Risk & return in a time of secular stagnation
Investor Insights - Monthly news for investment professionals 5 May 2016

There are very few periods in economic history that could not fairly be described as ‘challenging’. Even the best of times generally only reveals itself in retrospect. On the other hand, some times can also fairly be described as particularly challenging. We are living in one such time. The GFC and its wake has left the world at an economic crossroad. With all manner of increasingly unconventional policies tried by governments and regulators, the world is still sputtering at subpar growth levels. Some observers are beginning to suggest that this could be the new normal.

In this edition of Investor Insights, we review recent global economic history and some of the key policies that have been tried and discussed by regulators. Ultimately, we’re asking investors to consider what it could be like to live in a world of secular stagnation.

History of the last few months

The first few months of 2016 have delivered a very mixed bag for investors. Initially, sovereign yields in major countries moved towards historic lows, with spreads for other sovereigns and corporates widening dramatically. The underlying theme here, of course, was the move towards safety and away from risk.

As you’d expect, this theme resonated in share market valuations and currencies. The S&P/ASX200 dropped from 5,270 to 4,841 in the first fortnight of the year and the Australian dollar (long seen by traders as a ‘risk on’ exposure) dropped 5c from US73c to US68c.

However, from that point, and perhaps most strikingly from around the middle of February, world markets reset and recovered. Commodity prices began to rise and share prices recovered some ground (although they remain generally somewhat down on levels prevailing six to twelve months previously). Investment grade and emerging market sovereign spreads narrowed and emerging market and commodity exporting currencies like Australia appreciated.

In responding to these market gyrations, investors have to determine whether the volatility reflects genuine developments in the world economy, or the normal fluctuations that convey little of lasting importance. This sort of discernment is highly complex. Investors frequently look in vain for guidance from the commentariat, as the amusing screen shot below from the markets section of news.com.au shows.

Reserve Bank Governor Glenn Stevens addressed these developments at a global level in the United States in mid-April. He argued that – whilst it is impossible to be sure – it seems likely that the movements reflected softening in the emerging global outlook that was slightly overdone and therefore corrected in the weeks that followed. So what is causing markets so much concern?

Developments since the GFC

It is often underappreciated just how different the post GFC world is in comparison to what went before. Monetary policy has been the scene of the most dramatic actions by governments and regulators. In late 2008, central banks decreased official interest rates significantly. In many cases, such as Japan, Sweden, Denmark and Switzerland, these rates actually became negative. In other words, depositors (generally large institutions) were charged to keep their money in a central bank account. Since official rates are often a benchmark for all borrowing costs, these negative rates also spread to a range of fixed-income securities, like bonds. As at mid-March 2016, for example, investors in Japanese and German bonds received a negative yield out to around eight years (Germany) and 14 years (Japan) duration.

What’s more, when the interest rate lever was found to be insufficient to stimulate growth, some central banks (in US, Japan and the EU) undertook massive bond-buying programs. These programs were all designed to lower rates and encourage a ‘hunt for yield’ further out on the risk curve. By encouraging savers/investors to take more risk, the policy makers were seeking to stimulate economic activity.

The degree to which these policies were successful is debatable. In the US, business investment as a share of GDP had largely recovered by 2015 – but this may have occurred even without the accommodative monetary policy. In Japan, business investment has never recovered to the levels prevailing prior to the collapse of the bubble in the early 1990s.

What is clear is that these policies have had significant effects that are only just beginning to be discussed and explored. Two key effects included:

  • Effects on savers/investors: when interest rates are very low for a long time, assumptions embodied in retirement plans become questionable. How can target rates of return be achieved? This issue is made more complex when it is recalled that prevailing economic theory states that real (i.e. post inflation) interest rates should not be affected by monetary policy (low official cash rates) on a sustained basis. How can policy makers make sense of this?

  • Effects on growth: what are the prospects for sustained growth in the future? If the real economy can’t provide real returns on capital, nominal and real yields on bonds will remain low and growth rates will shift downwards on a long-term basis. In the light of recent experience and repeated downgrades on growth predictions, some commentators are once again talking of ‘secular stagnation’.

What is “secular stagnation”?

So what is ‘secular stagnation’? The phrase was first coined in the wake of the Great Depression by economist Alvin Hansen. Hansen argued that, with the key economic fruits of the industrial revolution already locked in and with lower rates of population growth, economic growth would be slower on a permanent basis.

This theory has obvious resonance in a world that is seeing the baby boomers move into retirement, birth rates decreasing rapidly and the remarkable technological advances that we witness daily apparently failing to move the productivity needle. Former Treasury Secretary, now Harvard Professor of Economics, Larry Summers, has been the foremost advocate for the view that secular stagnation is what the world of today is facing.

As the graphs that follow show, there is some solid grounding behind the secular stagnation thesis. The recovery from the GFC has most definitely not followed the expected trajectory and IMF global GDP forecasts have been consistently revised downwards.

In this context, Summers argues that monetary policy has lost its power to stimulate an economy. This is concerning, given that there is little doubt that slower population growth will have a significant negative effect on world economic growth going forward. Remember that Australia actually experienced a per capita recession during the GFC – it was population growth that saved us from tipping over into a technical recession. Remember that the global average number of births per woman has dropped from nearly 5 in 1960 to 2.5 today. Remember that global population growth has slowed from around 2% to around 1% - the lowest rate since the end of the World War II. China, the powerhouse of world economic growth for this millennium, has a fertility rate of just 1.5 (2.1 is replacement).

Now many argue that stabilisation in population numbers is right and necessary from a social and environmental perspective. Nevertheless, it cannot be denied that this will present significant challenges for economies and policy makers.

What is ‘Helicopter Money’?

If monetary policy has reached its limits, many are now arguing that governments should look to old-fashioned fiscal policy to stimulate growth. Into the breach steps ‘helicopter money’ – a series of monetary/fiscal stimulus measures taking their name from a thought experiment in an economic paper by economist Milton Friedman.

The essence of helicopter money is that money is transferred to individuals from the central bank. Australia has the distinction of being a flag bearer in this regard, with the stimulus package of 2009 fitting most definitions. In his US speech, however, Governor Stevens expressed doubts on the suitability of the policy. He argued that it would be a lot easier to start helicopter money than stop it. He also argued that there are many infrastructure projects offering positive returns that would generate a fiscal stimulus without the need for more radical actions.

What does all of this mean?

The ‘bottom line’ of all of this is that the world economy is in a serious and unprecedented position. Policy makers and economists are struggling to diagnose the problem, let alone agree on appropriate policy responses. The very fact that radical measures such as helicopter money are being debated shows that we are operating at the limits of conventional economic theory.

How can we respond?

As a nation, we have to prepare for what could well be an extended low growth global economy. On the other hand, amongst the world’s nations we are almost uniquely positioned to capitalise on some key international dynamics. As we’ve discussed in previous editions of Investor Insights Australia is perfectly positioned to be a part of, and benefit from, the Asian 21st century.

That does not mean that we can afford to relax. Serious thought needs to be given to how we would like our nation to look in fifty and one hundred years from now. Big picture thinking – not a strength of our political process in recent years – is a must. For example, what would Australia look like with a population of fifty or sixty million? Would that give us the critical mass to re-develop industries like manufacturing that have gone offshore in search of scale? Could this offset the demographic pressures that are leading to secular stagnation? What infrastructure would this require? How would we plan our cities? How would we respond to the demands that the additional population would place on natural resources and environment?

As investors, we need to factor in the possibility that returns will be permanently lower than the experience of the last 100 years tells us to expect. At an individual level, this will affect portfolio performance and – over time – retirement plans. At a macro level, government budgets will be affected both by declining revenues (from lower income growth) and expenditure pressures (from an ageing population). This will put pressures on pensions, welfare, medical budgets and the like.

In short, investors will be required to fend more for themselves and will find it more difficult to find required yield from conventional sources. The hunt for alternative sources of yield will be absolutely critical in this environment and, at La Trobe Financial, we remain absolutely convinced that property credit will be an increasingly important part of the solution for investors.

Missed our Market Update and Investor Briefing? watch it now by clicking on the link below.



Best regards,

Chris Andrews
Vice President,
Chief Investment Officer

     
view newsletter in a browser
     



The above awards and ratings were given to the Pooled Mortgage Option within the La Trobe Financial Credit Fund and may be viewed

La Trobe Financial Asset Management Limited ABN: 27 007 332 363 and AFSL No: 222213 is the issuer and manager of the La Trobe Australian Credit Fund. It is important for you to read the Product Disclosure Statement for the Fund before you make any investment decision. The PDS is available on our website www.latrobefinancial.com or by calling 1800 818 818. You should consider carefully whether or not investing in the Fund is appropriate for you.

- The rates of return from the Fund are not guaranteed and are determined by future revenue of the Fund and may be lower than expected. Investors risk losing some or all of their principal investment. The investment is not a bank deposit.
- Past performance is no guarantee of future performance.
- Withdrawal rights are subject to liquidity and may be delayed or suspended.
- The award and ratings were given to the Pooled Mortgages Option within the La Trobe Australian Credit Fund.
- Any rating is only one factor to be taken into account in deciding to invest.

1. Zenith's "recommended" rating indicates that it has high confidence in the manager meeting its objectives. The Zenith Investment Partners ("Zenith") ABN 60 332 047 314 rating referred to in this document is limited to "General Advice" (as defined by section 766B of Corporations Act 2001) and based solely on the assessment of the investment merits of the financial product on this basis. It is not a specific recommendation to purchase, sell or hold the relevant product(s), and Zenith advises that individual investors should seek their own independent financial advice before investing in this product. To view the relevant research information, please visit www.latrobefinancial.com The rating is subject to change without notice and Zenith has no obligation to update this document following publication. Zenith usually receives a fee for rating the fund manager and product against accepted criteria considered comprehensive and objective.
2. SQM Research - 4 stars to 4.25 stars - superior, suitable for inclusion on most Approved Product Lists. To view the relevant research information, please visit www.latrobefinancial.com This rating will not take into account your, or your clients' objectives, financial situation or needs. It is up to investors to consider whether specific financial products are suitable for your objectives, financial situation or needs. Research houses receive a fee from La Trobe Financial for rating the product.
3. Lipper Leaders Rating Total Return (Score – 5) Lipper Ratings for Total Return reflect funds’ historical return performance relative to peers. The ratings are subject to change every month. The highest 20% of funds in each peer group are named Lipper Leader or a score of 5 for Total Return. Lipper Leader ratings are not intended to predict future results and does not guarantee the accuracy of this information. More information is available at www.lipperweb.com. Thomson Reuters Copyright, All Rights Reserved.
4. Australia Ratings (AFSL 346138) makes every effort to ensure the reliability of the views and rankings expressed in its reports and those published on its websites. Australia Ratings research is based upon information known to it or which was obtained from sources it believed to be reliable and accurate at time of publication. However, like the markets, it is not perfect. This report is prepared for general information only, and as such, the specific needs, investment objectives or financial situation of any particular user have not been taken into consideration. Individuals should therefore discuss, with their financial planner or advisor, the merits of each rating for their own specific circumstances and realise that not all investments will be appropriate for all subscribers. To the extent permitted by law, Australia Ratings and its employees, agents and authorised representatives exclude all liability for any loss or damage (including indirect, special or consequential loss or damage) arising from the use of, or reliance on, any information within the report whether or not caused by any negligent act or omission. If the law prohibits the exclusion of such liability, Australia Ratings hereby limits its liability, to the extent permitted by law, to the resupply of the said information or the cost of the said resupply.
La Trobe Financial is one of Australia's leading independent credit specialist Fund Managers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Credit Funds under AFSL 222213. It employs over 150 staff and has managed over AUD$10 Billion covering over 100,000 investment grade assets since inception in 1952.

Copyright 2014 La Trobe Financial. All rights reserved. No portion of this may be reproduced, copied, or in any way reused without written permission from La Trobe Financial.

La Trobe Financial Services Pty Limited - Australian Credit Licence Number: 392385
La Trobe Financial Asset Management Limited - Australian Credit Licence Number: 222213

This publication does not constitute financial advice and should not be relied upon as such. It is intended only to provide a summary and general overview on matters of interest and it is not intended to be comprehensive. You should seek your own financial or other professional advice before acting or relying on any of the content.
Terms & Conditions | Disclaimers | Privacy Policy