Finance
This
is not a normal business cycle; monetary policy will be a lot less
effective in the future; investment returns will be very low. These have
come to be widely held views, but there is little understanding as to
why they are true. I have a simple template for looking at how the
economic machine works that helps shine some light. It has three parts.
First, there are three
main forces that drive all economies: 1) productivity; 2) the short-term
debt cycle, or business cycle, running every five to ten years; and 3)
the long-term debt cycle, over 50 to 75 years. Most people don’t
adequately understand the long-term debt cycle because it comes along so
infrequently. But this is the most important force behind what is
happening now.
Second, there are three
equilibriums that markets gravitate towards: 1) debt growth has to be in
line with the income growth that services those debts; 2) economic
operating rates and inflation rates can’t be too high or too low for
long; and 3) the projected returns of equities have to be above those of
bonds, which in turn have to be above those of cash by appropriate risk
premiums. Without such risk premiums the transmission mechanisms of
capital won’t work and the economy will grind to a halt. In the years
ahead, the capital markets’ transmission mechanism will work more poorly
than in the past, as interest rates can’t be lowered and risk premiums
of other investments are low. Most people have never experienced this
before and don’t understand how this will cause low returns, more debt
monetisation and a “pushing on a string” situation for monetary policy.
Third,
there are two levers that policy-makers can use to bring about these
equilibriums: 1) monetary policy, and 2) fiscal policy. With monetary
policy becoming relatively impotent, it’s important for these two to be
co-ordinated. Yet the current state of political fragmentation around
the world makes effective co-ordination hard to imagine.
The long and the short of it
Although circumstances
like these have not existed in our lifetimes, they have taken place
numerous times in recorded history. During such periods, central banks
need to monetise debt, as they have been doing, and conditions become
increasingly risky.
What does this template
tell us about the future? By and large, productivity growth is slow,
business cycles are near their mid-points and long-term debt cycles are
approaching the end of their pushing-on-a-string phases. There is only
so much one can squeeze out of a long-term debt cycle before monetary
policy becomes ineffective, and most countries are approaching that
point. Japan is closest, Europe is a step behind it, the United States
is a step or two behind Europe and China a few steps behind America.
For most economies,
cyclical influences are close to being in equilibrium and debt growth
rates are manageable. In contrast to 2007, when my template signalled
that we were in a bubble and a debt crisis was ahead, I don’t now see
such an abrupt crisis in the immediate future. Instead, I see the
beginnings of a longer-term, gradually intensifying financial squeeze.
This will be brought about by both income growth and investment returns
being low and insufficient to fund large debt-service, pension and
health-care liabilities. Monetary and fiscal policies won’t be of much
help.
As time passes, how the
money flows between asset classes will get more interesting. At current
rates of central-bank debt buying, they will soon hit their own
constraints, which they will probably have to abandon to continue
monetising. That will mean buying riskier assets, which will push prices
of these assets higher and future returns lower.
The bond market is risky
now and will get more so. Rarely do investors encounter
a market that
is so clearly overvalued and also so close to its clearly defined
limits, as there is a limit to how low negative bond yields can go.
Bonds will become a very bad deal as central banks try to push more
money into them, and savers will decide to keep that money elsewhere.
Right now, while a number
of riskier assets look like good value compared with bonds and cash,
they are not cheap given their risks. They all have low returns with
typical volatility, and as people buy them, their reward-to-risk ratio
will worsen. This will create a growing risk that savers will seek to
escape financial assets and shift to gold and similar non-monetary
preserves of wealth, especially as social and political tensions
intensify.
For those interested in
studying analogous periods, I recommend looking at 1935-45, after the
1929-32 stockmarket and economic crashes, and following the great
quantitative easings that caused stock prices and economic activity to
rebound and led to “pushing on a string” in 1935. That was the last time
that the global configuration of fundamentals was broadly similar to
what it is today.http://www.theworldin.com/article/12774/back-future
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