Global interest rates have fallen dramatically over the past 25 years, as the chart shows for government 10-year bonds:
UK rates peaked at 9% in 1995 and are now down at 1%: US rates peaked at 8% and are now at 2%
German rates peaked at 8% and are now down to 0%: Japanese rates peaked at 4% and are now also at 0%
But what goes down can also rise again. And one of the most reliable ways of investing is to assume that prices will normally revert to their mean, or average.
If this happens, rates have a long way to rise. Long-term UK interest rates since 1703 have averaged 4.5% through wars, booms and depressions. If we just look more recently, average UK 10-year rates over the past 25 years were 4.6%. We are clearly a very long way away from these levels today.
This doesn’t of course mean that rates will suddenly return to these levels overnight. But there are now clear warning signs that rates are likely to rise as central banks wind down their Quantitative Easing (QE) and Zero Interest Rate stimulus policies. The problem is the legacy these policies leave behind, as the Financial Times noted recently:
“In total, the six central banks that have embarked on quantitative easing over the past decade — the US Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England, along with the Swiss and Swedish central banks — now hold more than $15tn of assets, according to analysis by the FT of IMF and central bank figures, more than four times the pre-crisis level.
“Of this, more than $9tn is government bonds — one dollar in every five of the $46tn total outstanding debt owed by their governments. The ECB’s total balance sheet recently topped that of the Fed in dollar terms. It now holds $4.9tn of assets, including nearly $2tn in eurozone government bonds.”
The key question is therefore ‘what happens next’? Will pension funds and other buyers step in to buy the same amount of bonds at the same price each month?
The answer is almost certainly no. Pension funds are focused on paying pensions, not on supporting the national economy. And higher rates would really help them to reduce their current deficits. The current funding level for the top US S&P 1500 companies is just 82%, versus 97% in 2011. They really need bond prices to fall (bond prices move inversely to yields), and rates to rise back towards their average, in order to reduce their liabilities.
The problem is that rising yields would also pressure share prices both directly and indirectly:
Some central banks have been major buyers of shares via Exchange Traded Funds (ETFs) – the Bank of Japan now owns 71% of all shares in Japan-listed ETFs
Lower interest rates also helped to support share prices indirectly, as investors were able to borrow more cheaply
Margin debt on the New York Stock Exchange (money borrowed to invest in shares) is now at an all time high in $2017. Ominously, company buy-backs of their shares have already begun to slow and are down $100bn in the past year.
House prices are also in the line of fire, as the second chart shows for London. They have typically traded on the basis of their ratio to earnings
The average ratio was 4.8x between 1971 – 1999
But this ratio has more than doubled to 12x since 2000 as prices rose exponentially during subprime and then QE
The reason was that after the dotcom crash in 2000, the Bank of England deliberately allowed prices to move out of line with earnings. As its Governor, Eddie George, later told the UK Parliament in March 2007:
“When we were in an environment of global economic weakness at the beginning of the decade, it meant that external demand was declining… One had only two alternatives in sustaining demand and keeping the economy moving forward: one was public spending and the other was consumption….
“We knew that we had pushed consumption up to levels that could not possibly be sustained in the medium and longer term. But for the time being if we had not done that the UK economy would have gone into recession, just like the economies of the United States, Germany and other major industrial countries. That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”
Of course, as the chart shows, George’s successors did the very opposite. Ignoring the fact that a bubble was already underway, they instead reduced interest rates to near-zero after the subprime crisis of 2008, and flooded the market with liquidity. Naturally enough, prices then took off into the stratosphere.
Today, however, the Bank is finally recognising – too late – that it has created a bubble of historical proportions, and is desperately trying to shift the blame to someone else. Thus Governor Mark Carney warned last week:
“What we’re worried about is a pocket of risk – a risk in consumer debt, credit card debt, debt for cars, personal loans.”
Of course, the biggest “pocket of risk” is in the housing market:
Lower interest rates meant lower monthly mortgage payments, creating the illusion that high prices were affordable
But higher prices still have to be paid back at the end of the mortgage – very difficult, when wages aren’t also rising
The Bank has therefore now imposed major new restrictions on lenders. They have ordered them to keep new loans at no more than 4.5x incomes for the vast majority of their borrowers. And lenders themselves are also starting to get worried as the average deposit is now close to £100k ($135k).
Of course, London prices might stay high despite these new restrictions. Anything is possible.
But fears over a hard Brexit have already led many banks, insurance companies and lawyers to start moving highly-paid people out of London, as the City risks losing its “passport” to service EU27 clients. Over 50% of surveyors report that London house prices are now falling, just as a glut of new homes comes to market. In the past month, asking prices have fallen by £300k in Kensington/Chelsea, and by £75k in Camden, as buyers disappear.
The next question is how low could prices go if they return to the mean? If London price/earning ratios fell back from today’s 12x ratio to the post-2000 average of 8.2x level, average prices would fall by nearly a third to £332k. If ratios returned to the pre-2000 level of 4.8x earnings, then prices would fall by 60% to £195k.
Most Britons now expect a price crash within 5 years, and a quarter expect it by 2019. Brexit uncertainty, record high prices and vast overs-supply of new properties could be a toxic combination, perhaps even taking ratios below their average for a while – as happened in the early 1990s slump. As then, a crash might also take years to unwind, making life very difficult even for those who did not purchase when prices were at their peak.
Monetary policy used to be the main focus for running the economy. If demand and inflation rose too quickly, then interest rates would be raised to cool things down. When demand and inflation slowed, interest rates would be reduced to encourage “pent-up demand” to return.
After the start of the Financial Crisis, central banks promised that lower interest rates and money-printing would have the same impact. They were sure that reducing interest rates to near-zero levels would create vast amounts of “pent-up demand”, and get the economy moving again. But as the chart shows for US GDP, they were wrong:
□ It shows the rolling 10-year average for US GDP since 1950, to highlight longer-term trends
□ It confirms the stability seen between 1983 – 2007 during the BabyBoomer-led economic SuperCycle
□ The economy suffered just 16 months of recession in 25 years, as monetary policy balanced supply and demand
□ But the trend has been steadily downwards since 2008, despite the record levels of stimulus
The clear conclusion is that monetary policy is no longer effective for managing the economy.
Encouragingly, the UK Parliament’s Treasury Committee has now launched a formal Inquiry to investigate ‘The Effectiveness and impact of post-2008 UK monetary policy‘. We have therefore taken the opportunity to submit our evidence, showing that demographics, not monetary policy, is now key to economic performance. We argue that:
It was clearly important until 2000, when the great majority of people were in the Wealth Creator 25 – 54 age group (which dominates consumption and therefore drives GDP growth). But its impact is now declining year by year as more and more BabyBoomers move into the 55+ age group – when incomes and spending begin to decline quite rapidly
Friedman’s analysis of the effectiveness of monetary policy, when he argued that “inflation is always and everywhere a monetary phenomenon”, is therefore no longer valid. Modigliani’s “Life Cycle theory of consumption” is similarly out of date
The issue is simply that both Friedman and Modigliani were working in an environment which assumed that people were born, educated, worked – and then died soon after reaching pension age. In these circumstance, their theories were perfectly valid and extremely useful for modelling the economy
Today, however, the rapid increase in life expectancy, together with the collapse of Western fertility rates below replacement level, means that a paradigm shift has taken place. People are now born, educated, work – and then continue to live for another 20 years after retirement, before dying
The essential issue is that “you can’t print babies”. Monetary policy cannot solve the demographic challenges that now face the UK (and global) economy
We therefore hope that the Committee will conclude that monetary policy should no longer be regarded as the major mechanism for sustaining UK growth
Please click here if you would like to read the evidence in detail.
Italy was one of the 6 founding members of the European Union (EU) in 1957, along with France, the Netherlands, W Germany, Belgium and Luxembourg. Its referendum next month will therefore be a critical test of whether the Eurozone and EU can survive the pressure from the Populists.
If the Populists win, then the future of the Eurozone and the EU itself will be in doubt.
As often happens at critical moments, the subject of the referendum is of relatively minor importance. It was called by Premier Matteo Renzi to amend the constitution by approving a reform of Italy’s Parliament. The problem is that he then made himself the key issue in the referendum, by promising to resign if he lost, as he confirmed to Italian media last week:
“If the citizens vote no and want a decrepit system that does not work, I will not be the one to deal with other parties for a caretaker government”
Italy is now in a 2 week blackout period for polling before the vote on 4 December. But the final polls showed the “No vote” with a comfortable lead. There is therefore a major risk that Renzi will soon be following UK premier Cameron out of office. 3 quite different Scenarios could then develop:
Another premier takes over. Italian premiers have historically not lasted long. Before Renzi took over in 2014, there had been over 50 different premierships since Italy’s first post-War premier, Alcide de Gasperi, resigned in 1954. So maybe, the revolving door revolves again, and a new premier is appointed by the President
New elections are held, and another premier takes over. Renzi was the 3rd Italian premier in a row to take office without have a personal mandate from an election (neither Mario Monti or Enrico Lette had this). An election may therefore take place, after which perhaps the revolving door revolves again
New elections are held and an anti-euro coalition takes office. This would seem to be the base case Scenario, with a probability of at least 50%. It would likely means that Beppe Grillo’s anti-euro 5 Star Movement would take office with Berlusconi’s Forza Italia and the Northern League, and would then hold a referendum on leaving the euro – with the aim of capping Italian debts and nationalising its banks, as Grillo has promised
Given that around €360bn ($400bn) of all Italian loans are classed as “troubled”, and amount to around one-fifth of total loans, capping the debts would cause major disruption to the Eurozone and global financial systems. Leaving the euro would also mean, that foreign holders of Italian debt would be paid in Italian lira, not euros. And presumably this would be after a devaluation of the lira. So as the Financial Times warned on Monday:
“Since banks do not have to hold capital against their holdings of government bonds, the losses would force many continental banks into immediate bankruptcy. Germany would then realise a massive current account surplus also has its downsides. There is a lot of German wealth waiting to be defaulted on.”
DEMOGRAPHIC REALITY IS NOW CONFRONTING STIMULUS FANTASY
Italy’s real problem is not its Parliament, but that its economic policies haven’t adjusted to the New Normal world. Like most developed countries, politicians of all parties have failed since the end of the BabyBoomer-led SuperCycle, to understand the trade-off that has taken place between increased life expectancy and economic growth. Italy has a median age of 45 years, and as the chart above shows:
It now has only 24m in the Wealth Creating 25 – 54 cohort, versus 22m New Olders in the 55+ cohort
By 2030, it will have just 20m Wealth Creators and 26m New Olders
This is completely different from the 1950 position, when there were 18m Wealth Creators and only 8m New Olders
In addition, of course, Italy has become the main route for migrants and refugees following the EU’s deal with Turkey. 168k people have already arrived this year, compared to 154k in the whole of 2015 and 170k in 2014. Resources have been further strained by the sequence of earthquakes, which are made worse by the lack of anti-seismic regulations for its buildings.
It is small wonder, therefore, that the 5 Star Movement is building support, having won Rome in this year’s elections, whilst the Lega Nord (Northern League) won the Veneto and Lombardy regions.
Nor is it surprising that investors are starting to panic. As I discussed on Monday, Italy’s 10 year interest rate has doubled to 2% since the summer. It could go very much higher if Renzi loses, as the prospect of a vote to leave the eurozone and cap Italy’s debts comes closer.
This is the Great Reckoning in action, and there is probably little that the European Central Bank (ECB) can do to mitigate the position. In a few weeks’ time, investors may well wonder how they allowed Italian interest rates to trade below US rates for much of the past few years. And in a few months’ time, it may well seem equally incredible that anyone ever believed ECB’s President Mario Draghi’s 2012 boast that:
“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”.
It could be a very difficult H1 in 2017. Next month’s Italian referendum is followed in March by Dutch elections and in May by France’s Presidential election. Both may well be won by parties committed to leaving the EU itself.
It is therefore hard to ignore the possibility that by June, the EU could have effectively ceased to exist in its current form. Developing a contingency plan, in case this develops, could well be the wisest move you make in 2016.
Markets have one main function in life – price discovery. If I want to buy, and you want to sell, the existence of a market allows us to discover the price at which the market will balance in terms of supply and demand.
History, however, provides many examples of times when rulers decided they knew best, and destroyed market economics. The Soviet Union was one recent example, where the Central Committee of the Communist Party would decide what was going to be made and where, and the price at which it was being sold. That system of course collapsed with the Berlin Wall in 1989, but the collapse took decades to happen.
Today, we have another central organisation which is attempting to carry out the same manoeuvre – the main central banks in the West. They have also destroyed price discovery by flooding markets with endless supplies of free cash. The evidence for this statement is in the 3 charts shown here.
The chart above shows capacity utilisation (CU%) in the global chemical industry – the best real-time indicator that we have for the global economy. New data from the American Chemistry Council shows CU% fell yet again in August to 78.7%, nearly 2 percentage points below August 2015:
This pattern has only been seen before in 2001 and 2008, which were not good years for the industry or the global economy
It has now fallen every month this year, and the 2009 – 2016 average is nearly 10 percentage points below the average seen before the Financial Crisis began in 2008
The second chart confirms the downturn underway. It shows earnings for the UK’s FT 500 Index since 1985, set against the price/earnings ratio. As one would expect, given the CU% decline, earnings have been tumbling in the past year:
They peaked at almost 400 in mid-2011, and had eased to around 200 by mid-2015
Since then, they have more than halved to just 93 on Friday
Normally, of course, this would mean that market prices also fell, as the outlook for earnings worsened.
But the opposite has in fact happened, as the central banks have simply pumped out more and more free cash. They have even taken interest rates to negative levels in many major markets such as Japan, Germany and the UK.
Investors, increasingly desperate to try and meet their target returns for paying pensions etc, have responded by bidding up the price/earnings ratio from 18 a year ago to 49 today – easily the highest level ever seen in the period.
This takes us to the 3rd chart, showing the IeC Boom/Gloom Index. It measures sentiment versus the US S&P 500 Index, and shows this has fallen back to danger levels once more.
All the investors to whom I talk, recognise that the market is being completely rigged by the central banks. But, they say, “what can we do? We cannot go into cash, as it yields nothing, and benchmark Western government bonds also yield nothing”: $12tn of bonds even have negative yields. The fact that some of the best performing US$ debt markets in Q3 were El Salvador, Mongolia and Zambia highlights how desperate the “search for yield” has become.
How long will the central banks be able to keep markets artificially high and defy economic reality? We cannot know. But we do know they are providing a fertile breeding ground for populist politicians, as I will discuss on Wednesday.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 54%
Naphtha Europe, down 52%. “Petchem demand remains strong”
Benzene Europe, down 54%. “European derivative demand was struggling after the traditional seasonal slowdown in August. Many in the market had been braced for a strong upturn this month and into the fourth quarter, but this has yet to materialise”
PTA China, down 41%. “Some producers increasing their offers due to turnarounds in China and South Korea”
HDPE US export, down 27%. “China’s import prices fell in the week tracking lower offers of import cargoes from some suppliers”
S&P 500 stock market index, up 11%
The Western BabyBoomers (born between 1946-70), have been one of the luckiest generations in history. By and large, they have escaped the major wars that have plagued society down the ages. They have also lived in a world where living standards and material wealth have made astonishing gains. Equally priceless has been the rise in life expectancy, which means the average 65 year-old can now expect to live another 20 years.
But politicians didn’t want to acknowledge the impact of this shift in life expectancy on the economy. Nor did central bankers want to reveal that it was demographics that created the long economic SuperCycle between 1983 – 2007 (when the US suffered just 16 months of recession in 25 years). That would have spoiled the myth of their genius, and the forecasting ability of their supposedly all-powerful Dynamic Stochastic General Equilibrium economic models.
Similarly, nobody rushed to have a conversation with the voters about the need for a major increase in pension age:
□ The UK introduced state pensions just a century ago in 1909, when life expectancy was just 50 years. Only 400k of the UK’s 40 million population were eligible to receive it
□ It was “social insurance” – “a small amount of money for a small number of people for a small amount of time”
□ Today, it has become a universal benefit, received by 17% of the population. And this proportion is set to rise as the Boomers move into retirement
Of course, no politician wanted to tell voters that pension age should be increased in line with life expectancy. Nor did they want to face the consequences of the post-1970 collapse in fertility rates. This means that in more and more countries,there are more people over the age of 65 than children under 15. And as Bloomberg notes:
“A shrinking workforce cannot foot the pension bill”.
CENTRAL BANKERS DON’T WANT TO ADMIT THEY WERE LUCKY, NOT CLEVER
But now, the Boomers’ luck is running out, at least in the UK. The warning sign was seen in 2008 with the financial crisis. This highlighted the fact that today’s ageing population are creating a “replacement economy”. Monetary policy is irrelevant when confronted with the fact that 65-year olds do not have the same spending power as when they were 35. Equally important is that they now own most of the things they were buying when they were younger.
But it would be too embarrassing for central bankers to admits they had been lucky rather than clever.
Now the Brexit vote is bringing the chickens home to roost. Last week, the Bank of England put on its “Superman” tunic again – deciding to take interest rates even lower, and weaken the value of the pound.
They chose to ignore the fact that their action probably created a “disaster scenario” for pension funds.
The interest rate for government borrowing is the major factor in determining the solvency of any pension scheme. And a zero, or negative, rate for government bonds makes it almost impossible for a pension fund to meet its commitments to pensioners. The chart above, based on new data from the official Pension Protection Fund highlights the problem:
□ Massive funding deficits have developed since the Bank began its stimulus programme in 2009
□ More than 4 out of 5 defined benefit corporate pension funds are now in deficit – 84%
□ Their total deficit (including the surplus schemes) increased in July to £408bn ($530bn)
□ They were then only 77.4% funded – and the situation will be worse today due to the further decline in interest rates
As the former Pensions Minister, Ros Altmann, told the Financial Times yesterday:
“The Bank wants to stimulate the economy by bringing down interest rates, but the Bank is not acknowledging the negative impact these measures are having on pension deficits, and neither is the government.”
As Altmann warns, this deficit will have real world consequences. Either employers will have to increase their contributions, or pensioners will not get their promised pensions. Both outcomes will have negative consequences for the UK economy, as they will either reduce company profitability or reduce pensioners’ future spending power.
One also cannot ignore the potential for political fall-out if pension funds fail to meet their commitments to pensioners.
The problem is that the Bank – like its peers in Europe, USA and Japan – loves to be the centre of attention. It therefore chooses to ignore the fact that by creating further artificial demand for gilts in the short-term, it is creating major economic and political risks for the medium and longer term. And as we all know, there is a moment when a medium-term risk becomes short-term reality.
We may not be too far away from that moment now, as millions of pensioners start to realise their pension funds may well go bankrupt.
It may be an idea to keep your smartphone charged and within reach, if you are planning a trip to the beach this month. Certainly market behaviour since June has been more and more skittish. The experts, after all, were telling us that central banks were certain to do more major stimulus efforts to boost stock and commodity prices: they were also sure that the US economy was poised to do well.
Instead, we have had minimal stimulus from the European Central Bank (ECB) and Bank of Japan (BoJ), whilst the US Federal Reserve was clearly taken by surprise with Friday’s weak GDP news for Q2.
Now investors are beginning to worry that the central banks are out of stimulus ammunition, and have very little further room for manoeuvre. Japan has suddenly become the “weak link” in the chain:
Its interest rates have risen sharply since Friday when the BoJ disappointed markets with only minor policy moves
The benchmark 10-year bond is almost yielding a positive amount, after offering only negative yields since March
Some traders now even worry that the BoJ may have to raise interest rates to protect the banking sector
There was a similar state of confusion at the ECB last month, when markets were told to wait until after the holidays for any further stimulus.
So traders have gone on holiday leaving a vacuum behind them. And as we all know, “nature abhors a vacuum”. Oil prices are thus becoming a key indicator for the financial sector:
They are now down $11/bbl since their early June peak, a 21% fall
Their attempts to rally are being beaten back by news of ever-higher supply gluts in oil and products
And even though the US$ has weakened sharply over the past week, the hedge funds are not moving back into the market, as has always happened in recent years, when they believed that “weak dollar = higher oil prices”
So we could now be watching the second stage of the Great Unwinding in action. The first stage began nearly 2 years ago, when the dollar began to rise and oil prices to collapse. Now we may be seeing markets start to ignore the actions of central banks, and instead focus for the first time since 2008 on the fundamentals of supply and demand. If they do this, they may not like what they see:
Oil markets have record levels of inventory all around the world
Traders have become nervous about buying shares with borrowed money in the New York stock market
Developments in the European debt and refugee crises are also not encouraging
Plus there is increasing nervousness around the world over the outlook for the US Presidential election
As always, the IeC Boom/Gloom Index is highlighting the potential turning point. Although the S&P 500 has recently made a new all-time high, the Index did not confirm the higher numbers. Instead, it has retreated to just above the 4.0 level which has signalled pullbacks in the past.
If this proves accurate, and oil prices keep tumbling, then we may have a busy month ahead.