Commentary on Political Economy

Saturday, 9 January 2021

EXCELLENT SUMMARY BY JOHN PLENDER AT THE FT

 

Debt dangers hang over markets

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It is, to put it mildly, counterintuitive. In the midst of a global pandemic and one of the steepest recessions ever, mainstream investment markets are very fully valued by historic standards.

Since their bounce back from the coronavirus-induced plunge last March, they are so expensively priced that — in the judgment of veteran fund manager Howard Marks of Oaktree Capital: “The prospective returns on everything are about the lowest they’ve ever been.”

In short, investors are not being adequately compensated for risk in an uncertain world. So it is important to be clear about the nature of financial risk in the year ahead.

When market valuations are elevated there is always a potential vulnerability to negative shocks. Among the obvious triggers are possible resurgences in the coronavirus, dips in economic activity and an escalation of bankruptcies in troubled sectors such as retail, hotels, transport and property.

Moreover, the pandemic has taken hold at a time of rising geopolitical tension, with the US and China engaged in unprecedented strategic competition.

In the short term, markets will probably gyrate according to the ebb and flow of news on coronavirus and vaccines. Yet while these risks are real, investors have surely been right to look beyond the current dire economic landscape to better times, because of the timely collective policy response to support economies and the extraordinarily rapid development of vaccines.

Between early March and the end of May, the US Federal Reserve bought $2.3tn of Treasury securities and agency mortgage-backed securities, while in the UK, the Bank of England launched its largest and fastest asset purchasing programme amounting initially to £200bn of gilts and corporate bonds, equivalent to about a tenth of UK gross domestic product. Other central banks around the world followed suit, pumping liquidity into stricken markets.

The UK government addressed the collapse in demand inflicted by lockdowns with a substantial £123bn package of fiscal measures. While the size of the UK’s intervention was unprecedented, the IMF’s estimates last summer suggested the response in other G7 economies was typically even larger.

Now, recovery is under way. In its latest World Economic Outlook, the IMF’s projection for global growth in 2021 is 5.2 per cent after an estimated decline of 4.4 per cent for 2020.

Central banks act as market makers

Markets are thus being driven primarily by economic policy decisions. And in a policy-driven market, the biggest single risk is policy reversal. A recent example is the precipitate pursuit of austerity by the UK and other governments after the great financial crisis of 2007-8. But in a world of continuing deficient demand, excess capacity and high unemployment, an overhasty end to government support seems unlikely in 2021, except perhaps in fiscally ultra-conservative Germany and other parts of northern Europe.

Even the IMF, traditionally a dyed-in-the-wool fiscal curmudgeon, has warned against early tightening. The British Conservative government under Boris Johnson has so far shown little appetite for a return to austerity.

Meanwhile, Andy Haldane, chief economist of the Bank of England, has warned against pessimistic narratives. “Now is not the time,” he argued in a speech in September, “for the economics of Chicken Licken, the fictional fowl who, having been hit on the head by an acorn, declared the sky was falling in.”

Sharp spike in debt ratios across mature markets GM090116_21X

Overall, fiscal policy in most of the developed world looks set to remain expansionary, while the central banks have demonstrated their readiness to act as market makers of last resort.

Admittedly their tool box is limited with nominal interest rates close to zero or negative. But they can still inject liquidity into markets by buying assets through so-called quantitative easing. Indeed, part of the reason for the rich valuations in today’s markets, according to Longview Economics, a research boutique, is that ever more newly-created money is chasing an ever-shrinking pool of investable assets as the central banks take assets on to their own balance sheets.

These purchases increasingly extend to riskier paper such as corporate bonds, in the case of the Bank of England, or equities with the Swiss National Bank and the Bank of Japan. In effect, central banks have de-risked public markets, at least in the short term, while taking more risk on to their own balance sheets.

All this suggests that there is little immediate threat of a banking crisis or of financial instability more generally, as long as we ignore the totally unexpected.

Nor is there any immediate constraint on central banks to further expand their balance sheets. Even if they make losses on these risky investments and become technically insolvent, the net present value of seignorage — the profit they make on creating money — far exceeds potential losses. The only limitation arises if their credibility erodes to the point where the public, plagued by rampant inflation, is no longer prepared to accept their IOUs.

That credibility problem tends to make central banks uncomfortable with continuing balance sheet expansion. The Fed, for example, has indicated that it would like in due course to shrink its balance sheet. If and when that happens, there will be a high risk of market disruption. The merest hint of balance sheet retrenchment in late 2018 and earlier in 2013 caused serious market wobbles.

Global debt has soared and topped $270tn GM090117_21X

Because central banks are only too aware of this danger, they seem unlikely to move before economic recovery is more firmly established. And when they do, they will exercise extreme caution.

With central banks systematically rigging markets, the resulting ultra-low interest rates pose risks to the structure of investors’ portfolios.

The reinvestment risk

The most pressing is reinvestment risk — the likelihood that investments providing a good return today cannot be replaced with equally attractive investments tomorrow, for example maturing bonds.

Eric Knight of fund manager Knight Vinke sees this as potentially the single most destructive risk now facing long-term investors. He points out that a reduction in average returns from 8 per cent per annum to 6 per cent will result in the value of a pension fund’s portfolio falling by 35 per cent in 30 years and by 50 per cent in 50 years.

Investors who seek to maintain past levels of returns have to take on more risk in pursuit of yield.

Across the capital markets this has perverted the normal relationship between risk and reward: witness the narrowed gap between yields on investment grade corporate bonds and junk bonds; likewise the recent ability of Peru, a developing economy in a region notorious for sovereign defaults, to raise 100-year money at a coupon of a mere 3.23 per cent. Note, too, the risk-hungry penchant of British and other developed world investors to inflate the bitcoin bubble.

While many people in the developed world have solid pensions that are related to final or average salaries and are backed either by the state or private pension funds, a large and growing group of people in the UK and elsewhere are members of defined contribution (or money purchase) schemes, where the level of their retirement income is affected by market fluctuations.

They are forced to accept lower returns where, in the great majority of cases, they choose to invest via a scheme’s default option. This offers a standard portfolio where the pension pot is substantially diverted into fixed-interest and index-linked government bonds as people approach retirement. Such a strategy does reduce risk in an academic sense but at today’s valuations most of these government IOUs offer guaranteed losses in real terms after inflation, and sometimes in nominal terms as well, when held to maturity.

Many scheme members, if they were aware of the consequences, might prefer a default option that entailed switching into stable, income-producing equities such as Nestlé or Unilever rather than bonds.

In addition to the mispricing of risk, investors also face the problem that central bank liquidity creation has generated high valuations across multiple asset classes and countries. With those asset classes being more closely correlated than in the past, it becomes much harder to achieve portfolio diversification.

Traditionally, fund managers have looked to fixed interest bonds to hedge against volatility in equities. This is now in question. Economists Fernando Avalos and Dora Xia of the Basel-based Bank for International Settlements, the central banks’ organisation, point out that the response of 10-year US Treasury yields to sell-offs in the US’s S&P 500 equity index has become more muted since 2018, with bond prices falling (and thus bond yields rising) when equities have fallen. As a result US Treasury bonds’ status as the safest haven in a global storm has become less secure.

Line chart of total return on FTSE indices, adjusted for inflation* (Jan 1976 = 100) showing UK equities have outperformed gilts over the long run

Of the mainstream asset classes available to retail investors, only gold and commodities now offer genuine diversification from equities and bonds. These are, by definition, speculative assets that yield no income. That leaves expensive hedging via derivative instruments, or expensive absolute value collective funds where investment strategies are designed to deliver returns regardless of the direction of markets. For most retail investors the conventional well-structured, diversified portfolio is now out of reach.

How should investors position themselves against the risk of inflation? In the short run this is scarcely a concern. Since the great financial crisis, aggregate demand in the developed world has been anaemic and despite falls in unemployment to relatively low levels before the pandemic inflationary pressure was absent. Now, with the coronavirus, the deflationary forces in the economy have become intense. Yet there may be inflationary trouble further ahead.

In their new book, The Great Demographic Reversal, Charles Goodhart and Manoj Pradhan argue that the profound deflationary impulse of the past three decades was chiefly due to an enormous surge in the world’s labour supply resulting from favourable demographic trends and the entry of China and eastern Europe into the global trading system.

As domestic demand in advanced countries was weakening, global supply was increasing. The result was crushing downward pressure on inflation and interest rates. These trends, they say, are now about to reverse sharply thanks to the ageing of populations, while the world is in retreat from globalisation. “The future,” they add, “will be nothing like the past — and we are at a point of inflexion . . . the multi-decade trends that demography brought about are set for a dramatic reversal.”

If they are right, labour stands to be re-empowered relative to capital as workforces shrink. In a distributional struggle between workers and a growing retired population, workforces’ bargaining power will increase, with obvious inflationary consequences, while older people, who are more likely to vote than the young, will seek to fight back via the ballot box.

The pandemic may, in any case, have changed wider societal attitudes to low pay and precarious working conditions, so that the political climate will favour better pay and conditions. As the need for care workers increases, say Goodhart and Pradhan, the number of workers available for other work will decline. Against that background, the likelihood that quantitative easing would raise general price levels, rather than simply push up asset prices as has happened since 2008, looks real.

Other grounds for worrying about the risk of inflation include the extraordinary rise in global debt, which stands at levels never seen outside wartime. According to the Institute of International Finance, a trade body, global debt has surged by over $15tn since 2019, hitting a record of more than $272tn in the third quarter of 2020. It expects that figure to rise to $277tn by the end of 2020, equivalent to 365 per cent of global gross domestic product.

This accumulation of debt is a direct result of ultra-low interest rates. William White, former economic adviser and head of the economic and monetary department at the Bank for International Settlements, suggests that by keeping interest rates too low in the attempt to generate economic growth central banks have induced corporations and households to take on more debt.

This, says Mr White in an interview, creates a debt trap and rising instability. When a financial crisis strikes central banks have to save the system, but in doing so they create even more instabilities. “They keep shooting themselves in the foot,” he adds.

Will the pandemic change societal attitudes to low pay and precarious working conditions? © Neil Hall/EPA/Bloomberg

The interest rate trap

It is safe to assume that the great debt overhang is unsustainable and will never be paid off in full. After the first and second world wars, debt levels were brought down by a combination of robust economic growth, which helped raise tax revenues, and de facto defaults, either informally through inflation or formally by way of debt reconstruction.

Unless there is a much greater improvement in developed world productivity (and thus growth) than now seems plausible, inflation will again have to do much of the debt reduction. The question for investors is whether central banks can respond to rising inflationary pressure by raising rates on this huge debt pile without prompting a devastating shock to markets.

In Mr White’s judgment, central banks know they cannot leave interest rates as low as they are, because they are inducing still more bad debt and bad behaviour. But they cannot raise rates because then they would trigger the very crisis they are trying to avoid.

Monetary policy has been asymmetric. Central banks have put a floor under markets in crises, but failed to put a cap on prices in bubbles. Because interest rates have never risen as much in upturns as they have dropped in downturns the central banks’ capacity to promote economic growth has been decreasing.

There is no easy way out of this trap. So for retail investors the message is that government bonds, traditionally regarded as safe assets, are in the long run dangerous. Real assets, such as property — notably residential, warehouses and care homes — and a modicum of portfolio insurance by investment in gold, will offer greater safety in what is anyway likely to be a low-return world.

Consider, now, a final category of risk: the political and the geopolitical. Who knows what Donald Trump might yet do to upset markets in the last days of his presidency? How will the strategic competition between China and the US develop, including in its military dimension? Could tensions in the Middle East erupt into war? How will Brexit unfold and what consequences might there be for sterling? Will the forthcoming departure of German chancellor Angela Merkel, Europe’s pre-eminent political leader, be accompanied by market turbulence? And can industry and commerce deliver on governments’ Paris agreement targets on carbon emissions without much tougher regulation? These risks are unquantifiable.

With central banks’ asset purchasing programmes increasing wealth inequality and the coronavirus adding to social inequality, including even life expectancy, the pressure for populist policy is intense. Historically, populism has encouraged monetary financing of public debt, followed by a descent into inflation. This is deeply troubling.

For the moment, though, investors’ most pressing financial concern should be the reality that the world economy is hostage to debt and wayward monetary policy. There will, in the end, be a reckoning. But the timing of any market crunch is inherently unpredictable — nor how it hits any particular country such as the UK. The American economist Herb Stein famously remarked that if something can’t go on forever, then it will stop. Less well known is the rejoinder by fellow economist Rudi Dornbusch who said: Yes, but it will go on a lot longer than you anticipate.

Copyright The Financial Times Limited 2021. All rights reserved.

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