Policymakers and Businesses Confront Reality: Adapt or Die

Steven Malin | 17/11/2016
Policymakers and Businesses Confront Reality: Adapt or Die

Summary

With the Fed’s monetary policy growing less effective, perhaps it’s time for the Fed to reassess its targets. There’s a new industrial revolution underway, and governments and central banks that fail to adjust could further weaken real economic growth over the long run.

Key takeaways
  • Some Fed officials now believe that the central bank’s actions not only fall short of their targets, the targets themselves may be wrong.
  • To generate growth, the IMF advocates complementing accommodative monetary policies with fiscal stimulus and structural reforms, but experience in Japan suggests that this combination is not sufficient.
  • New financial regulations promise to provide market orderliness in crises, but they also create new financial risks and dampen capital spending by businesses.
  • Capital spending remains encumbered by unprecedented forces that go well beyond the influence of business decision makers.
  • Decision makers will adapt to opportunities and challenges presented by the “fourth industrial revolution” or else face sustained failure to meet the expectations of their stakeholders.

Questioning the efficacy of monetary policy

Some commentators, including several within the US Federal Reserve (Fed) itself, now assert that each incremental monetary-policy action has become less effective than the one before. Fed Vice Chairman Stanley Fischer concluded in August 2016 that “monetary policy is not well-equipped to address long-term issues like the slowdown in productivity growth.” As a partial remedy, the International Monetary Fund (IMF), among other official international organizations, calls for coordination of monetary, fiscal and structural policies among individual countries and regions. However, experience in Japan suggests that the combination proposed by the IMF will not be sufficient to elevate the economic growth path very much over the near term.

New financial regulations bring comfort and discomfort

New regulatory reforms improve the framework for money-market functioning during times of crisis. For example, new rules governing money market funds (MMFs), effective October 17, 2016, require, among other things, a floating net asset value for institutional MMFs to allow them to fluctuate with changes in the market value of fund assets. With the addition of liquidity fees and redemption gates, MMF boards will be able to impose fees and erect gates to halt runs during periods of stress.

Disruptive reactions to these new rules by market participants already have yielded unintended consequences that could impede economic resurgence. Some investors have shifted funds from riskier prime MMFs forced to abide by the new rules to safer, exempt government funds, putting downward pressure on the long end of the Treasury yield curve. The London Interbank Offered Rate (LIBOR) and rates tied to it spiked upward, resulting in more than USD 2 trillion in additional annual interest costs. The new rules, atop other regulations, have reduced the supply of credit to businesses while also making potential business borrowers more reluctant to invest in fixed capital.

Adapt to the fourth industrial revolution

If economic resurgence takes hold, cash-rich companies will look to capital investment to offset higher unit labour costs and protect their longer-run profit margins. Regardless, the development, marketing and implementation of new technologies continue to radically reshape the organization of businesses, business-location decisions, infrastructure needs, the demand for and supply of labour, the physical structure of work places, and the demand for resources.

For businesses, the failure to rethink and redirect business strategy, investment, governance and organization will result in lost competitiveness and opportunities to enhance profits. For governments and central banks, failure to adjust economic policies and regulations will further weaken real economic growth and productivity over the long run. Inertia will encourage a further shift of output and incomes to emerging-market countries and the most forward-looking developed countries.

For investors, as the fourth industrial revolution proceeds, substantial new opportunities will open up in companies that will become the industrial leaders of the next generation. As the head of the investment committee of an internationally-known, California-based technology giant told Allianz Global Investors last year, “We are always one innovation by a startup company away from being knocked out of business.”

Over the decade ahead, technological breakthroughs will open the door to even more advanced technologies. Technologies and their interfaces will be fused across physical, digital and biological domains in:

  • smart and connected machines and systems;
  • quasi-artificial intelligence;
  • quantum computing;
  • system robots;
  • gene splicing and genomics;
  • nanotechnologies;
  • virtual reality; and
  • machine learning.

Existing companies will be forced to change their business models, just as traditional car companies have adapted to autonomous vehicles and brick-and-mortar retailers have turned mobile phones into shopping carts. Fusion of technologies also will help lead to environmental and infrastructure solutions.

Governments and central banks that fail to master the implications of this industrial revolution not only will miss their targets, they will set the wrong targets. Businesses that fail to adapt will jeopardize their long-run viability.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association]; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

© 2016 Allianz Global Investors. All rights reserved.

Expert-Image

Steven Malin

Investment Strategist, US Capital Markets Research & Strategy
Steven Malin is an investment strategist and a director with Allianz Global Investors, which he joined in 2013. As a member of the US Capital Markets Research & Strategy team, he is responsible for making weekly US and global asset-allocation recommendations. Steven’s responsibilities also include analyzing global economic, financial, political and regulatory developments; and briefing institutional, retail and retirement clients. Before joining the firm, he was the director of research at Wealthstream Advisors, a private wealth management firm; and an advisor to Aronson Johnson & Ortiz, a quant-based institutional equity manager. Earlier, Steven was a senior portfolio manager at AllianceBernstein, serving institutional, sub-advisory, Taft-Hartley and private clients throughout North America. He also worked at the Federal Reserve Bank of New York for more than 16 years, and during this time he was an officer who held several senior position. Before that, he was the senior economist, founder and director of the regional economics center at The Conference Board. Steven has a B.A. in economics from Queens College and a Ph.D. in economics from the Graduate Center of the City University of New York.

Europe’s Big Banks: Well-Capitalized, But Not Profitable

18/11/2016
Europe’s Big Banks: Well-Capitalized, But Not Profitable

Summary

The European banking sector has come a long way since the 2008 crisis, largely thanks to the ECB. But restoring profitability will be a long-term effort, says Senior Credit Analyst Simon Outin, which could lead to a prolonged bout of heightened market instability.

Key takeaways

  • The sector’s issues mainly stem from decreasing revenues due to insufficient volumes and accelerating margin compression
  • The ECB has made large European banks better-capitalized and better-provisioned, but not more profitable
  • We expect market volatility to be the order of the day for the coming months – and possibly for years

The European banking sector is much stronger today than it was in 2008, at the beginning of the Great Financial Crisis. Indeed, since that time:

  • capital levels have more than doubled;
  • asset quality has materially improved;
  • new risk-averse management teams have restructured business activities; and
  • politicians have given regulatory and supervisory authorities more power than ever.

Still, something isn’t right in the European banking sector. For instance, returns on tangible equity are already below 10 per cent on an aggregate basis. In addition, market consensus points to lower and lower returns that are now in the 5 per cent area for full-year 2016. These issues mainly stem from decreasing revenues due to insufficient volumes and accelerating margin compression.

Yet restoring profitability is easier said than done. Cost-cutting is the most obvious answer in the current low-growth, low-interest-rate environment, yet the downside of cost-cutting may be greater than its upside. Consider the many banks that suffer from the use of costly legacy IT systems: Upgrading this infrastructure would require heavy investment and involve elevated operational risk. Banks could also reduce the number of employees, but that might prove controversial for systemically important banks in countries with high unemployment.

We doubt that the ECB in its supervisory capacity will materially help large European banks to improve their profitability. Rather, the ECB’s recent supervisory actions have focused on strengthening the banks’ capital positions and asset quality. As a result, large European banks are better-capitalized and better-provisioned, but they are not more profitable.

Unfortunately, this situation is hard to solve quickly and may in fact be here to stay, which could lead to heightened market instability. In fact, the EURO STOXX Banks (Price) Index has already lost close to 30 per cent of its year-to-date market value, and the index’s price-to-book ratio is now around 70 per cent. Similarly, banking debt has significantly underperformed when compared to other types of corporate debt.

As such, we expect market volatility to be the order of the day for the European banking sector for the coming months – and possibly for years – with no clear upward or downward direction overall. We also believe passive investment strategies are likely to miss opportunities linked to this volatile state. Active strategies, on the other hand – particularly those that rely on detailed fundamental analysis – may be better-suited to help investors navigate today’s tough environment for European banks.
 

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association]; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

© 2016 Allianz Global Investors. All rights reserved.

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