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The end of monetary magic?

Refine for robustness and sustainable income
Letter to Investors

The end of monetary magic?

Christian Nolting
Global CIO

More than a decade ago, central banks embarked on a highly unconventional monetary policy path – generally referred to as “quantitative easing”. This made possible the longest recorded U.S. economic upswing in history along with a strong rise in asset prices. But can this monetary “magic” continue to work?

As we move into a new decade, the power of additional monetary policy easing appears to be fading, but a replacement has yet to be found. The growing assumption is that other forms of policy will be needed to keep the global economy on an even keel. But policymakers are far from agreeing on what exactly these new policy approaches might be, let alone how to implement them.

So, whether we like it or not, central bank “magic” will continue to play an enormous role in both economic policy and markets. Recent debate around the Fed’s involvement in quasi-QE (as evidenced by its growing balance sheet) and the ECB’s restarting of monthly purchases underline the fact that monetary magic is still a subject for debate.

Investors should therefore accept that, although monetary magic may be fading, we will be living with its effects, and searching for a replacement, for some time yet. This is the premise of our annual outlook for 2020 and we use six investment themes to explore the implications of this. Such an environment will remind us of the importance of strategic asset allocation (SAA) and the robustness it provides to the investment process.

  • 01
    In our first theme, “Policy pressures need prudent response”, we therefore start by looking at the state of the global economy, with signs of a growth slowdown amplified by trade tensions, political concerns and other issues. With monetary policy presumed to be reaching its limits in terms of effectiveness, calls for more fiscal spending will become more vocal, but don’t expect a massive fiscal boost. From an investor’s point of view, this is an environment that will require a robust investment approach, an ability to focus on long-term returns and a willingness to consider alternative investment approaches.
  • 02
    With central banks maintaining a very accommodative monetary policy for a lack of any alternatives, as noted above, low or negative yields should remain a reality. Hence our second theme, “Living with a low yields world”. Investors should not assume that they can simply sit this out, and wait for higher yields – a considered response is necessary. In particular, you need to be sure about the reasons you are holding non-yielding bonds, and remember that risk-diversifiers are not necessarily income providers. This is an area where you may also need to consider how to capture returns from illiquidity premia in private markets for equity and debt.
  • 03
    Within fixed income, getting a positive absolute return will require risk, with the notable exception of U.S. Treasuries – and even these will struggle to deliver positive real returns. The task therefore is to “Find new income harbours”, our third theme for 2020. Within the developed markets, looking beyond U.S. Treasuries and into the corporate space, U.S. investment grade (IG) and the European crossover segment (the borderlands between IG and high yield) are possible investment destinations. More promising might be the corporate space in emerging markets (EM), as well as sovereign holdings here, with a preference for hard currency.
  • 04
    Equities will remain a key part of most portfolios, and we see scope for further gains here too – but with the risk of further volatility attached. From the start of 2020, we think that both regional and “style” preferences could change. As our fourth investment theme, “Balance your style”, this may be the point where some high-quality “value” stocks start to offer real opportunities as “value” stocks start to catch up with their “growth” peers – which have previously outperformed them. We would look for defensive "value" and predictable cash flow. At a sectoral level, we also see opportunities in global industrials.
  • 05
    FX considerations also play an important role in portfolios. Here, the question remains whether exchange rates are driven by geopolitical and political factors or by differences between central banks’ monetary policies and other fundamentals. “Politics tops policy”, our fifth theme for 2020, suggests that the former could win out in 2020. Pressures for intervention (in various forms) to reduce the value of the USD will continue, with the JPY’s role as a diversifier still very relevant. Slowing global growth may argue against commodities overall, but there will be some opportunities, for example around gold.
    Monetary magic is not over yet – but cannot do the trick alone. This environment will remind us of the importance of strategic asset allocation for portfolio robustness
  • 06
    We continue to think that there is an important place for investing into long-term themes within an investment portfolio that will shape and steward the world of tomorrow. Our two new themes for 2020 include a look at areas benefiting from 5G and the implications of faster communications for industrial productivity and development. We look too at resource stewardship in a world increasingly concerned about urban refuse generation and recycling rates. The interaction between technology and sustainability remains key to dealing with demographic implications.

So what will 2020 bring? An evolving world, but not a completely different one. Central banks will remain centre stage, despite talk of the end of monetary magic: for an investor, this means that you need to reconcile yourself to living with low interest rates for some while longer and make sure that you have a robust investment process to capture the opportunities on offer. As regards investment returns, history suggests that years of sharp gains (as in 2019) are not usually followed by falls, but often instead by more modest growth - so 2020 should still be worth approaching in a positive spirit.

Christian Nolting
Global CIO
Instant Insights
2020 in a nutshell

  • Economic growth slowdown to be accompanied by changing policy pressures.
  • Low rates need a reassessment of bond holdings in portfolios.
  • Further equity gains but style and regional preferences will shift.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings here. Produced in December 2019.

Strategic asset allocation: our investment cornerstone

Any investment portfolio has to address the issue of asset allocation – the division of investment between asset classes. Studies suggest that strategic asset allocation accounts for the bulk (around 90%) of portfolio returns – we all know from experience that alternative sources of return, for example through security selection or timing the overall market, are more difficult to sustain. They are not an effective basis on their own for robust portfolio performance but do contribute to returns if managed in a prudent manner. But, given the investment uncertainties that every investor faces – and which have become more visible in recent years – how should one create an appropriate strategic asset allocation? The first step is to realize that there is no single optimum strategic asset allocation. Individual investors have different investment preferences. They are also starting from different places – with access to different sorts of investable assets and facing different challenges, for example around FX. The second step is to acknowledge that uncertainty needs to be part of the analysis. No one can predict the future with perfect certainty. Allocations should not be premised on a single (unlikely) outcome: instead, this is a question of likelihood.

Making a reasoned response to uncertainty

At an asset class level, three factors are relevant for asset allocation: expected returns, volatility (the degree of variation of asset prices) and correlations (the relationships between the prices of different assets). As noted above, we cannot predict these with absolute certainty. But, based on knowledge and history, we can start to estimate them. A summary of our long-term asset class returns, for example, is in the box below.

Figure 1: Selected future asset class return assumptions for the next 10 years (in local currencies)
Source: Deutsche Bank Wealth Management. Data as of December 2, 2019. Returns are % p.a.
U.S. Treasuries, 7-10 year
(Bloomberg Barclays U.S. Treasuries)
German Bunds, 7-10 year
(Bloomberg Barclays German Treasury)
Emerging markets hard currency sovereign
(Bloomberg Barclays EM USD Sovereign)
U.S. equities
(S&P 500)
European equities
(MSCI Europe)
Emerging Markets equities
(MSCI Emerging Markets)

The key is to know where we can be reasonably confident, and the areas where our predictions may be less secure. In short, we must understand the nature of uncertainty and include it in the investment process. This will allow us to build a strategic asset allocation. As noted above, strategic asset allocation is likely to account for the bulk of a portfolio’s returns. But it is possible to take the process further in two ways. First, through tactical asset allocation that makes shorter-term deviations from the strategic asset allocations to benefit from market events. Second, for some portfolios, we can use a systematic hedging process to increase the proportion of potentially higher-yielding assets in a portfolio, while aiming to control risk. Again, this is a matter of recognising and understanding uncertainty and using it to our advantage. We cannot control the investment environment but we can try to understand its likely evolution and the implications.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings here. Produced in December 2019.

Theme 1

Policy pressures need prudent response

Slowing growth will add to economic policy challenges. Stay focused on strategic asset allocation.

Monetary policy still key but reaching its limits

There is still a reliance on monetary “magic” as economic slowdown worries have encouraged major central banks to loosen monetary policy again. However, many of the factors that are hurting economic performance are non-monetary in nature and thus beyond the scope of monetary policy to address or ameliorate. For sustainable growth, structured reforms, continued investment and many other factors are needed. Trade conflicts also cannot be resolved by central banks. Another continuing worry is that politicians and markets have become over-used to the ongoing support of the monetary magicians and will struggle, respectively, to implement and acclimatize to any alternative approaches. In addition, monetary easing channels already appear stretched and unlikely to work in the same way or as effectively as before: monetary policy may have decreasing marginal utility. Markets also face potential challenges from political developments – most obviously via the U.S. election, Brexit and stresses within the German ruling coalition – but other more structural trends will also be important, for example “deglobalization” (with the peak of global trade growth probably already behind us) and concerns around rising debt levels.

Figure 2: Diverging public debt trends – the U.S. and Germany
Source: Datastream, Deutsche Bank Wealth Management. As of December 1, 2019.
  • U.S.
  • Germany
Substantial fiscal boost unlikely

This will add to pressures for policy alternatives. Calls for fiscal stimulus, for example, will become more vocal in 2020 but the impact of existing U.S. fiscal stimulus is fading and no big change in Eurozone fiscal policy is likely, despite obviously divergent trends between the two regions (Figure 2). And while we may get some gentle easing in Eurozone fiscal policy (Figure 3), we don’t envisage a massive fiscal boost. The angling of policy towards immediate stimulus could also mean that structural reforms take a back seat in many countries – although we expect Chinese policy development to combine the two. A sense of continued policy uncertainty, combined with growth fears, high valuations for equities and lacklustre earnings growth will tend to boost volatility. But it remains important that investors keep a clear view of long-term priorities while engaging in active management and attempting to capture tactical opportunities.

Figure 3: Mild Eurozone positive fiscal impulse* expected
Source: European Commission, Deutsche Bank Wealth Management. Data as of December 1, 2019.
* The fiscal impulse refers to the change in the size of a budget deficit/surplus, rather than its absolute amount.