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 year 2016 has 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 8 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 include:
- 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.
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.