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The Big Picture

Updated: Jun 3, 2022

Looking back, the biggest events over the last 18 months have been the substantial falls in G7 bond yields and the oil price as well as the sharp rise of the US Dollar.

"Classical economics text books ignore debt as a factor of growth"

To be clear, what has been happening in bond markets is almost without precedent. Bond markets are thus a source of uncertainty and potential instability. Excellent real returns since the early 1980s have been driven by three things: the high level of the yield itself in real terms, falling inflation, and falling real interest rates. We are now at a point where neither inflation nor real interest rates can fall much further, so predicting poor returns from bonds has never been easier surely. But then that’s what most were doing – us included - at the back end of 2013 and look where that got them. 2014 saw US and European sovereign long bonds return 24.9% and 12.8% respectively, hardly poor.

Although one can be absolutely sure that the bond bull market will end, timing it is hard. Bond yields in the US stayed low throughout the 1930s, 40s and 50s, only rising sustainably above 4% in the mid-60s (see chart) though real returns would have been negative for some of this time as a result of high inflation during the war years.

In a debt soaked world it is very hard to get growth going. Classical economics text books ignore debt as a factor of growth, arguing that on a net basis it sums to zero. Instead, they present economic growth as a function of workforce growth plus productivity growth. I’m not trained as an economist – a good thing, I keep telling myself – but it seems to me that an underleveraged economy has the potential to grow faster as credit spreads throughout an economy (imagine how much more activity can take place if a product can be exchanged for a promise rather than another product!) This is a good thing – credit, what is essentially an IOU, is one of man’s greatest inventions - but it does mean that the same must from time to time happen in reverse. The deleveraging of Japan’s private sector over the last twenty or so years stands as testament to this.

In June 2013, then Fed governor Bernanke commented that US growth forecasts were being revised up and that the Fed would soon begin tapering its bond buying program, causing bond yields to rise sharply. After hitting 3% at the end of 2013, the ten year yield has since slipped back to below 2%, defying pretty much everyone’s expectations. Despite the Fed’s optimism, it gradually became apparent that the economy would not be strong enough to absorb the ending of QE. The falling oil price only served to increase the downward pressure on inflation and thus bond yields.

It seems extraordinary that six years after the crisis we are none the wiser as to how economies will be weaned off “unconventional monetary policy.” One thing that is clear however is that central bank money printing has not led to the runaway inflation that many feared. Indeed, the opposite is the case: inflation is running below central banks’ targets for much of the developed world, and in fact is now negative in Europe. How can this be, given all the stimulus?

Economists such as Larry Summers and Robert Gordon argue that global growth is stagnating as a result of weak demographic trends and the absence of some game changing technology such as the steam engine, internal combustion engine or the silicon chip. It is also possible that workers have so much competition nowadays from robots, other labour-substituting technology as well as workers elsewhere in the world that a rise in real wages quickly results in a shift to alternatives, particularly when the cost of capital is so low.

It seems therefore that one can view currently low bond yields in two ways. The pessimist would argue that they reflect a flight to safety and fears of yet-to-surface instabilities within economies and financial systems. The optimistic view would be that they reflect low inflation which is a good thing, as well as the aforementioned structural issue surrounding labour costs. In such a world, the owners of capital are the winners. You don’t get rewarded for investing in government bonds because there is no or little risk with respect to credit or interest rates.

I tend to side with the optimists, though that doesn’t mean I think bonds are a good investment. Although there may not be a new game changing technology about to burst onto the scene in the way that the steam engine and the internet did, there is certainly technological progress that does not get celebrated widely in the media. As economists Brian Wesbury and Robert Stein of First Trust Advisors note, “tablets and phones that cost a few hundred Dollars today have capabilities that cost millions just 20 years ago. Shale oil drillers are successful on most of the wells they drill versus much lower percentages of success in the days of wildcatters. 3-D printing reduces prices, while increasing flexibility in production. Low cost apps, websites, and the cloud undermine the need for brick and mortar investment.”

Furthermore, although technological progress may often be linear, its effects can most certainly be non-linear. For example, photovoltaic cell efficiency may well be closing in on a tipping point at which usage takes off.

Published in Investment Letter, May 2015

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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