Monetary Policies (MP) evolve over time

Just like how the Global Financial Crisis caused the shift from MP1 (modulating interest rates) to MP2 (quantitative easing), the COVID-19 shock catalysed the shift from MP2 to MP3. 

MP3, a term coined by Bridgewater Associates, is a coordinated monetary and fiscal response used when MP1 and MP2 have limited effectiveness. The central bank finances fiscal stimulus via “printing of money”, which is directed to spenders and specific groups in need to stimulate the economy. 

MP3 is more directed at spenders rather than investors and savers like in MP1 and MP2. It can also address inequality by redistributing wealth to where is most needed. Nevertheless, this fiscal policy element can make MP3 politically controversial and its effectiveness hinges on the quality of decision-making and ability to direct funds to the right areas by politicians. 

MP3 was used to tide through COVID-19

Reason #1 – MP3 overcomes the primary limitations of MP1 and MP2, proving to be more effective in the particular context of the COVID-19 shock. 

COVID-19 lockdowns caused significant loss of livelihoods and substantial reduction in expenditures, especially for less well-off households. MP3 demonstrates the greatest effectiveness in precisely channelling funds to support these groups via providing income replacement. Hence, stimulating demand and spending where was most needed.  

Reason #2 – MP3 was effectively the last remaining choice since both MP1 and MP2 were less viable.  

MP1 was less viable: Since the aftermath of the Global Financial Crisis in late 2009, market conditions were characterized by ultra-low interest rates to support the recovery of the economy. Interest rates were low and even negative, especially across the developed world (Figure 2). Therefore, this made MP1 (i.e., cutting interest rates) a less viable option since there was minimal headroom to continue cutting interest rates. 

MP2 was less viable: MP2 is limited by already low longer-term expected returns on assets. The unprecedented amount of asset purchases by central banks (Figure 3) has caused the effectiveness of MP2 to diminish over time. Risk premiums decline, asset prices are pushed up to levels that become challenging to elevate further, and the wealth effect weakens. For example, numerous QEs (QE1 during the 2008financial crisis, QE2 in Nov-20, QE3 in Sep-12, QE 4 aka QE infinity in Sep-19) in the US have made QE less effective. Additionally, some central banks, like the ECB, were already running low on bonds that they could buy back (Figure 3). Furthermore, to reiterate, MP2 also lacks significant effectiveness in channeling money and credit to those without financial assets and thus perpetuates a widening opportunity gap.

Case Study - Roosevelt in the 1930s

‍MP3 was also implemented in the US during the 1930s, where moves made by Roosevelt draw close parallels with Biden today. Both circumstances share many similarities (e.g., big wealth gaps, ~0% interest rates, significant printing of money, shift from republican to democratic leaning, etc.) and reinforces the rationale behind implementation of MP3 during COVID-19.

However, MP3 caused strong inflationary pressure…

MP3 is inherently inflationary: MP3 creates demand without concurrently generating supply. During COVID-19, MP3 compensated for income loss caused by extensive shutdowns but did not correspondingly address the production output that those incomes would have otherwise contributed to. 

Caused persistent inflation globally: Therefore, excess money competing for a limited supply of goods resulted in rapid inflation across the world from 2021. While signs of inflation were already present in early 2021, they were deemed transitory and only began to rise uncontrollably in late 2021 (Figure 4). 

Exacerbated by Russia-Ukraine war: Russia’s invasion of Ukraine in February 2022 marked the start of supply chain disruptions and subsequent imposition of sanctions. This further declined supply, contributing to elevated prices, especially for many essential commodities that Russia and Ukraine produce and export. In recent weeks, grain prices have risen considerably over concerns of possible shortages as Russia started blocking Ukraine’s export of grain through the Black Sea. 

…That led to rapid monetary tightening and waning investor confidence

End of easy money: Naturally, most of the world’s central banks turned hawkish and began aggressively hiking interest rates (Figure 5) to combat global inflation. For example, the Fed raised the Federal Funds Rate by more than 5 percentage points over 16 months, from 0.25% - 0.5% in March 2022 to 5.25% - 5.50% in July 2023. This tightening cycle has been the fastest in 4 decades (Figure 6) and signifies what Howard Marks refers to as a “sea change” – signifying the conclusion of an era of easy money, with little likelihood of base interest rates reverting to the 0-2% range as in the past. 

‍Bearish investor sentiments: With rising cost of capital and narrowing equity risk premium due to monetary tightening caused by the inflationary effects of MP3, investors have started exercising greater caution. Safer assets like money market funds and bonds saw huge inflows. Corporates started delaying M&A and listing plans since valuations are down and the cost of financing M&A is higher. While this caused short-term pain, especially in the equity markets, it also means that there is significant dry powder and idle cash awaiting deployment. Precedent cases have demonstrated that robust equity returns typically follow.

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MP3 also partly contributed to the recent US Banking Crisis 

MP3 caused a rise in deposits, pushing money into banks at record rates. Since private credit was insufficient to keep up with increased deposits, money was instead channeled into government bonds. 

However, the subsequent monetary tightening caused by MP3 resulted in significant losses, especially for banks with overexposure to long-term US treasury bonds. The alarming losses prompted concerns and initiated a bank run first at Silicon Valley Bank, subsequently creating a domino effect on other US regional banks. 

Adapting our investment strategies to fit a MP3 induced market environment is key

Knowing what the various monetary policies are and how they impact the markets is not enough. We also need to think about how to adapt our investments to fit the existing market conditions. To kickstart, we have 3 ideas below.

#1 Exposure to equities benefitting from inflation

A recurring trend in the last five instances of US inflation spikes (occurring in 1948, 1970, 1975, 1981 and 1991) is that affordable consumer products and services tend to generate significant value in relation to their 3-year IRR (Figure 7). In today’s context, alongside traditional discount retailers, exposure to technology companies enabling affordability for consumers could also generate substantial returns. Examples include e-commerce enablers (e.g., SCI), incentive platforms (e.g., ShopBack) and used car marketplaces (e.g., Carsome) 

#2 Using commodities as an inflation hedge

‍Commodity prices are leading indicators of inflation and are commonly used for inflation hedging. Unsurprisingly, commodities outperformed in 2022, when inflation was skyrocketing (Figure 8). Therefore, exposure to commodities in MP3 environments is advantageous.

#3 Changing risk-reward dynamics of bonds and REITs

‍Highly geared assets like REITs face significant headwinds in light of rising interest rates resulting from the inflationary effects of MP3. Higher interest expense translates to lower distribution per unit and narrows REITs yield spread. From a risk-to-reward perspective, safer assets like bonds, with rising yields may therefore be more attractive. Purchasing them at the height of the hiking cycle where bond prices are unlikely to fall would be ideal. 

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