Brett Lewthwaite, Global CIO and Head of Macquarie Fixed Income and Currency
Wednesday 28 June 2017
If we were only allowed one chart
Brett Lewthwaite, Global CIO and Head of Macquarie Fixed Income and Currency
In May we conducted our annual Investor Insight Forum presenting to our closest wholesale financial advisers in all the major capital cities. For the Fixed Income component of the Forum rather than present a repeat of our well known long held views - based on what we often refer to as the overwhelming evidence - as we have done many times now, we decided to take a different approach in a presentation titled "Beyond the Hype - the folly of consensus". In other words, we explored why market forecasters keep missing - particularly when it comes to interest rates and bond markets.
Looking for evidence not comfort
We also reflected on why it rarely feels comfortable to stand away from the crowd, even when that stance is supported by deep research and analysis. The lure of the crowd is strong, and being amid the crowd with similar views to the majority is without doubt wonderfully comfortable. Unfortunately, being comfortable generally results in average, if not poor, portfolio return outcomes. In fact, embracing the discomfort and standing away from the crowd is often the more rewarding stance, however uncomfortable it may be. With this in mind, we deliberately focus on letting the evidence speak for itself and base our views and presentations on our in-depth research and analysis – that is, we base our views on the overwhelming evidence, however close to market consensus that may or may not be. Being non-consensus hasn't and never will be a deliberate stance, although it does seem to have been a common theme since the financial crisis of 2007/08.
Reflecting on this and having effectively found ourselves at odds with consensus has carried a sense of vulnerability, and the reality is that it has often felt unpopular. Even though the evidence based real story hasn't been a bad one. It just hasn’t been as exciting as the seamless and immaculate 'return to normal' theme, however hopeful and unrealistic this theme may be. Nonetheless, what starts out as lonely, grounded, vulnerable and unpopular later leads to a gradual grinding increase in credibility as the overwhelming evidence drives the market and portfolio outcomes that we broadly anticipate. Nonetheless, some things don't seem to change. The willingness of market commentators or “the street” to embrace unrealistic outlooks continues. 2017 seems little different.
Indeed being open and accessible and somewhat well known for our grounded views, we welcome, receive and attract a lot of feedback from investors in all areas of financial markets. Interestingly the feedback takes two primary forms, the first is the segment that is looking for assurance of their own similar less popular views 'are you sure?' - The second is the segment that with a sense of care reach out to remind us 'everyone else' that is 'market forecasters" believes in the 'return to normal' thesis. They are troubled that so many could do the same research that we do, and yet have conclusions that can be so different - and lean toward advising us on where we are clearly falling short in our analysis.
That one chart
Our favourite misunderstanding of the current environment includes the theme of mean reversion, that markets move in cycles and anytime now it is written that the 30 year decline in interest rates will reverse - often referred to as the bond bubble narrative. This and other popular 'return to normal' narratives under estimate the structural challenges that the global economy faces. Debt, demographics, digitalisation, dependency on Central Bank support, and risk of de-globalisation, all support our conviction in our medium term view that we are very much "Stuck in the [ever increasing indebtedness] muddle". But, if we wanted to point to the primary driver of this view, indeed if we were allowed to point to just one chart to support our view, without under emphasising the other structural influences, the chart would relate to that one four letter word that is often missing from much of the research on the outlook - D E B T.
Debt to GDP and yields
Source: Minack research, November 2016
We too are of the 'monetary policy' generation, knowing little other environment than the one where Central Banks adjust the overall cost of credit - interest rates - in the search for business cycle stability. What started out quietly as the new tool to manage economies, eventually grew an enormous unintended side effect. For over 30 years now, Central Banks have used monetary policy to encourage credit growth as a means to spur economic growth, and circumvent Schumpeters 'creative destruction' phase whereby those who have utilised credit recklessly are purged from the system i.e. default on their debts - thereby decreasing the debt build up. Instead, this smoothing of the business cycle and 'bailing out' of the more reckless has led to an ever increasing build up in debt levels that has now become an enormous burden. It is a financial law, the more debt one is in, the less able we are to tolerate certain levels of interest rates, and as this debt burden has ballooned, interest rates have fallen and fallen and are now weighed down at unnaturally low levels - even negative levels in places like Europe and Japan.
Can this go on much longer?
Despite the reflation hope and excitement spurred by the new US administration that has been embraced by markets, this theme appears set to continue. The enormous debt burden grows each and every day as government budgets continue to run deficits that are forecast to increase further due to demographics, rather than balance out or wishfully (using ‘dynamic’ accounting measures of growth and increased tax receipts) run at surplus levels.
Being realists, we want to be clear that while we hold the view that the debt burden will keep interest rates low, we also know that this situation of indebtedness is supposed to lead to a default scenario - those who overuse debt eventually either pay it down or experience trouble servicing the debt and default - individuals, corporations and governments alike. We remain ever aware that this should be the end game. However, since the financial crisis it has become clearer and clearer, via the unthinkable trillions of Quantitative Easing (QE) that Central Banks can no longer afford this business cycle to end. To allow this mature business cycle to run its natural course, to allow the creative destruction phase to reduce the debt burden, and thereby permit the possibility of higher and more normal interest rates, has for a long time now no longer been seen as a possible scenario - the impact on the social fabric and geo-political landscape would be far too dramatic. And so the game of Central Bank support appears set to go on, and on - as it has in Japan since 1990 – indeed shifting further into the unthinkable is the more likely scenario.
Add D E B T to your forecast
So why do market forecasters not refer to D E B T and its effect on the outlook for the global economy? Why do economists default back to this-is-a-normal-cycle analysis (zero, even negative rates, and trillions of QE suggests it's anything but), and fret about impending inflation, but not consider the challenges that inflation appears likely to face in front of such widespread global indebtedness. We do not know, although we note it is often, if not always, absent when we sift through the extensive research reports that we analyse, particularly in those disposed toward a return to normal thesis. D E B T is key to understanding the prevailing environment and should feature heavily in any credible analysis of the outlook.
Recently, the market had embraced two new assumptions in the hope of return to normal 1) that more stimulus is coming (fiscal, regulatory and other 'pro-business') and 2) that this stimulus would be effective. However, we highlight that this is not dissimilar to the assumptions and 'benefit of the doubt' reactions applied to the each and many rounds of once unthinkable levels of monetary policy assistance that are now widely acknowledged to have disappointed with relation to flow on effectiveness to economic growth. We have seen this pattern before - is this time different? Confidence in the ability and the timing of implementing new pro-business policies have been fading (and with it conviction in Animal Spirits) and it appears the cyclical uptick in the global economy may have peaked. Further, the US Fed has been slowly increasing interest rates and ‘the crowd’ expect this to gradually continue, likely more so if the new stimulus is forthcoming. While we are not so convinced the Fed can hike much – watch the D E B T burden - the 'benefit of the doubt' assumptions are facing a series of headwinds, even if fiscal stimulus eventually arrives and is effective.
The fall in bond yields since the beginning of the year, despite consensus calls for the opposite, is an indication that the structural influences and our chart of the D E B T burden are once again reasserting themselves.