Through the looking glass: from low yields to old solutions

Sometimes you need time away to really see how much has changed. What’s really grabbing my attention now is the low growth, low inflation, low interest rate world in which we find ourselves. It’s partly a hangover from the global financial crisis; but it’s also a product of secular forces – i.e. it’s not going away any time soon – and the resulting low-yield environment is throwing up significant challenges.

I don’t think we’re in Kansas any more

IMG growthImagine going back to 2010 – when the world appeared to be digging itself out of the global financial crisis. Imagine telling yourself that in 2016 – eight years after Lehman – that global growth is expected to come in at around 3%, compared with an average of 5.1% in the five years before the crisis. Imagine trying to explain that despite strillions of dollars of central bank bond purchases, inflation is virtually non-existent in developed economies. And then try to explain that $13t+ of bonds now trade with negative yields. 

 Would you believe your 2016 self?

 These are extraordinary times – and they beg the question, where on earth are we going next?

Lower for longer?

In the short-term it seems that the Fed is minded to raise rates one more time in 2016 – payroll data permitting. This puts emerging markets (EM) back in the spotlight. The economic outlook has strengthened, but much of this is commodity price stabilisation – which means the recent vogue for EM assets is somewhat vulnerable. The last period of divergence also saw US companies looking to Europe for cheaper debt and acquisitions. The world is a different place now, but set against BREXIT concerns will be the low yields occasioned by ECB and BoE purchases.

But all of this could be tempered any ‘lower for longer’ guidance provided by the Fed.  The most important message from the recent Jackson Hole meeting wasn’t about what the Fed will do next, but what it – and other central banks – will be doing for years to come. The clear message – which we’ve been hearing for a while now– is that interest rates aren’t going anywhere fast.

r ratesThat’s because of the falling neutral or “Goldilocks” rate of interest – the level that allows stable economic growth without excess inflation. It dived during the global financial crisis (GFC), but this is part of a much longer trend as the attached chart from a Federal Reserve Bank of San Francisco letter illustrates.  There is more money going into savings due to longer life expectancy. Emerging markets are moving into safer assets. Productivity has fallen – slowing growth. Inflation is sluggish – again due to the GFC shock, but other forces are in play, such as the role of technology in increasing price transparency and changing the way we work.

 The upshot is that although some of this might reverse, a lower natural rate of interest seems here to stay. This leaves conventional monetary policy less room to stimulate the economy if the economy turns down, requiring central banks to look at unconventional tools  like bond buying– which brings us onto the world of low yields.

To quote from Janet Yellen:

“By some calculations, the real neutral rate is currently close to zero, and it could remain at this low level if we were to continue to see slow productivity growth and high global saving. If so, then the average level of the nominal federal funds rate down the road might turn out to be only 2 percent, implying that asset purchases and forward guidance might have to be pushed to extremes to compensate.”

The low yield problem

Clearly, the recent run in the bond markets is good news for those looking for finance, but the bigger picture is more worrying. Negative bond yields and record equity prices shouldn’t exist concurrently.  It’s like betting on recession and boom or deflation and inflation at the same time!

 All this is symptomatic of markets moving in tune with central banks – rather than fundamentals. Last week analysts from Citigroup expressed their concern about the broken relationships between corporate profits and credit spreads. They draw attention to the fact that credit spreads haven’t moved despite defaults in the year-to-date already add up to the entire total for 2015 and the rise in bad news – as tracked by the Baker, Bloom & Davis economic policy.  Earnings are falling in the US and Europe, but investors squeezed out of bond markets are hunting returns in equities.

 The problem is that  “lower for longer” doesn’t mean “this low forever” – at some point you’d think there will need to be some kind of normalisation from central banks. Meanwhile, bond markets are being crowded out to the point where even central banks are struggling to buy and  investors are being forced along the yield curve into riskier areas – for example the rush into EM bonds.

Meanwhile, pension schemes are coming under additional pressure. According to Mercer, pensions run by S&P 1500 companies were underfunded by $568b by the end of June— over $160b wider just seven months earlier thanks to further drops in bond yields. The FTSE350 also faces a pension’s shortfall of up to £149b – which moved £10b wider in the five days after the BoE cut interest rates at the end of last month. Recent stress tests showed European banks are better capitalised, but Italian banks are still struggling with their book of non-performing loans and they and the rest of the sector look set to struggle against falling profitability whilst yields remain this low. UK bank earnings forecasts have already fallen by 35% over the last 12 months – according to Citigroup – on the yield worry and falling growth forecasts.  Stress tests have traditionally tested against yield spikes – not troughs.

 Old solutions

Hence why fiscal stimulus is coming back from the theoretical wilderness. Governments are starting to acknowledge the limits of monetary policy – and its impact on inequality through the rapid rise in asset prices, which have left many feeling left behind in this recovery. Thus far it’s mainly manifesting in rhetoric, election promises, more tolerance on Eurozone fiscal limits and  hints that central banks are at least partially handing the baton to governments. The question now is how much they are willing to spend when debt-to-GDP levels are still high?

 What can companies do in this environment? Growth is there – recent figures continue to show patchy improvement – but it’s going to be at a premium. Moreover, without some kind of shock there will be little inflation to push up prices. The obvious answer is to invest in new technology – or to invest in companies with new technology. We’re finding more and more that companies are choosing the latter – through deals and alliances – as industries merge and blur. M&A has a role in taking out overcapacity and better allocating capital to growth areas.

But companies might want to be mindful that currencies could be volatile and any ‘fiscal flip’ could take a number of different forms – redistributive, a Keynesian investment or protectionist. Each offer their own opportunities and threats. According to the WTO, new trade-restrictive measures are outpacing the number of new measures to support trade around the globe – including import tariff rate hikes, domestic content requirements, BREXIT is symptomatic is a larger trend of drawbridge raising in response to tougher times.