The global economy is in fine form. Recent figures tell us that in the last year the United States grew by 3.0%, the euro area by 2.4% and China by 7.0%. Growth in almost every significant nation has outpaced market expectations. The exception for now is India, which is still struggling with the fall out of Prime Minister Modi’s demontisation policy.
Despite favourable monetary conditions, inflation is below 2% in most developed markets and below 4% in most emerging markets. This has created a benign environment for global trade; for corporates, whose rising pricing power has fed through into earnings; and for risk assets, which have benefitted from low volatility.
We are not completely convinced that this positive moment for the world economy is sustainable and we have raised concerns about the lack of productivity growth in the G7 and the financial stability risks associated with easy money. Nevertheless, we think the outlook for both developed and emerging markets over the next 2 years looks relatively positive.
If productivity continues to disappoint, inflation will start to rise. If money stays easy for too long, financial stability tends to weaken, a particular concern of the Bank of International Settlements. A key question therefore for both economists and investors is – as ever – if, when and by how much will central banks raise interest rates. Central banks have a responsibility to manage both inflation and general financial conditions.
There are two different issues here. One relates to the nominal interest rate; the other refers to the real interest rate. Nominal interest rates remain in an exceptional place. Policy rates in Europe, Japan and the US are below 1.5%. Sukanto Chanda at Deutsche Bank has assessed the $8trn global credit market and finds that 17% of all sovereign and credit debt trades at negative interest rates. These positions depend almost entirely on central bankers’ monetary policies and are likely to reverse as soon as banks embark on a sustained course of balance sheet and policy normalisation.
But this leaves the question of how high interest rates need to go to complete the process of normalisation. To get to an answer, we need to know what the risk-free real interest rate consistent with full employment is, as this reflects the underlying balance of supply and demand in credit markets.
A study in 2014 by former Bank of England Governor Mervyn King and David Low was the first that attempts to estimate the ‘global risk-free interest rate’. They use 10-year inflation indexed government bonds across developed nations as a proxy and find that yields have fallen by about 450 basis points since 1987 and are close to 0%. What this means is that developed economies that are neutral on monetary stimulus require nominal yields to rise to around 2-3%. Since many state bonds are not far off, this suggests that the amount of further tightening required from banks is limited.
The drivers of this multi-decade shift are numerous and relate to both the global desire to save (which has gone up) and the demand for credit (which has gone down). This means that global investment as a share of GDP has remained relatively constant over the period despite a large fall in the cost of credit.
The three supply-side factors that have increased the desire to save include: (1) reductions in the dependency ratio; (2) the creation of a savings glut from emerging economies in Asia, and more recently Northern Europe; and (3) rising inequality, as wealthier people save a greater fraction of their income.
On the demand-side, pessimistic expectations for innovation and productivity growth have cooled demand for credit. The falling price of capital also means that businesses need to spend less to meet their production needs.
So if low rates are the new normal, we have to revise our outlook for expected returns for risk assets. If new innovations are not forthcoming and more global capital chases fewer investment opportunities, returns are likely to stay low.
There are risks to policy too. Low rates and volatility will encourage ‘searching for yield’ – that may lead to problems for financial stability down the road.
Additionally, if central banks are committed to low inflation targets, there is much less they can do to stimulate the economy in the event of another recession. Nominal interest rates cannot credibly be held much below 0%, so banks will either need to rely more on unconventional measures such as QE or raise their inflation targets. It also means fiscal policy will be more important in turning around depressed economies.
With real interest rates at close to 0%, the bar for fiscal expansion is effectively lower as debt interest costs become almost a non-issue. The question in the future will increasingly be: does extra spending create at least as much in GDP? And the answer will almost always be yes.
Changes in the global economy in the last thirty years have reshaped the landscape for markets and policy. Today, both markets and policy are in new, unchartered territory. This need not be a bad thing, but the uncertainty puts additional responsibility on the industry to look out for known unknowns and be ready to respond to any unknown unknowns.
Our investment strategy committee, which consists of seasoned strategists and investment managers, meets regularly to review asset allocation, geographical spread, sector preferences and key global market drivers and our economist produces research and views on global economies which complement this process.
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