Being a journalist forces you to be fairly cynical about big trends, especially when it comes to investment. I’ve always assumed that fundamentally most clever ideas work until someone writes about them – at which point they start to fade in value. But every once in a while, even I have to stick to my proverbial guns and fight for one big macro idea which I think makes sense of the world as we find it – in this case, that interest rates can’t rise too much over the long term. In effect, I am a paid-up member of the New Interest Normal brigade – also called by Pimco The New Neutral. Why? It strikes me as just plain common sense that although interest rates will rise in the short term, probably back to around 3.5% in the US, they’ll average much lower rates over the long term i.e the next few decades. My guess is that we’ll see an oscillation around 0 to 4% with 2% being a very rough long term average, although in time weighted terms I think that average will probably be closer to 1%.
Why am I so confident? Debt. There’s just too much of it sitting on peoples/corporates/governments balance sheets. We seem to have tripped into a default system which forces capital recycling at a global level via bonds. It’s an easy to trade, liquid system which allows great pools of excess capital to be moved around the planet with ease. The proviso, of course, is that the borrower pays back the money at some stage.
The other driver for long term low rates is demographic. The developed world is mostly aging fast, with seismic implications for growth and savings. This demographic trend works its way through into the real economy via numerous channels:
- Slower population growth weakens labor force growth and in turn potential;
- a shrinking population lowers economy-wide investment in capital, weakening growth potential; higher life expectancy raises people’s ex-ante desire to save.
So, although it is obvious that the US Federal Reserve will win the prize for getting back to 3.5% first, it’ll probably by then be staring into a new slowdown and worries about financial Armageddon. At which point it’ll slam on the brakes and effect a handbrake reverse and start cutting rates.
None of what I say is terribly original, of course, Many fixed-income investors have been making the argument for years, notably, Pimco and it’s New Neutral thesis. Last week they updated their investors on this scenario via a note by Nicola Mai.
The chief focus of this update from Pimco is on those global debt levels. Has anything changed? Yes, of course – it’s got much, much worse.
Pimco has reviewed data from the Bank for International Settlements (BIS). The BIS compiles data on a quarterly basis for more than 40 different economies, ensuring consistency in the approach for measuring debt across countries. Pimco focuses on the total level of debt in the nonfinancial sector (comprising households, nonfinancial corporates and government) and the level of private nonfinancial debt (comprising households and nonfinancial corporates), both measured as a share of GDP. The results are summed up in the chart below.
“ Total nonfinancial debt has kept rising globally in recent years, from just over 200% of global GDP in the years preceding 2008 to over 240% currently. Debt increased across both developed market (DM) and emerging market (EM) economies, with the increase across EM countries proving particularly steep: from around 120% of GDP in 2008 to around 190% currently. The key driver of the rise in EM debt has been China, where total debt rose by a staggering 110 percentage points of GDP, from around 150% in 2008 to nearly 260% today. Across DM countries, debt has been rising across most major economic areas (eurozone, Japan, U.K.), and has been broadly stable at a high level in the U.S.
“Private nonfinancial debt (Figures 3 and 4), an important aggregate when it comes to monetary policy transmission, has also risen globally at the margin, from around 140% of GDP in 2008 to nearly 160% currently. Private debt is rising steeply in EM countries (with China leading the way). Within the DM complex, private debt has been reduced in the U.S. and U.K. and remained largely stable at a high level across the eurozone and Japan.”
“Overall, not only has the debt overhang from the credit expansion in the run-up to the financial crisis not been corrected, but it has arguably gotten worse. This is not to say that there haven’t been pockets of improvement: There has been meaningful deleveraging in the U.S. household sector, and progress in deleveraging across the private nonfinancial sector in the U.K. and in parts of the eurozone. But debt overall (both total and private) has continued to rise globally, with a particularly steep increase seen in EM countries.”
So, why do these high debt levels impact the wider economy? According to Pimco “High debt pushes down the neutral rate by increasing economic agents’ ex ante desire to save, given the focus on debt reduction; by raising the economy’s sensitivity to monetary policy and in particular to interest rate increases; and by tying the hands of central banks, which need to take debt sustainability into account when setting monetary policy.”
There is of course some good news. Most of this increased debt is affordable, especially in the developed world. Using BIS data again, Pimco reckons the biggest danger is in emerging markets – notably China, Hong Kong, Indonesia, Singapore, Mexico, Malaysia, Turkey and Thailand.
The Pimco analysts even try to work out what a sensible, ‘normal’ long term rate might be – using an equation which looks something like Δ debt = ( i − g ) x debt – pb.
They find “average nominal borrowing rates consistent with a stable government debt/GDP ratio are 1.7% in the U.S., 2.3% in the U.K., −0.7% in Japan, 5.5% in Germany, 1.3% in France, 3.2% in Italy and 2.2% in Spain (see Figure 8; these are average rates across existing maturities). When we translate these into nominal policy rates, central bank rates consistent with government debt stability are in the order of 1% in the U.S. and the U.K., −0.5% in Japan”.
The investment implications?
- At some point in the not too distant future bonds will be attractively priced because
- Long term bond rates will struggle to push much above 3.5% without pushing into macro economic headwinds
- Risky assets (such as equities) are also supported because low long term rates raises the net present value via a low long-term discount rate on cash flows. “This would suggest that valuations may be less stretched than they appear”.