A slightly more speculative observation today.
The price of many financial assets but notably bonds are buoyed by the New Normal interest rate thesis. This suggests that we live in a new era of permanently lower interest rates, powered by demography (excess savings), excessive debt and global capital imbalances. It’s a thesis I agree with.
One part of the New Normal school lays the blame for these permanently lower interest rates at the door of central banks. But as I mentioned last week in my report from the Amundi World Investment Forum, Ken Rogoff, the US economist, offered an alternative suggestion.
He thought that real global interest rates were low because of secular drivers and that central banks were simply playing catch up – the key driver being low productivity rates. Thus if central banks did aggressively raise rates they’d simply kill any economic growth stone dead. On a side note, I’d also observe that if the US Federal got really aggressive in terms of rates they’d also have President Trump on their backs – no respecter of institutional norms. In a panel after the Amundi event exclusively for the press, all the US-based economists – Stieglitz, Rogoff and Roubini – agreed that the Fed was likely to be the next target of a swamp draining populist US president.
Anyway, the consensus in the financial markets is for lower rates, longer. US rates almost certainly will rise over the next 18 months but they are unlikely to go much above 3.5% at which point they’d head straight back to zero again. As for the ECB and BoE – well, they are so far behind the curve they’ll never get anywhere close to 3.5% before the next recession.
These low rates support both bond and equity valuations – bonds most obviously but equities also via the dividend and risk-free rate transmission mechanism.
So, what could possibly go wrong with this scenario? Hard money hawks think surging inflation will sink this consensus but I’m not so sure. Sure, inflation rates have gone up a bit but not by anywhere near what we expect – with energy as the obvious exception. Crucially the other key transmission mechanism – increasing wage rates – has seemingly broken down after decades of anti-union crusading and deindustrialisation.
Rogoff offers a novel headwind in the shape of surging productivity growth rates. Like many, he concedes that technology hasn’t helped push productivity rates much higher in recent decades, largely because the advances in the internet don’t seem to have produced huge game changes for corporates. Advances yes, but no enormous revolution. This relative lack of change via technology has possibly contributed to low productivity growth rates.
But Rogoff thinks big changes are coming down the line courtesy of AI, big data and automation. I sense he’s right. Talk to the Hard Left critics of capitalism for instance and they are dead scared that we are about to plunge into a new era of automated, roboticised societies where the residual power of labour is shredded. Libertarian tech visionaries have the same fear which is why they are rallying around ideas such as the Minimum Basic Income (a flawed idea of epic proportions).
My sense is that Rogoff, the Marxists and Libertarians are right – something big is coming, probably led by China and Japan. A massive change will rip through corporates giving the owners of capital even greater profit margins. Crucially it will spur them to invests countless billions and trillions in a tech arms race which will suddenly boost demand for capital.
The knock on effect might be an increase in productivity rates even as Labour is hollowed out as a factor of production. The combined effect of
- increased technological innovation
- increased capital investment in said technology
- increased macroeconomic productivity growth
could be to INCREASE the natural long-term real rate of interest. Normally there would be a howl of collective despair about such a scenario as ordinary borrowers find themselves squeezed, but in this scenario capital(wealth) inequality would probably have vastly increased and most citizens probably wouldn’t be hugely impacted – they’d be renting access to capital at this point. Owners of capital would, of course, be hit by these increased interest rates but the increased rate of return on investments might help mitigate the losses.
In this scenario, we could see a decade’s long slow sell-off of fixed income assets and a painful valuation readjustment process for some equity sectors.
I don’t see any obvious signs of this scenario playing out at the moment but I do think we New Normal rates enthusiasts need to be on alert for a paradigm shift. We need to keep watching productivity rates and understand how China is embracing AI and machine learning. A turning point might be fast approaching as we head into the Twenties….