Commentary on Political Economy

Monday 28 December 2020



The response to secular stagnation will drive the markets post-Covid

Joe Biden arrives to address a drive-in campaign rally in Atlanta, Georgia, ahead of the January 5 runoff elections. Secular stagnationists are putting pressure on the president-elect to reject austerity © Mike Segar/Reuters

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The writer is chairman of Fulcrum Asset Management

When Lawrence Summers identified the central importance of secular stagnation for the global economy in his speech at the IMF in 2013, the Harvard professor put his finger on the most important motivating force for the financial markets in the 2010s.

And it remains so. The direction of secular stagnation after the pandemic passes into history will be crucial for asset prices.

Prof Summers’ interpretation of the term — originally coined by Alvin Hansen in 1938 — argued that excess savings relative to intended investment had driven the global equilibrium real rate of interest well below zero by the mid 2000s, making it difficult for monetary policy to provide the needed stimulus after the 2008 financial crisis.

Actual real interest rates did fall somewhat, but not enough to forestall sluggish growth, so inflation dropped below the 2 per cent central bank targets, notably in Japan and the eurozone.

These forces explained many of the key trends in global markets. Short-term interest rates remained “lower for longer”, not because the central banks tried to inflate an artificial bubble in asset prices but because they responded appropriately to the downward pressure on equilibrium real rates.

Nominal and real bond yields continued to fall in advanced economies, hitting the effective lower bounds in many. As the demand for “safe” fixed income securities exceeded supply, a desperate search for yield spilled into corporate credit and emerging market debt, forcing credit spreads lower.

Equities benefited from the lower discount rate on future profits resulting from lower risk-free interest rates. Share prices defied the sluggish growth in output and rose to dizzying heights. Meanwhile, profits have benefited from low wage inflation, another possible symptom of secular stagnation.

Yale’s Robert Shiller, who had warned of earlier equity and housing bubbles, has recently written that lower bond yields support the high valuations of equities, relative to past and future profits. In his view, there is no obvious equity bubble in the overall market this time.

Equities that gained from technological and structural changes, in particular, the Faangs — Facebook, Apple, Amazon and Google and Netflix — were deemed to have the best long-term revenue growth prospects, so they benefited the most from declining discount rates.

However, recent valuations in these new growth companies, fuelled by speculative phenomena such as the explosion of special purpose acquisition companies, or Spacs, do seem to be extremely frothy and are very vulnerable to any rise in real bond yields.

Even during the pandemic, secular stagnation still played a critical role. Markets had become accustomed to large-scale central bank asset purchases alongside burgeoning US budget deficits under President Donald Trump, without seeing any adverse effects. So they were willing to accept the massive fiscal and monetary injections of 2020 with equanimity.

A few decades ago, when global savings were in short supply, that would not have been the case. A global pandemic during the inflationary 1970s would have raised interest rates, making expansionary policy far more difficult.

It is little exaggeration to say that investors are all secular stagnationists now. But what of the future?

The latest thinking from Prof Summers, Jason Furman and other academic proponents of the theory suggests that the same long-term forces that have dominated recent decades will re-emerge after the pandemic.

They reject the idea that structural forces such as the global savings glut, demographic ageing and income inequality will reverse sufficiently to end this saga in the next few years.

Nor do they expect a “Roaring 1920s” spending mentality to emerge after Covid-19. This is in line with a recent lecture by Helene Rey. She argues that the long-term effects from the financial crisis and the pandemic will keep equilibrium interest rates very low during the 2020s.

Financial markets are likely to resume the behaviour seen before the pandemic. Near-zero bond yields will support buoyant equity markets.

However, there is a caveat: fiscal policy may become sufficiently stimulative to reverse the direction of travel for equilibrium real interest rates.

As US president-elect Joe Biden enters office, secular stagnationists are putting pressure on him to seize a rare opportunity to reject austerity and boost the fiscal stimulus by $2.5tn from 2021-23.

Commentators including Martin Wolf have argued that the legacy of high public debt ratios, taken alone, should not result in financial crises or inflation, so in theory there is plenty of fiscal scope for expansion.

An economic Marshall Plan is clearly needed to repair infrastructure, improve climate change and reduce inequality.

But what is good for the world economy is not necessarily good for asset prices.

A fiscal injection of several percentage points of US gross domestic product could begin to reverse secular stagnation. But it may also raise long-term discount rates and puncture the bull market in global equities.

Investors should be careful what they wish for.

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