Iain Stewart, manager of the Newton Real Return fund, on the reasons to doubt the interest rate normalisation story.
According to the consensus (and the mantra of authorities), economic growth can now continue on an accelerating path as fiscal headwinds diminish, aided by an end to the deleveraging process.
A key assumption is that stimulus from monetary policy has finally been sufficient to reignite the ‘animal spirits’ that will underpin further economic gains.
Meanwhile, there is conviction that a gradual normalisation of official interest rates is justified, on the assumption that, in the longer term, rates should approximate to the nominal growth rate of the economy.
The interest rate theorists have got it wrong...
However, we think there are reasons to doubt this theory.
While the hypothesis sounds appealing (and materialised during the 1990s), history shows the link between the growth of nominal GDP and the level of interest rates has been loose at best.
Not only were treasury yields significantly below nominal GDP growth for most of the 1960s and 1970s, but they have been below this level throughout the past decade or so. We are not convinced this ‘anomaly’ will now reverse.
A further assumption supporting the bull case on the economy is that the process of deleverage is complete. However, we believe current debt burdens will remain a headwind to growth and challenge the ability to raise rates.
The current (QE-focused) approach (ie. more borrowing at historically low rates) encourages the opposite behaviour of that required in the long term. Rather than creating a virtuous cycle in demand, QE appears to be, at best, redistributive. Spending power is transferred from savers to debtors, from the asset poor to the asset rich, and from future to present generations.
Lifting house prices and boosting housing turnover supports expenditure on household goods but, if consumer debt rises, demand increases are unlikely to be sustainable. For corporations, low rates prevent immediate job losses as defaults remain low. However, this also means ‘bad’ capital is not eradicated and ‘zombie’ businesses sap the economy of dynamism.
Arguably, the true driver of an economy is profits growth, not the inflation of asset prices. Global profits have returned to near their previous cycle peak. Although there is a distinction between US corporate earnings at new cyclical highs and those elsewhere that lag this previous peak, expectations are heavily skewed towards further profit increases in 2014.
However, with US margins high, largely owing to record-low interest and employment costs, the scope for further improvement appears limited. Stronger growth may well increase labour costs.
If economic activity is stronger, interest costs are unlikely to decline. Sales growth is rarely able to offset these two headwinds.
One factor noted to support the idea that we are currently ‘mid-cycle’ is the apparent slack in the economy. Unemployment in developed economies is higher than we have been used to but this does not mean economies will necessarily grow robustly – each cycle in the 1970s saw the unemployment rate trough at a higher level than previously.
Also, absence of CPI-measured inflation should not be mistaken as absence of all inflation. While official CPI remains quiescent, evidence of financial excess abounds once again: for example, record corporate debt issuance (especially in the riskiest grades) and the largest volume of US IPOs since 2000.
If QE fails to generate the sustained growth and employment sought, authorities are likely to implement further unconventional policies – they have no plan B. But as the gold price and emerging market currencies have demonstrated in recent years, it is not guaranteed that monetary intervention will always lift risk assets.
Failure to achieve ‘escape velocity’ is likely to be consistent with a need for more cautious asset allocation. If the current juncture proves to be more akin to a peak in a shallower trend of rising asset prices rather than the outset of a renewed cyclical upswing, defensive equity characteristics should continue to produce consistent returns.
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