In the September issue, we look at how the ‘Nixon shock’ changed US monetary policy forever.
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The 15 August 2021 marked the 50-year anniversary of President Nixon taking the US off the “Gold Standard” - a monetary system whereby foreign central banks and governments could exchange their US dollar cash holdings into gold. By breaking the link with gold, commonly known as the “Nixon Shock”, the US could expand its money supply without being constrained by how much bullion was held in reserves. Essentially, this move to a pure fiat money-based regime made it easier to issue more debt to finance growth. President Nixon would not have known it at the time, but that momentous event enabled the US authorities to swiftly deliver unprecedented fiscal and monetary stimulus to support the economy during the pandemic nearly 50 years later. This has led to a very different business cycle from the past in two key ways.
First, the pandemic-led recession was brief. The National Bureau of Economic Research, the arbiter of timing business cycles, recently reported that the downturn lasted just two months (between March and April 2020), the shortest US recession from data that goes back to 1854. To put that in context, the previous recession that started during the Global Financial Crisis (GFC) in 2008 lasted 18 months.
Second, the nature of the crisis was more akin to a natural disaster, rather than a ‘normal’ recession that was driven by Fed tightening and/or over-leverage that takes time to unwind. By opening up the economy from lockdowns, stimulus-boosted output growth recovered quickly: US real GDP grew 12.2% from a year ago in the second quarter, the fastest growth rate for over 70 years at least1.
Given the success of the vaccine rollout in the developed world, it appears that the impact on the broad global economy from this short, sharp recession has not led to persistent macro weakness. On the contrary, there has been a strong recovery in investment, limited bankruptcies/stress in credit markets and no significant rise in long-term unemployment. As such, the IMF left its latest July 2021 global GDP growth projection unchanged at 6.0% from its forecast in April, though revised up its 2022 estimate to 4.9% from 4.4%.
The fiat currency regime has shown that policy makers have the flexibility to smooth financial stress by flooding the monetary system with liquidity using Quantitative Easing (QE or central bank asset purchases). For markets, this policy support, and the relief that there has not been structural economic damage, has lifted global stocks. The US S&P 500 equity benchmark index has now doubled from its low point in March 2020 in what is the quickest bull market doubling from a trough since World War II.2
Nursing a stimulus hangover in 2022
The downside from an unprecedented $10tn expansion in G4 central bank assets since the pandemic began is that financial markets have become increasingly addicted to the wave of liquidity flows it creates. Goldman Sachs, an investment bank, estimates that 2021 net inflows into global equity mutual funds and Exchange Traded Funds are currently running higher than the previous 25 years combined!3 A key uncertainty is how markets will behave when central banks begin to taper their asset purchases. There are growing expectations that the Fed will taper its QE programme in the latest July FOMC minutes, potentially at the start of 2022.
Moreover, ample liquidity pumped into the financial system by central banks is leading to potentially speculative froth in house prices globally. According to data covering 25 major country residential markets compiled by the Dallas Fed, first quarter real house prices rose 6% from a year ago, the biggest increase from 45 years of data, and have now exceeded their previous peak of 5.5% in the second quarter of 2005. The risk for the global economy is that residential prices collapse from elevated levels and this leads to a downturn in global growth, like the housing bust during the GFC.
Another hangover for markets is the drag on growth from lapsing fiscal stimulus, such as expiring emergency enhanced unemployment benefits and business loans and grants. Notwithstanding additional spending from the expected US infrastructure and social agenda bills to be spent over several years, Congress is not set to offer more pandemic relief to the economy. Under current law, less money will be spent by the government in 2022 compared to the large amounts of stimulus in 2020 and 2021. The non-profit Brookings Institution estimates that fiscal spending will be a drag of 2.3% on real GDP growth by the end of 2022 and needs to be offset by increased private demand.
For now, equity investors may be complacent about some of the future market risks, and valuations have been bid up. The global price to earnings ratio is trading on 18.3x, at the high end of its historical range, and is up from a pre-pandemic peak of 17.0x4. On balance though, given the relative visibility of the economic recovery and a Fed that is willing to be patient to remove policy accommodation, equities still have room to rally.
However, as the day approaches for the Fed to taper, it would be reasonable to expect more market volatility to price in rising macro risks in 2022.
1,2,4 Refinitv/Smith & Williamson, data as at 1 September 2021
3 Data Driven Investor, “Money is flowing into stocks at record-breaking pace”, data as at 16 August 2021
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.