Many are calling for monetary policy to pass the baton to fiscal stimulus going forward. Yet, given large outstanding debt loads globally, it is unclear how effective fiscal policy will be. Ricardian equivalence argues that the fiscal multiplier may be close to zero when economic actors perceive that increased government debts will need to be eventually paid for in the future.
When the Prescription is Fresh Air
As a result of central banks continuously trying to prop up economic growth since the financial crisis, bad economic news hasn’t meant bad news for asset prices. Financial gravity asserts that asset prices can only detach from fundamentals for so long however. After waiting for fundamentals to improve enough to catch up to valuations for years, this scenario now seems unlikely. With central banks reaching their limits, it is more likely that valuations will fall back to fundamentals.
While it is unclear what the exogenous shock may be that could send the global economy into recession, expect any such occurrence to be met with a punishing reaction in asset markets as investors realize that central banks no longer have their backs.
How should one position for this asymmetrically risk-weighted future probability of valuations dropping to fundamentals? Favor bendable and unbreakable assets in your portfolio composition and only slowly dollar-cost average into breakable assets as they re-price towards true economic fundamentals.
Brian J. Smith is senior vice president of U.S. fixed income at TCW.