Why lower for longer will remain the anthem for markets

Writing the obituary for the bull market in bonds has proved every premature

by: John Plender

Alan Greenspan © Bloomberg

Do you recall Alan Greenspan’s famous conundrum? Back in 2005 the then chairman of the Federal Reserve was baffled that US bond yields continued to fall despite tighter monetary policy.

The persistent decline in real rates since then continues to baffle market observers and throw up multiple explanations.

Of course, the financial crisis has played a part. In a balance sheet constrained world, expectations of growth are inevitably lower, while the decrease in the supply of safe assets, thanks in part to central banks’ bond buying activity, has put downward pressure on yields. Yet there is much more to it than that.

This is a global phenomenon, common to both advanced and emerging market economies, that has gone on for more than 30 years. In fact, long-term real interest rates have fallen by about 450 basis points (hundredths of a per cent) over that period.

And it is not just the decline in growth expectations that explains today’s extraordinarily low yields. Changes in saving and investment behaviour are the key to understanding the underlying dynamics.

In the latest edition of the International Journal of Central Banking, Lukasz Rachel and Thomas D. Smith of the Bank of England take a fascinating stab at identifying the different components of that 450 basis point decline.

On the savings side of the equation, they identify three important trends. The first is demography, most notably slower labour force growth. The resulting decline in the workforce’s desired level of savings accounts for an estimated 90 bps of the fall in real rates.

Then there is the impact of higher inequality within countries, which reflects the fact that the rich save more of their income than the rest of the population, which adds 45 bps to the total. Increased precautionary saving by emerging market governments since the Asian crisis of 1997-8 explains another 25 bps.

On the investment side, the authors show that desired investment levels have fallen thanks to a 30 per cent fall in the relative price of capital goods since the 1980s, accounting for 50 bps of the fall in real rates, along with a preference shift away from public investment projects that explains 20 bps.

In addition, they reckon that the rising spread between the rate of return on capital and the risk-free rate has further reduced desired investment and risk free rates by 70 bps.

Finally, they argue that slower global labour supply growth and headwinds at the technological frontier, such as a plateau in educational attainment, may cause global growth to slow by up to one percentage point over the next decade and that expectations of this decline could account for about 100 bps of the fall in real rates seen recently.

All told, that provides an explanation for 400 of the 450 bps fall in long-term real interest rates. Since most of the trends they identify remain intact, the duo from the Bank of England conclude that we will be in a low-rate world for quite some time.

There are, of course, a number of heroic assumptions behind these figures. Also some omissions.

I would place more emphasis, for example, on the way lower desired investment is partly driven by incentive structures that entrench short-termism in corporate boardrooms.

And, if China and other Asian economies significantly rebalance away from investment towards consumption, the picture could look very different. That said, it is worth taking the analysis and asking what the implications for policy might be if we assume it to be correct.

The first potentially disturbing observation is that, in this low-growth, low-interest-rate world, central banks will remain dependent on unconventional measures.

It is a world in which it would make sense to place greater reliance on fiscal policy to manage the cycle. The supply potential of the economy would also need to be enhanced by structural reform.

Yet only the first of these prescriptions lies within the bounds of the politically possible.

Fiscal activism is anathema on Capitol Hill for anything bar hurricane relief and sops to vested interests. It is also out of the question in the eurozone as long as Germany calls the shots.

As for structural reform, unconventional central bank measures were meant to buy time for just that.

Nothing much happened. So the most plausible bit of the forecast is, sadly, that growth will be lower for longer.

Cold War II Expands to Asia

By Patrick Watson

September is not unfolding as expected. Then again, as Yogi Berra said, “It’s tough to make predictions, especially about the future.”

Just a few weeks ago, this month was supposed to bring an angry stand-off in Washington and possibly a government shutdown or debt default. Those could still happen, but President Trump’s deal with the Democrats pushed it back to December.

That’s probably good because many other things need the government’s attention: Hurricanes, floods, earthquakes, and wildfires, to name a few. Yet as costly and lethal as those are, they’re minor compared to the threat of nuclear war.

While that risk is small, it’s not zero. A nation’s leaders have to prepare for the possibility of nuclear war, and their preparations have an economic impact.

It seems right now is a particularly good time to think about this.

Photo: AP

A War No One Wants

North Korea celebrated US Labor Day weekend with its largest nuclear test yet, which followed a series of long-range missile tests, including one that flew directly over Japan.

Placing a nuclear warhead on a missile in a way that it survives the trip and explodes on the intended target is a different matter. We don’t know if Kim Jong-Un can or will do that, but we can’t rule it out either.

At our Mauldin Economics Strategic Investment Conference back in May, geopolitical expert George Friedman said the US appeared to be planning a military strike against North Korea. He may yet be right, even though the Trump administration seems to prefer economic sanctions so far.

Meanwhile, South Korea and Japan are understandably nervous. Treaties obligate the US to defend both from attack... but will we if it means risking Seattle or San Francisco? I’m not so sure.

More to the point, South Korea and Japan aren’t sure either. That means they must prepare to go it alone. Both are perfectly capable of building their own nuclear weapons if they wish.

Call me an optimist, but I don’t expect open war—nuclear or otherwise.

Instead, I think the region will simmer as it is now, with harsh rhetoric and occasional small skirmishes. All sides will build up for a war none of them want to fight.

Photo: AP

If this sounds familiar, you may have lived through the decades-long Cold War.

Back then, we didn’t have to wonder if the USSR could strike the US with nuclear-tipped missiles; we knew they could. Yet life went on. Markets paid little attention.

That kind of atmosphere is already returning to Europe, as Russia and NATO face off over Ukraine, the Baltic states, and elsewhere. Now we see similar tension in East Asia.

If someone launches real missiles at real targets, all bets are off. Short of that, we can confidently predict higher defense spending for all countries involved.

War is never good, but preparing for war can be good—if you are a defense contractor or someone investing in a defense contractor. They get paid whether anyone shoots or not.
Consistent Outperformer

I’ve noted before that defense is the best all-weather stock sector. The companies that make weapons, planes, and other military equipment routinely demolish market benchmarks.

For instance, here is the iShares US Aerospace & Defense ETF (ITA) plotted against the S&P 500 over the last five years.

The defense sector, as ITA defines it, didn’t just beat the market by a few points. Its total return doubled the market in the last five years.

I’m not cherry-picking time periods here. You can run the same comparison for one year, 10 years, whatever range you want, and keep finding the same thing.
The defense industry occasionally has a bad quarter or two, but over time it outperforms.

Yes, I know: Past results don’t indicate future results.

But some things just go with the human condition. People will keep eating… and governments will keep buying weapons.
Not Just Asia

Why is North Korea launching so many missiles now? From what I read, its long-range goal is to reunify the two Koreas. To make that happen, it needs the US to stop protecting the South. The saber-rattling is an attempt to scare us out of the region.

Will it work? Probably not. But even if the US bows out, South Korea and Japan will keep buying American weapons. Our defense industry will win regardless.

There may be another layer to this, though.

Some analysts think Pyongyang’s missile and nuclear tests are actually sales pitches. They demonstrate North Korea’s weapons prowess to countries like Iran and Syria.

North Korea’s arms industry plus its willingness to sell to governments most of the world shuns, like Syria, are key to its economic survival. And the tighter US-driven sanctions get, the more important North Korea’s arms exports will be.

So, this isn’t just about Asia. North Korea is also enabling conflict elsewhere, and some of its arms exports might be targeting US troops in Syria and Afghanistan.

That’s not good, but stopping it probably isn’t worth a nuclear war. So we stay in the default position: a Cold War-like stalemate.

The defense industry will thrive as long as this goes on, and I think it will go on for a long time. Later this week in Macro Growth & Income Alert, Robert Ross and I will recommend an income-generating options play on a little-known US defense contractor that sells the Pentagon some non-lethal but essential equipment.

Opportunities like that one happen all the time in defense. It’s a sector every investor should watch.

Deconstructing Deglobalization

Harold James

PRINCETON – US President Donald Trump and his advisers’ fierce rhetoric on trade and immigration has led some to wonder if our current era of globalization is now at risk. If it is, an even more pertinent question is whether the end will be accompanied by violence. 

Stock markets have become increasingly jittery, owing to recollections of past moments when international economic integration was thrown into reverse. New trade wars or military conflicts could conceivably unravel the complex commercial interrelationships that have delivered prosperity since World War II.

In previous episodes of deglobalization, catastrophic events such as World War I or the financial crash of 1929 disrupted the flows of commerce, finance, and people that had previously linked countries together. One result of these crises was that nationality and citizenship became the key components of political and social life.

The same pattern of reversal and disintegration can be found earlier in history: the end of the Roman Empire and the disintegration of China’s Eastern Han Dynasty, to name just two. Some historians even regard the American and French Revolutions as deglobalizing events. American revolutionaries rejected foreign rule and trade, and French revolutionaries sundered the Bourbon dynasty’s European alliances. In both cases, the revolutionaries asserted new rules of citizenship.

It would seem that modern political society is predisposed toward deglobalization. Historically, this tendency has been triggered when the emotional balance of a society changes. Social turmoil often gives rise to new leaders whose governing mentality leads to rash, short-sighted, inconsistent, and otherwise bad decisions. When poor decision-making in one country adversely affects other countries, it can then trigger a vicious circle of retaliation and escalation.

Over the last century, three related emotions, in particular, have fueled backlashes against globalization: fear, suspicion, and anomie. Generally, widespread fear of financial losses, or of dangers posed by other countries, reflect a society’s deeper anxiety about a constantly changing world.

In the 1980s, the financial analyst James Montier created a “fear and greed” index, in which market sentiment is driven entirely by the interplay of greed and fear of loss. Montier’s central insight was that the potential for fear increases alongside the level of greed on display. Fear is thus the historically determined wages of greed, just as death, in Christian theology, is the wages of sin.

It is worth remembering that the twentieth century’s major military conflicts were all preceded by financial crises, which themselves were preceded by periods of wild exuberance. The crash of 1907 preceded World War I; and the 1929 crash, the 1931 European banking crisis, and the Great Depression preceded WWII.

The second emotion that drives deglobalization, suspicion, can create a trap. As Elvis Presley famously put it: “We can’t go on together / With suspicious minds / And we can’t build our dreams / On suspicious minds.”

During the period of reckoning after a financial crisis, those who have come out on top are also often believed to be the culprits. In some cases, the public directs its ire at another country; in other cases, it targets ethnic minorities or social groups such as financial elites. In the first half of the twentieth century, Jews were the most frequently targeted group, whereas in the 1997 Asian financial crisis, Chinese traders in the Philippines, Malaysia, and Indonesia were singled out.

Suspicions can also be heightened by security concerns. Before WWI, many Londoners worried that German restaurant waiters were spies, as a few doubtless were. And today, many Europeans have fears about refugees and radicalization in Islamic communities that are disproportionate to the actual threat.

Fear and suspicion thrive when the processes of globalization erode core values, sources of meaning (such as traditional occupations), and ways of life. In advanced industrial countries, the backlash against migration and trade is often framed as a matter of either “saving” jobs or compensating globalization’s “losers.” But in both cases, the response ignores the fact that there are no new decent jobs to provide sources of meaning and identity.

This has been a problem at least since mass industrialization began to accelerate in the nineteenth century. Fyodor Dostoyevsky opened his classic 1862 account of prison life, The House of the Dead, with a paean to the importance of work – even for those in Siberian penal colonies. Ordinary activities like creating an object or even cleaning a room can confer a sense of self-worth, he observed. But the pointless toil assigned to prisoners – such as digging and then refilling holes – did the opposite: it was meant to destroy their dignity and annihilate their sense of self.

History shows that tackling the emotional roots of deglobalization will require an enormous feat of social imagination. The task before us is nothing less than to reestablish a universal sense of human dignity and purpose.

Financial flows today are smaller than before the 2008 financial crisis; and, since 2014, international trade has grown at a slower rate than production for the first time since WWII. Despite efforts such as China’s “Belt and Road” initiative, which aims to unite Eurasia through infrastructure and investment, it is conceivable that the world has reached “peak finance” and “peak trade, and possibly “peak globalization.”

Still, there is one major area of international connectivity that shows no sign of declining: the exchange of information. Global data flows will continue to increase, constituting a growing share of economic value.

But can digital globalization also create new sources of meaning? Experimental artists and social-media experts would say that it can. But if the new interconnectivity has the paradoxical effect of making people feel more isolated and adrift, those people will pick old imagined certainties over globalization any day.

Harold James is Professor of History and International Affairs at Princeton University and a senior fellow at the Center for International Governance Innovation. A specialist on German economic history and on globalization, he is a co-author of the new book The Euro and The Battle of Ideas, and the author of The Creation and Destruction of Value: The Globalization Cycle, Krupp: A History of the Legendary German Firm, and Making the European Monetary Union.

The Sandcastle

by Jeff Thomas

The decline from democracy to tyranny is both a natural and inevitable one.

That’s not a pleasant thought to have to consider, but it’s a fact, nonetheless. In every case, a democracy will deteriorate as the result of the electorate accepting the loss of freedom in trade for largesse from their government. This process may be fascism, socialism, communism, or a basket of “isms,” but tyranny is the inevitable endgame of democracy. Like the destruction of a sandcastle by the incoming tide, it requires time to transpire, but in time, the democracy, like the sandcastle, will be washed away in its entirety.

Why should this be so? Well, as I commented some years ago,

The concept of government is that the people grant to a small group of individuals the ability to establish and maintain controls over them. The inherent flaw in such a concept is that any government will invariably and continually expand upon its controls, resulting in the ever-diminishing freedom of those who granted them the power.

Unfortunately, there will always be those who wish to rule, and there will always be a majority of voters who are complacent enough and naïve enough to allow their freedoms to be slowly removed. This adverb “slowly” is the key by which the removal of freedoms is achieved.

The old adage of “boiling a frog” is that the frog will jump out of the pot if it’s filled with hot water, but if the water is lukewarm and the temperature is slowly raised, he’ll grow accustomed to the temperature change and will inadvertently allow himself to be boiled.

Let’s have a look at Thomas Jefferson’s assessment of this technique:

Even under the best forms of Government, those entrusted with power have, in time, and by slow operations, perverted it into tyranny.

Mister Jefferson was a true visionary. He knew, even as he was penning the Declaration of Independence and portions of the Constitution, that his proclamations, even if they were accepted by his fellow founding fathers, would not last. He recommended repeated revolutions to counter the inevitable tendency by political leaders to continually vie for the removal of the freedoms from their constituents.

Around the same time that Mister Jefferson made the above comment, Alexander Tytler, a Scottish economist and historian, commented on the new American experiment in democracy. He’s credited as saying,

A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy, which is always followed by a dictatorship.

So, was each of the above gentlemen throwing a dart at a board, or did they each have some kind of crystal ball? Well, actually, neither. Each was a keen student of history. Each knew that the pattern, by the end of the 18th century, had already repeated itself time and time again. In fact, as early as the fourth century BC, Plato had quoted Socrates as having stated to Adeimantus,

Tyranny naturally arises out of democracy, and the most aggravated form of tyranny and slavery comes out of the most extreme form of liberty.

Today, much of what was called the “free world” only half a century ago has deteriorated into a combination of residual capitalism, which has been largely and increasingly buried by socialism and fascism. (It should be mentioned that the oft-misinterpreted definition of “fascism” is the joint rule by corporate and state—a condition that’s now manifestly in place in much of the former “free” world.)

Today, many people perceive fascism as a tyrannical condition that’s suddenly imposed by a dictator, but this is rarely the case. Fascism is in fact a logical step. Just as voters succumb over time to the promises of socialism, so a parallel decline occurs as fascism slowly replaces capitalism. Fascism may appear to be capitalism, but it’s the antithesis of a free market. As Vladimir Lenin rightly stated,

Fascism is capitalism in decline.

Comrade Lenin understood the value of fascism for political leaders. Whilst he retained a close relationship with New York and London bankers, and a healthy capitalist market was tapped into for Soviet-era imports, he was aware that his power base depended largely on denying capitalism to his minions.

So, from the above quotations, we may see that there’s been a fairly erudite group of folks out there who have commented on this topic over the last 2,500 years. They agree that democracies, like sandcastles, never last. They generally begin promisingly, but, given enough time, any government will erode democracy as quickly as the political leaders can get away with it, and the progression always ends in tyranny.

We’re presently at a major historical juncture—a time in which much of the former free world is in the final stages of decay and approaching the tyranny stage.

At this point, the process tends to speed up. We can observe this as we see an increase in the laws being passed to control the population—increased taxation, increased regulation, and increased promises of largesse from the government that they don’t have the funding to deliver.

When any government reaches this stage, it knows only too well that it will not deliver and that, when the lie is exposed, the populace will be hopping mad. Therefore, just before the endgame, any government can be expected to ramp up its police state. The demonstrations by governments that they’re doing so are now seen regularly—raids by SWAT teams in situations where just a small number of authorities could handle the situation just as well. Displays of armed forces in the street, including armoured vehicles, in instances of disruption.

In London, Ferguson, Paris, Boston, etc., the authoritarian displays have become ever-more frequent.

All that’s now necessary is a series of events (whether staged or real) to suggest domestic terrorism in several locations at roughly the same time. A state of national emergency may then be declared “for the safety of the people.”

It’s this justification that will assure the success of tyranny. Historically, the majority of people in any county, in any era, choose the illusion of safety over freedom. As John Adams was fond of saying, 
Those who would trade freedom for safety will have neither.

From this point on, it would be wise for anyone who lives in the EU, US, UK, etc. to watch events closely. If a rash of “domestic terrorism” appears suddenly, it could well be the harbinger that the government has reached the tipping point—when tyranny under the guise of “protecting the safety of the people” is inaugurated.

The most essential takeaway here is that, although some may object (even violently), the majority of the people will trade their freedom for the promise of safety.