12 Oct 2021
The third quarter started very much where the second quarter left off, with markets performing strongly, encouraged by the belief that the goldilocks economy, especially in the US, would continue. Early economic data during the quarter, including unemployment numbers, suggested a slowdown in the breakneck pace of the recovery seen in Q1, leading investors to believe that central bank policies would remain firmly supportive of markets, while governments continued with their pledge of providing fiscal support during the early stages of the recovery. The first two months of Q3 showed an outperformance of the growth investment style over value, although there was some more mixed performance amongst technology stocks outside of the sector’s mega caps. In a bull market driven by multiple expansion over earnings growth in the post GFC period, it is the decline of the natural rate of interest or r* which has arguably been the most important factor behind strong returns across all financial assets. This lower discount rate on future earnings has driven the outperformance of growth over value in the past decade, especially against a backdrop of subdued economic activity. After a brief value rally in the first quarter, investors have once again focused on the prospects of continued positive but subdued growth and a return to the economic conditions described by Larry Summers as ‘secular stagnation’.
Some economic commentators had expected the retirement of the baby boomer generation, which would take this demographic cohort from being net spenders to net savers as they retired from the labour force, to alleviate downward pressure on the natural (equilibrium) rate of interest. However, papers were presented by Atif Mian, Ludwig Straub and Amir Sufi in a recent study prepared for the 2021 Jackson Hole Economic Symposium, hosted by the Federal Reserve Bank of Kansas City (which at the last minute due to Covid-19, returned to last year’s virtual format), suggesting that a different factor has driven the increase in savings and, therefore, the discount rate applied to equities is lower. The economists involved compared the importance of demographic shifts in the US to rising income inequality on the evolution of saving behaviour from 1950 to 2019. Their study suggested that rising income inequality is more important than the ageing of the baby boom generation when it comes to spending patterns. Their work highlighted that saving rates are significantly higher for high income households within any given birth cohort relative to other households in the same birth cohort, or in other words, the highest income households in not only the baby boom generation but the generations preceding this have a higher propensity to save, while lower income households in any given birth cohort have a higher propensity to spend. In the US, there has been a large rise in the income share of high-income households since the 1980s and this pattern has been seen globally, both in the developed and developing world and the result is a large rise in saving by high income earners whether they are based in the United States, Europe, or China and this has occurred at a time when the natural rate of interest, which determines the discount rate applied to equities, has fallen. These findings have challenged the view that demographic shifts due to the ageing of the baby boom generation, significant savers during their peak earning periods, were the primary factor behind the decline in r* (equilibrium rate of interest).
The three economists highlighted that the natural rate of interest has fallen to extremely low levels during the last 40 years, presenting serious challenges to policy makers and complicating the ability of central banks to respond to an economic downturn with monetary policy at the zero-lower bound in the US and in negative territory in other regions. The persistently low natural rate of interest led to the economic backdrop being labelled one of ‘secular stagnation’ in which there was an excess supply of savings driving real interest rates down. As a result, there have been concerns about asset price bubbles. The paper acknowledged that the period where there’s been a decline in this interest rate from 1980 onwards, has occurred alongside several differing trends; not just rising income inequality, but also an ageing population, shifting patterns in global savings, changes in how businesses invest and a fall in the inflation rate.
The Survey of Consumer Finances in the US covers the 1950-2019 period and demonstrates that there had been a shift in income share towards higher saving (richer) parts of the population. The study was careful to analyse this income distribution within similar birth cohorts to remove any demographic factors which could explain the fall in rates. The study found that the top 10% income households within a given birth cohort have a saving rate that is between 10 and 20 percentage points higher than the bottom 90%. By the end of the period, the top 10% within any birth cohort income distribution has an income share almost 15 percentage points higher than the top 10% prior to the 1980s. With a naturally higher savings rate amongst the top 10% of the population, boosted by the share of overall income enjoyed by high-income households, there has been a significant increase in savings entering the financial system. The three economists estimated that between 3 and 3.5% more of national income was saved by the top 10% from 1995 to 2019 compared to the period prior to the 1980s which represented 30-40% of total private saving in the US economy from 1995 to 2019, arguing that this scenario is a powerful force putting downward pressure on interest rates.
The paper also showed that savings rates across different working age distributions don’t vary substantially, so even when baby boomers move into the higher saving middle aged group, the rise in actual saving across the board is modest, suggesting that age distribution doesn’t contribute to patterns in household saving. By the end of the sample period, the baby boom generation enters the low saving rate retirement years and with their savings declining, some would have expected the downward pressure on the natural rate of interest to moderate, yet as investors have seen, r* has continued to decline. The large differences in saving behaviour between high income households and the rest of the population is present within the baby boom generation itself in the US; the top 10% save more than earlier generations and the bottom 90% save less, indicating that the rich and non-rich households of the baby boom generation have displayed substantially different saving behaviour over their life cycle.
This topic has been picked up by Martin Wolf at the Financial Times who points out that in an unprecedented economic era of post-pandemic recovery, historic norms have little relevance as the world has not been here before. The paper presented at Jackson Hole pointed out that the natural rate of interest or equilibrium rate, which balances demand and supply in the economy, should result in stable prices and has fallen in the US over the past 40 years since 1980 from around 4% to zero today. The targeting of an equilibrium rate of interest has resulted in the inflation policy adopted by most central banks. The decline in equilibrium rates has been matched in all other high-income countries and is a large factor behind why central banks have had to make huge asset purchases in crisis situations if nominal rates are already at the zero bound. There is no scope for a traditional monetary response to a downturn.
At the aggregate level, savings must match investment, so as the rich get richer and try to save more, interest rates fall. Demographic factors have also weakened the propensity to invest. The offsets have come from both persistent fiscal deficits, together with higher spending by the bottom 90%, both of which have been fuelled by debt and the rise in house prices. This tendency towards income inequality is shared by almost all large economies, not just in the developed world, and has been very strong in some countries such as China. The Global Financial Crisis and subsequent Eurozone crisis saw a central bank response which rescued the financial system but doubled down on low rates. While the Covid-19 crisis was a bolt from the blue, the response by central banks was on an even bigger scale, with an increase in broad monetary aggregates which has helped fuel the recent uptick in inflation, together with supply side disruption.
For most countries there are few reasons to expect income inequality to change and central bank stimulus was always likely to result in increases in the price of real assets. The country that has shown the greatest inclination to follow through on redressing this to date has been China, where the move has been towards promoting a society with ‘common prosperity’, whereas in the developed world, progress on this front seems much slower; in the US, the impact of corporate lobbying is a serious obstacle to change. The structural long-term disinflationary forces have not gone away and looking back at the three Ds discussed in previous market updates, debt levels have increased due to Covid-19, while the impact of demographics and disruptive technology remain ever-present. Recent worker shortages in some industries have seen businesses respond by accelerating plans for greater automation.
This leads on to looking at the shorter-term and even in a secular disinflationary environment over the medium and long-term, there can be upticks in cyclical inflationary forces with the current disruptions to the supply chain being a case in point. Certain industries, often those most disrupted by the pandemic, have found it hard to re-attract laid off workers, and are happy to raise wages, although whether wages will rise across the board enough to compensate for the increased costs of many essentials such as food, energy and heat remains to be seen. Supply side disruptions have resulted in manufacturing closures in some countries in Asia including Vietnam as the Delta variant in these countries has proved to be much harder to control. The limitations of a ‘just-in-time’ supply chain have been demonstrated with a rise in shipping costs impacting on both economic activity and prices amid reports of many containers being stranded on the wrong side of the world. The time horizon of the expected transitory inflationary pressures has now been expanded from a few months well into 2022.
The most recently released minutes of the US Federal Reserve meeting were taken by market participants in the first few days as being dovish, when in fact there was a small shift in tightening expectations with most Fed members now expecting the first rate rise in 2022 and a further three in 2023. Comments by the Bank of England also refer to heightened inflationary pressures and it seems expectations for a UK rate rise have now been brought forward to the November to end March period.
The final week of September saw government bond yields react to what have been slightly more hawkish signals from the major central banks, combined with gas shortages, a rally in the oil price, and increased costs of fuel. This resulted in US treasury yields reaching their highest level in three months and rising above 1.50% for 10-year treasuries and UK gilts yielding over 1%. Consumer price inflation in the US has now topped 5% for three consecutive months and the Bank of England expects UK inflation to exceed 4% well into next year. Investor positioning had become progressively more bullish on the outlook for government bonds. In the short term, these raised interest rate expectations have hurt growth stocks, reinforcing behaviour in rotational markets in 2021. The acceleration in the bond market selloff, which had seen yields creep up since early August, resulted in heightened volatility in equities, or in layman’s terms a sharp pullback, with the rise in yields centred across the middle and long end. These moves were reminiscent of the first quarter when the reflation trade dominated market sentiment and saw strong outperformance of value stocks over growth-orientated investment styles. The recent moves need to be placed in context and it remains the case that next year should continue to see above trend economic growth, especially as many countries have been slow to fully vaccinate their population. Next year globally, economies should benefit from far fewer lockdowns unless a new deadly variant of the virus emerges.
Globally, house prices remain very strong, in some cases encouraged by central bank policy, and wages are generally rising, although at varied rates depending on the industry in question. While real interest rates have risen, 10-year US real yields, or in other words the post-inflation return to investors, remain negative, although a little less so than three months ago. Bond markets may also now be anticipating a pullback in purchasing by the world’s biggest buyers of government bonds, the central banks. This year has seen a total of around $300bn of monthly bond buying from all the central banks combined, so as they exit from this policy, some short-term turbulence is expected.
Some market commentators such as Mohammed El-Erian believe that with US benchmark treasury yields, the most important market indicator in the world (signalling expectations about growth and inflation) have come through central bank policies such as QE. Consequently, their information content has become distorted and less relevant with a de-coupling of bond prices (yields) from economic fundamentals. El-Erian believes that, if the Fed embark on tapering rather than continuing monthly bond purchases at the same level as at the height of the Covid-19 pandemic, there is a lower risk of severe disorderly market adjustments as policy will be more transparent.
This year has seen bond yields gyrate quite violently over short periods of time without any huge change to the immediate macro fundamentals with the jump in yields over the past week coinciding with a period where economic growth estimates have been pared back slightly, although admittedly, inflationary expectations have become a little more entrenched. The style rotation in equities which had been driven by bond markets shows how difficult macro forecasting is for markets in the short-term. While short-term macro forecasting remains extremely tricky, longer-term secular trends or themes have been and will likely continue to be an important influence on how an investor should shape their portfolio. Bottom-up stock picking needs to be carried out within a wider context with the theme of wealth inequality discussed earlier clearly a factor behind the outperformance of growth over value stocks. Within China, companies need to be aligned with the objectives of the Party which is now focused on ‘common prosperity’ rather than high headline growth rates, and concerns over inequality could alter sector trends to some degree. In China, companies whose policies are most at odds with this have seen a severe reaction in their share price during the third quarter.
To date in 2021, equity market performance has been driven far more by macro considerations in the form of expectations about future levels of inflation, short-term interest rates, and bond yields rather than stock picking, with extreme and sometimes violent rotations between the value and growth investment styles. This has meant that at certain periods of time, however good a stock picker is, they have not been able to defy headwinds over the shorter-term. Globally, central banks and governments over the last 18 months have provided unprecedented monetary and fiscal support to economies and financial markets. This stimulus meant that there was confidence in the prospects for an economic rebound resulting in strong asset prices and, more recently, a fear of rising inflation. Investors looking at fundamentals (high levels of stimulus) would have expected a stronger economy, higher corporate profits, tighter labour markets, and if more money is chasing a limited supply of goods, for prices to rise, or in other words for there to be higher inflation. Perhaps for the first time in the post GFC period, supply side bottlenecks due to the Covid-19 pandemic have seen demand outstrip supply in certain sectors, and with the disruptions to the shipping market, globalisation has had less of an impact in relieving these tensions. Pre-GFC, inflation targeting central banks would have pre-empted a change in inflationary expectations by tightening monetary policy to ensure the economy they watch over did not return to a 1970’s style high inflation era. Since the GFC, central bankers in the US, Europe, and Japan have targeted a 2% rate of inflation but none of them have been able to achieve this and in the case of Japan, come anywhere near its target despite, for many countries, lengthy periods of economic expansion, when governments have run significant budget deficits and tried to expand the money supply through QE and low interest rates. The so-called Phillips Curve which argues for an inverse relationship between unemployment and inflation has not worked in the post GFC period. There’s little mention now of the Phillips Curve and the non-inflationary rate of unemployment.
Inflation and its impact on interest rates are especially important at a time when financial assets have re-rated upwards and a lack of visibility on inflation is a major factor behind the sharp style rotations seen this year. Central bank actions in preventing a Covid-19 depression by flooding the financial markets with money has driven significant gains in asset prices and, while not by intention, widened the inequality gap. The areas of the economy seeing the strongest price rises have been home prices, used cars, some materials and commodities and components of smartphones such as semiconductor chips. There has also been a shortage of labour in certain sectors resulting in cost increases for businesses which will be passed on to the end consumer to preserve margins.
Those arguing that higher inflation will be transitory point out that pre Covid-19, central banks had no success in even reaching their inflation targets for a short period of time and once the disruptive influences of Covid-19 on the global supply chain pass through, the world will return to a period of subdued growth with disinflationary pressures. In most cases, price rises have not been driven by a significant rise in demand but rather supply disruption. Unless the average worker sees an increase in compensation to offset the higher cost of living, disposable income will come under pressure.
With the end of lockdowns across the globe, a period of strong consumer spending due to pent up demand was inevitable and those who have remained in work or benefitted from government furlough schemes have seen a build-up in savings. This, however, is likely to prove temporary. Post 2022, pent-up consumer demand could be yesterday’s story and the supply chain disruptions will no doubt have rectified themselves. Combined with some pullback in the level of monetary support and QE by central banks, growth rates are likely to moderate back towards trend, significantly easing today’s inflationary pressures.
For investors today, the question whether higher inflation is permanent or transitory is perhaps the most important factor influencing portfolio construction. If you view the answer as being important but not knowable with certainty, constructing a portfolio which can avoid extreme outcomes may be the most prudent course of action.
Investing is an art rather than a science that has always embraced uncertainty. Uncertainty, however, does not mean that an investor cannot prepare a portfolio for the future and some degree of weather proofing is prudent; exiting a pandemic means that there are no historical precedents for what will happen next. While equities have certainly performed strongly in recent years, the earnings yield versus bonds has not really budged and looking at the valuations of all asset classes outside of equities, it is hard to find investment choices that are likely to deliver on the aspirations of longer-term savers, other than equities, especially pension fund savers. In this environment, for those committed to markets for the long run, it is usually best to remain fully invested, unless evidence to the contrary is absolutely compelling.
Investors should also think over their attitude to risk. Equity markets are inherently volatile from time to time and many of the sharp setbacks that have occurred over the last 50 years have not been easy for investors to predict. Some have occurred at times of extreme over-valuation by historic norms of equities, in absolute terms, which is generally during times of economic optimism, ‘justifying’ the view in the eyes of the majority that ‘this time is different’. In the 1970s, the oil crisis ushered in a period of high inflation which proved to be something most economists found hard to explain, and therefore the success of Paul Volcker, US Federal Reserve Chair, in taming the inflationary tiger through raising interest rates, dramatically caught most investors by surprise. Similarly, the Telecommunications, Media and Technology (TMT) bubble, the GFC and the Eurozone Crisis, to name but three, have only been forecast by a minority of investors, otherwise the bull market would have ended before these factors impacted on economic fundamentals.
When setbacks occur at times of expensive valuations, there is always the potential for these to be severe and fast moving as was the case in 1987, 2000 and 2008 (where overvaluation was most apparent in credit). Covid-19 was a left field event and completely unpredictable. While equities show periods of volatility, this can be very different from risk if it’s defined as the permanent loss of capital and if investors have a truly long-term time horizon, they should consider how much they are prepared to spend to hedge out volatility risks, for example, in the form of holding low-yielding government or investment grade bonds. At times of market volatility, the safe-haven status of even investment grade corporate debt has not held up as well as investors might expect, as was seen during both the GFC and during the Covid-19 pandemic. In periods of extreme stress when investors need investment grade debt to maintain long-term low correlation with equities, this does not always occur.
Martin Wolf, chief Financial Times economics commentator, has written that equities have delivered long-term outperformance for investors despite World Wars, a depression, a Global Financial Crisis, and now a pandemic. To deliver security in old age, investors not only need to save for a pension but in a way that will give a positive real return, or in other words, provide a pot of money that grows in value faster than inflation. In today’s low-rate world where the price of safe assets has been distorted by central bank policy, it seems likely that the only sensible way to achieve this is to invest in risky assets. To reduce risk, investors should focus and differentiate between short-term price volatility and the possibility of serious impairment to the value of their capital. Ironically, actuarial considerations have forced many pension funds to move in the opposite direction, not capitalising fully on the post Financial Crisis bull market. Empirical evidence backs up this approach with the work of Elroy Dimson, Paul Marsh, and Mike Staunton in successive Credit Suisse global investment year books, demonstrating that for longer than a century a portfolio of equities has done staggeringly well, especially if diversified globally. While investors in the UK market in the current millennium, and in Japan since the post 1990 period, have only seen muted returns or worse, those with a truly global portfolio have fared far better. The UK FTSE ended 1999 at a record high of 6,930 and was below this level during the last Monday of September.
However, thanks to the reinvestment of dividend income, nominal returns were positive with an annualised rate of 3.3% until 31st December 2020. In contrast, Wall Street, which was also hard hit in the TMT blow up, has seen the S&P 500 reach around three times its end ’99 level. The UK (one of the less well performing markets in more recent times) since 1900 has delivered an average annual real return of 5.4% compared to 6.6% in the US. In contrast, UK government bonds have given an average real return of 2.0% p.a. The argument for investors holding bonds is that, in Wolf’s words, wars or revolutions can ruin equities, but he adds very importantly, they also destroy the value of bonds (fixed interest securities). For most investors, holding a widely diversified portfolio of equities, especially if combined with the selection of top performing fund managers, offers the best long-term investment strategy even, or perhaps especially, in an uncertain world.
Today, the world is seeing shorter-term cyclical inflationary pressures which have led to periods of volatility, especially intra-market in terms of style rotation, something which is masked by overall index levels. The medium to long-term prospects for the global economy suggest that the structural forces of debt, demographics, and disruptive technological change will return the world to an era of secular stagnation and the most recent work on the impact of income inequality only reinforces this view. John Maynard Keynes stated that the market can remain irrational longer than you can stay solvent, and this demonstrates why talented investors reliant on high levels of leverage can be forced out of positions that will be winning ones over the longer-term.
Martin Wolf concluded that, while ‘equities may offer a free lunch, you must be able to wait for the meal’. This again reinforces the view that for investors with a sufficiently long-time horizon who are prepared to sit through periods of volatility, which history demonstrates is not the same as the risk of permanent loss of capital, there remains the potential to make excellent returns. Investment is also about risk management and extreme over-valuation does run the risk of permanent impairment of capital, especially if occurring in narrow areas of the market such as technology stocks in 2000 and Japan in 1989/1990. Even in the US, the ‘nifty-fifty’ period resulted in the US seeing the Dow regain its 1969 level only in 1982. Often investors are over exposed to the most vulnerable parts of the market as these are the most fashionable and over-owned, which is why valuations are high. This again emphasises why some weatherproofing of portfolios is prudent. In the short-term, the biggest threat to markets remains an inflation scare, even if it does not actually occur. If the US saw upward pressure on 10-year Treasury yields towards the 2% level, this could see equities suffer a period of volatility, although a major bear market does look unlikely.
Market returns can be augmented by skilled fund selection and for investors utilising managers who have demonstrated the ability to deliver return with lower than market levels of volatility, a portfolio with a high weighting to equities remains fully justified. The most significant threat to equity markets today would be a period of sustained higher-level inflation with cyclical pressures strong enough to overturn the strong secular disinflationary trends in force. As it is impossible to predict with any certainty whether this is likely to occur, there seems no reason to significantly alter asset allocations in response to an unknown macro scenario when history demonstrates that equity markets offer the best option for growing the real (post inflation) value of investments in most circumstances, a view reinforced by the dearth of valuation opportunities in what are considered to be ‘safe assets’ and the consistently poor returns from most absolute return strategies.
Graham O'Neill, Senior Investment Manager, RSMR
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
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