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.
The Financial Times has kindly printed my letter below, wondering why the US Federal Reserve still fails to appreciate the impact of the ageing BabyBoomers on the economy
Sir, It was surprising to read that the US Federal Reserve is still puzzled by today’s persistently low levels of inflation, given that the impact of the ageing baby boomers on the economy is now becoming well understood (“An inflation enigma”, Big Read, September 19).
As the article notes, factors such as globalisation and technological advances have all helped to moderate price increases for more than two decades. But the real paradigm shift began in 2001, when the oldest boomers began to join the lower-spending, lower-earning over-55 generation. As the excellent Consumer Expenditure Survey from the Bureau of Labor Statistics (BLS) confirms, Americans’ household spending is dominated by people in the wealth creating 25-54 age cohort. Spending then begins to decline quite dramatically, with latest data showing a near 50 per cent fall from peak levels after the age of 74.
This decline was less important when the boomers were all in the younger cohort. BLS data show it contained 65m households in 2000, with only 36m in the older cohort. But today, lower fertility rates have effectively capped the younger generation at 66m, while the size of the boomer generation, combined with their increased life expectancy, means there are now 56m older households.
Consumer spending is around 70 per cent of the US economy. Thus the post-2001 period has inevitably seen a major shift in supply/demand balances and therefore the inflation outlook. So it is disappointing that the Fed has failed to go up the learning curve in this area. Demographics are not the only factor driving today’s New Normal economy, but central bankers should surely have led the way in recognising their impact.
US GDP growth is slowing, again, as the chart of the Atlanta Federal Reserve’s “GDP Now” forecast shows:
Forecast Q1 growth has slipped to just 0.6% from an initial 3.4% at the end of January
Consensus economic forecasts are still much higher, but even they have fallen to 1.7% from 2.2%
The decline has been accelerating, due to disappointing data from a range of key indicators. as the Atlanta Fed note:
“The forecast for first-quarter real GDP growth fell 0.4% after the light vehicle sales release from the U.S. Bureau of Economic Analysis and the ISM Non-Manufacturing Report On Business from the Institute for Supply Management on Wednesday and 0.2% after the employment release from the U.S. Bureau of Labor Statistics and the wholesale trade release from the U.S. Census Bureau this morning. Since April 4, the forecasts for first-quarter real consumer spending growth and real nonresidential equipment investment growth have fallen from 1.2% and 9.7% to 0.6% and 5.6% respectively.”
Worryingly, therefore, we seem to be repeating the usual pattern of disappointment – with New Year optimism being followed by harsh reality – as the US Federal Reserve’s deputy chairman, Stanley Fischer, noted nearly 3 years ago:
“Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back.”
The key issue, of course, is that policymakers have still not accepted that the US economy is inevitably moving into a low-growth mode, due to its ageing population. As the Chief Economist of the Bank of England, Andy Haldane noted recently, the impact of:
“Demographics in mainstream economics has been under-emphasized for too long”
There is little sign of the new policies that are urgently required to take account of the changes that have taken place in life expectancy and fertility rate. As a result, forecasts continue to be made on the basis of wishful thinking at the start of each New Year. As I noted in December:
□ Increasing life expectancy means people no longer routinely die around pension age. Instead, a whole New Old generation of people in the low spending, low earning 55+ generation is emerging for the first time in history. The average western BabyBoomer can now expect to live for another 20 years on reaching the age of 65
□ Fertility rates in the developed world have fallen by 40% since 1950. They have also been below replacement levels (2.1 babies per woman) for the past 45 years. Inevitably, therefore, this has reduced the relative numbers of those in today’s Wealth Creator cohort, just as the New Old generation is expanding exponentially
Friday’s US jobs numbers confirmed this obvious truth, as the second chart shows:
□ Less than 2/3rds of the US over-16s population now have jobs. The current percentage of 62.9% is back at 1978 levels – when the median age was 30 years, compared to today’s 38 years – and so relatively more young people were still in school and college
□ The picture for men is particularly worrying, with just 68.9% at work, an all-time low. The dcline seems to have accelerated since the Finanical Crisis began, with the participation rate falling from 73.2% in 2007
□ The percentage of women working is also still in decline, although at a slower rate. It is at 57.2% today compared to the 60% peak in 1999 before Boomer women began to retire
Even more worrying is the data shown on the 3rd chart, which highlights the changes in real wages, adjusted for inflation, since records began in 1979:
□ Average earnings in 2016 were only just higher than in 2009, at $347/week versus $345/week
□ Average earnings for men at $381/week are well below the peak of $402/week in 1979
□ Only women’s earnings are moving in the right direction, with 2016 at a new high of $312/week
□ But, of course, this highlights how women’s earnings still average only 82% of men’s earnings
It is no great surprise that US and global GDP continue to disappoint, given this evidence from the jobs market. And nothing will change until policymakers accept that today’s ageing populations require completely new policies.
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.
The Financial Times has kindly printed my letter below
, welcoming the Fed’s decision to address the impact of demographics, but arguing that it needs to focus on demand issues, given the impact of today’s ageing populations.
Sir, It is good to see the US Federal Reserve is finally beginning to address the impact of demographics on the economy, after years of denying its relevance. But as John Authers confirms in his excellent analysis of the Fed’s new research paper (“The effects of ageing”, The Big Read, October 26), its continued focus on supply-side issues means it is looking down the wrong end of the telescope.
The Fed’s approach might have made sense in the past, when demand was on a growth trajectory as the baby boomers joined the 25-54 cohort, which drives wealth creation. But today’s problem is growing overcapacity, not lack of supply, given that the ageing baby boomers already own most of what they need, while their incomes are declining as they enter retirement.
The problem is that the Fed’s economic models were developed at a time when the population effectively contained only two main segments — the under-25s and the 25-54 cohort. From a policy perspective, the number of over-55s was too small to be of interest. But this is no longer true, as increasing life expectancy means the baby boomers can now hope to live for another 20 years after reaching retirement age.
Equally important is that since 1970, fertility rates have been below the replacement level of 2.1 babies per woman in the developed world. Thus the relative size of the wealth creator cohort has been reducing for the past 45 years, while the numbers in the 55-plus cohort have been increasing. The result is that the ageing baby boomers are now nearly a third of the developed world’s population.
Policymakers therefore need to urgently refocus on the demand-side implications of ageing, if they want to craft suitable policies for this New Normal world.
Finally, one of the major Western central banks has agreed that the ageing of the BabyBoomers does indeed have an impact on the economy. John Fernald of the San Francisco Federal Reserve Bank, wrote in a new paper this week:
“Estimates suggest the new normal for U.S. GDP growth has dropped to between 1½ and 1¾%, noticeably slower than the typical postwar pace. The slowdown stems mainly from demographics and educational attainment. As baby boomers retire, employment growth shrinks. And educational attainment of the workforce has plateaued, reducing its contribution to productivity growth through labor quality. The GDP growth forecast assumes that, apart from these effects, the modest productivity growth is relatively “normal”—in line with its pace for most of the period since 1973.”
The paper only takes a limited view of the impact, just focusing on the labour market implications, as the second chart shows. This highlights, exactly as we discussed in Boom, Gloom and the New Normal; How the Western BabyBoomers are Changing Demand Patterns, Again, the enormous impact of the Boomers on the US labour force. As Fernald rightly notes:
“In the 1950s and 1960s, population (yellow line) grew more rapidly than the working-age population ages 15 to 64 (blue line) or the labor force (red line). In contrast, in the 1970s and 1980s, the labor force grew much more rapidly than the population as the baby boom generation reached working age and as female labor force participation rose. Those drivers of labor force growth largely subsided by the early 1990s. Since then, the labor force, working-age population, and overall population have all seen slower growth rates.”
Hopefully, Fernald or his colleagues will now go on to look at the issue of demand patterns. This is more critical than the labour issue in a consumer-based society such as the USA – where consumption is 70% of GDP.
As I noted in the Financial Times last year, those aged 55+ consume very much less than younger people, and essentially create demographic headwinds for the economy. They already own most of what they need, and their incomes decline as they enter retirement. So the Fed’s policy of printing money to boost demand is inevitably going to fail, as we have seen over the past decade.
But, after all these years, it is good that a start has been made, and that someone in a major central bank has recognised that the issue exists. It is impossible to move forward when everyone is in denial. The fact that Fernald works for the San Francisco Fed may also be a hopeful sign, as this was formerly the home of the current Fed Chair, Janet Yellen.
The problem, of course, as I discuss in this new interview with Will Beacham, Deputy Editor of ICIS Chemical Business, is that much of the damage has already been done. The chemical industry is the 3rd largest in the world after energy and agriculture, and it now faces major issues of over-capacity at a time of slowing (or perhaps even negative) demand growth.
The UK’s Brexit vote to leave the European Union has been the catalyst for a sudden realisation that all is not well in the global economy. It seems likely that 2017 will prove to be a difficult year. I hope that the interview may help you to prepare for this.