more likely policymakers would be to step in with rate cuts and create a short-term bounce.

In our view, these puts have been successful. 2019 has been a Goldilocks market: the breathing space won by the puts has created a short-term rally in equities, but has failed to solve the underlying problems the puts were designed to mask.


A Recap on Our Puts

The first put that we identified was the Powell Put. When markets stumbled in 2018, the Federal Reserve rode to the rescue, suspending its program of interest-rate hikes, reversing course to initiate a programme of rate cuts. This has arguably had the desired effect – the S&P 500 Index has rallied since 24 December 2018. We note that the rise has almost entirely been due to multiple expansion: while the index itself is up 37% between 24 December 2018 and 3 January 2020, earnings per share have only grown 1.32% over the same period (Figure 1 and 2).


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Source: Bloomberg; as of 3 January 2020.

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Source: Bloomberg; as of 3 January 2020.

However, there is a limit to how much further the Powell Put can be relied upon: markets are pricing in no further rate cuts in 2020 (Figure 3). Every four years, the independent Fed faces a challenge – how to manage the economy without appearing to favour a party’s presidential candidate. This year, this is truer than ever. As such, we believe the Fed would only cut rates in the months before an election if drastic circumstances require it.

Additionally, while it would be correct to identify that by engaging in repo operations, the Fed is already engaging in some form of quantitative easing, in our view, a return to full-scale bond purchasing seems unlikely without a large deterioration of the underlying economic situation. This situation leaves the Powell Put stuck. On the one hand, the Fed does still have the option of restarting full QE and cutting rates, but would only do so if there was a marked deterioration – which would in itself be bad for the equity markets. Powell’s cavalry will not be riding over the hill in the near future, which, in our view, means that this rally may not have much further to go.

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Source: Bloomberg; as of 6 January 2020.

Another of our puts concerned the Italian budget. Again, the put was in reaction to market fears rooted in late 2018, when the disagreement over the Italian budget caused the spread between BTPs and bunds to reach a high of 326 basis points on 20 November.1 The put we identified was the conciliatory reaction of the EU, which declined to aggressively enforce the deal it struck with the Italian government regarding its budget deficit.2 Indeed, the Italian budget deficit, the weakness of European economies (such as Germany, which avoided recession by the skin of its teeth in the third quarter of 2019) and the systemic risk that Italy’s indebtedness still poses to the European banking system are still causes for concern.

Instead, what is in the process of changing is the attitude of the European Central Bank towards accommodative monetary policy. In our previous commentary, we detailed how the October meeting of the ECB’s Monetary Policy Committee saw a revolt of French, German, Austrian and Dutch representatives against Mario Draghi’s policy of renewed QE. As we have previously posited, Christine Lagarde may take a much conciliatory line towards the hawks than Draghi when it comes to resolving the committee disputes. The Italian budget put worked because it was an extension of a consistent EU policy lasting nearly a decade: “whatever it takes” to keep it all together. However, by itself, we believe the put solves nothing; it does not resolve the weakness of the regional economy, nor magically reduce the enormous pile of debt accumulated by Club Med members.

We should acknowledge that both Draghi and Lagarde have pushed for fiscal policy to pick up some of the slack.3,4 They may well get their wish after the German Finance Minister and Leader of Social Democratic Party (‘SPD’), Olaf Scholz, lost a leadership challenge. The new incumbents, Norbert Walter-Borjans and Saskia Esken, have campaigned on a campaign of increased public spending, infrastructure investment and a higher minimum wage, whilst arguing that the ‘Black Zero’ debt policy should no longer be sacrosanct.5,6 It is likely that Christian Democratic Union of Germany (‘CDU’) will concede to at least some of these demands as the price of maintaining the current ruling coalition.

This leaves the ECB with a problem: if fiscal spending is replicated across the continent, the trajectory of government debt loads will trigger increasing bond market volatility. In our view, investors will demand compensation for the increased risk of lending to sovereigns - interest rates will have to rise.

It is worth analysing this conundrum through the lens of Ben Bernanke’s ‘Helicopter Money’ speech7, in which Bernanke sketched out a scenario where monetary policy failed to address deflation. The steps after conventional monetary policy were: unconventional monetary policy such as QE, then expanding fiscal policy, and if this failed, further expansion to the point of Milton Friedman’s concept of helicopter money. With central bankers calling for expansion of fiscal policy, we are clearly some way down Bernanke’s timeline, one in which the risks grow larger with each step. One interesting point to note is the reference made by Lagarde to the potential for purchasing green bond as part of a future programme of QE.8 In our view, this raises the spectre of Modern Monetary Theory (‘MMT’), defined as the use of massive government purchasing as a way of controlling demand, and by extension, the money supply. It is not impossible to imagine a scenario where green bonds are used to bring in MMT by the backdoor: large-scale purchasing of green bonds backed by large-scale infrastructure construction could be one way of carrying out MMT without deviating from central banks’ mandate.

Related to our Italian budget put was the ‘Icarus’ put – French President Emmanuel Macron’s doomed attempt to defy recent history and reduce the share of the French state’s spending in overall GDP. Like Jacques Chirac before him, Macron was forced to retreat, in this instance as a wave of protests from the gilets jaunes complained about his policy of increasing fuel duty at the same time as removing the impôt de solidarité sur la fortune, the wealth tax. Instead of reducing the scale of government spending, Macron not only offered EUR5 billion of tax cuts to low and middle income earners9 but also cancelled the proposed tax hikes, the full cost of which has been estimated to be as high as EUR25 billion.

Macron’s failure to rein in state spending is representative of a wider trend of centrist collapse across the continent.

Indeed, in the Spanish election of 10 November, the centre-right Citizens Party lost 47 seats, the far-right party Vox gained 28, and the anti-austerity Unitas Podemos was able to hold onto 35 seats, losing only seven (Figure 4). This was enough to leave the ruling Socialists as the largest party, and accentuate the trend of Spanish politics away from the centre and towards more extreme parties. Italy’s European elections reveal a similar trend, with the Lega Nord and the Five Star Movement gaining a plurality in 28 and 14 seats, respectively, out of a total of 73. Likewise, Germany saw the Greens, Die Linke (the heirs to the East German Communist party) and the far-right AFD pick up 37 of the 96 seats. If such trends continue, it is doubtful that the political ambition to tackle European budget deficits could be found. By this measure at least, Europe appears to be on a worrying path of political polarisation and populism.

Figure 4. Seats Won in 10 November Spanish election

Source: Interior Ministry, the Guardian; as of 10 November. 100% of votes counted, 52 of 52 provinces reporting results. Turnout: 69.87% (-5.87%).

Figure 5. Italian European Election Results

Source: Ministry of Interior; as of 26 May 2019.

To balance this pessimism, we note that German Finance Minister Olaf Scholz has signalled that Germany will end its opposition to a Eurozone banking union.10 Scholz proposed a common European insolvency framework, measures to tackle sovereign debt and non-performing loans and, most importantly, common European deposit insurance. If implemented, this would go some way to combatting some of the systemic risks within the European financial system. This directly addresses two of the major problems we have identified in the European banking system: it offers a route to recapitalisation for southern European banks and allows for excess capital in one section of the banking system to be moved to where it is needed most. This is not an unconditional offer however, as Scholz simultaneously demanded the adoption of common European corporate tax code, which is unlikely to be popular with tax havens such as the Republic of Ireland and Luxembourg.

Our Brexit put remains in effect. The UK’s General Election was effectively fought on a Brexit basis, with Prime Minister Boris Johnson campaigning with the slogan ‘Get Brexit Done’. Risk is not entirely off the table, since Johnson has successfully passed an EU Withdrawal Bill, due to take effect on 31 January, 2020. This leaves a year to negotiate a free-trade agreement with EU which, in our view, may be an impossible undertaking. Whilst the short timetable might be a successful negotiating tactic, we believe it is more likely that the UK signs a limited trade deal which only covers manufacturing, rather than both manufacturing and services.

Aside from Brexit, the UK election has echoed the trend across the continent for fiscal expansion. The Labour Party’s manifesto, for example, was truly staggering: promising to build 1 million new homes, create a GBP400 billion ‘national transformation fund’ to spend on infrastructure funded by borrowing, roll out free broadband to every home at the cost of GBP40 billion with an ongoing annual maintenance cost of GBP5 billion, and renationalise the rail network. This was costed at an extra GBP83 billion by the party11, which then promptly announced they would retrospectively pay an additional GBP58 billion in lost pension entitlements to the WASPI12 women. In comparison, the Conservatives looked frugal, offering a mere GBP2.9 billion of additional day-to-day spending.13 In our view, despite the Conservative victory, the Overton window in British politics has decisively shifted towards higher spending. As a consequence, the UK’s debt trajectory may steadily worsen.

The next put to analyse is what BCA Research termed the ‘socialist put’. How has the Chinese government’s stimulus package performed? Our answer is: not brilliantly. Figure 6 compares Bloomberg’s China Credit Impulse with the Li Keqiang index. The former measures the 12-month change in new credit as a percentage of GDP (i.e. if new credit represented 10% of GDP growth 12 months ago, and is now 12% of GDP growth, the credit impulse is 2 percentage points). The latter – created by the eponymous former Party Committee Secretary as a way of cutting through China’s notoriously dodgy economic statistics to measure growth – measures Chinese railway cargo volume, electricity consumption and loans disbursed by banks. Put simply, if the credit impulse is growing, the Li Keqiang is expected to grow with about a 3-month lag. Although the credit impulse has been growing throughout 2019, we have seen no corresponding growth in the Li Keqiang index. In our view, this implies that the socialist put is failing. It could well be that the Chinese economy is somewhat saturated with credit, and there may be little room to productively deploy capital.

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Source: Bloomberg; as of November 2019.

The final put in our series was the ‘trade deal’ put. We argued that US President Donald Trump’s need for political victories would override all other considerations in his negotiation of a trade deal with China. Our hypothesis was that the Trump administration would sign an incomplete, or poor, deal quickly, and then trumpet it as a great political victory. A ‘Phase One’ trade deal was announced on 13 December, intended to be signed on 15 January. The deal is fairly limited, and does not address major aspects of the dispute. It is likely, in our view, that the scope of the deal was affected greatly by Trump’s desire to combat weakness in the global economy before the 2020 Presidential election. This view is reinforced by poor economic data such as the fall in the US ISM Manufacturing PMI to 47.2, its lowest level since June 200914 (although services are holding up at 52.8). This whole sequence has highlighted to investors a worrying trend of de-globalisation, which may now be entrenched in the US. There is broad political consensus that combatting China is the correct path of American foreign policy: no Democrat candidate is suggesting that they would pursue a more conciliatory policy. With these negotiations failing to resolve the underlying issues between the two great powers, markets will have to adjust to a confrontational relationship from now on.


We enter 2020 with a great deal of momentum: central banks have kept to their mantra of easy monetary policy, to the point where we may see inflation above their 2% targets, which could provide even more fuel for risk assets.

However, it would be foolish to ignore the big warning signs that are flashing. Easy monetary policy is likely to make the withdrawal symptoms worse when interest rates are eventually tightened; and gold remains strong, which is historically unusual for a period of equity risk premium reduction. As we have previously written, this indicates that investors may not be placing all their faith in the current rally.

This cycle of fiscal expansion into debt burden will take time to play out. In the short term, we would expect the expansion to cause a short-term growth spike – after all, money will be borrowed and spent, which is why we argued in November that the coming six months will see the last euphoric burst of the cycle. In our view, the puts act as a placebo on markets: unable to tackle the underlying causes of moribund growth, the stimulus will nevertheless cause a short-term spike in earrings.

Our puts are in operation, but have not addressed the underlying problems they sought to contain. 2020 may be therefore bumpy: with monetary policy makers out of ammunition, we may just get government-funded euphoria until the lights go out.


1. Source: Bloomberg.
2. Italy was allowed to continue to run a national debt of 132% of GDP (in breach of the EU’s 60% target), in return for a reduction the overall target budget deficit from 2.4% to 2.04% of GDP. The Italian government’s growth assumptions were also reduced from 1.5% to 1.0%.
12. Women Against State Pension Inequality