In the current low interest rate environment it seems incredible to remember that the US federal funds rate (the equivalent of South Africa’s repo rate) was at 20% in the middle of 1981. The Federal Reserve chair at the time, Paul Volcker, had decided that high inflation had to be tackled, and he did so by strangling the supply of money.
High interest rates were in fact a feature for most of the early 1980s, being above 15% in the US for most of that period. Even in Japan they were close to 10%, and in double digits in the UK.
From that point, however, rates have been declining. By the turn of the century they were at, or close to 0% in much of the developed world.
Since the global financial crisis some countries have even seen what many economists once thought impossible – negative interest rates. In places like Japan, people had to pay the bank to hold their deposits.
This has, understandably, caused the opposite of what Volcker achieved back in the early 1980s. Since money has been incredibly cheap, countries, companies and individuals have taken on high levels of debt.
Impact on returns
This has been one of the major causes behind the global economic expansion we have experienced for the better part of the last half a century, since it was easy to raise capital. Rapidly rising populations in most of the developed world also increased production levels, and therefore economic output.
Interest rates cannot, however, keep going lower and populations across Japan and western Europe are not only ageing but, in some places, declining. As John Stopford, head of multi-asset income at Investec Asset Management, points out, we are entering a very different environment.
“The leverage cycle that we have been through over the last 40-plus years, together with demographic tailwinds that have been behind global growth, have been very important drivers of financial market returns and asset growth,” he says. “Potentially, however, we are at an inflection point for both.”
As monetary policy inevitably starts to tighten, what are the implications, not just for growth, but for investment returns?
Falling interest rates have consistently pushed up bond prices for decades. At the same time, strong company earnings have supported equity market gains. More recently, quantitative easing (QE) has delivered even more cheap money.
When the wheel turns
“The danger in financial markets is that we have all benefitted,” Stopford points out. “If it all starts going in reverse, that has significant implications for growth, interest rates, and asset returns.
“We are now entering an interesting point where central banks are starting to take away the punch bowl,” he adds. “QE hasn’t just pushed up equity prices, but the price of everything, and it has pushed yields down. If that reverses, how does that undermine asset values in the short and long term?”
At issue is the conundrum that central banks will face when the next economic downturn hits.
“In the short term you have a cyclical set of forces pushing treasury yields higher,” Stopford notes. “It’s very late cycle in the US with low unemployment and inflation starting to show its head. Historically the Fed has tightened until something breaks, until there is a recession.”
There have been no instances of the Fed raising rates, then allowing them to stay constant, and then raising again. When the recession comes, rates get cut.
“The big problem for us is that in historical cycles the Fed and other major central banks have cut rates by 4% to 5 %,” Stopford points out. “But if they are only able to push them up to 3% this time, the US has to become creative. In Europe, I don’t think they will ever be able to raise rates. So what are they going to do? A lot of the levers that were pulled last time, they are not going to be able to pull again.”
The broader consequences
If monetary policy can’t be used to stimulate economies, how are governments going to respond? It’s unlikely that they will simply be happy with a protracted recession. That may leave only the option of taking on more debt and inflating it away.
“There are really three scenarios,” Stopford believes. “Managing to have more of the same is the most optimistic. That means looser policy than we are used to in the past and reasonable growth globally. But that will almost certainly mean periodic asset bubbles as central banks have to keep supplying cheap money.”
The other two are less appealing, but also possibly more likely.
“If you have too much debt and growth that can’t support that debt you either have a default or inflation,” Stopford says. “Central banks and policy makers would probably choose inflation.”
That, however, has some potentially much broader and unattractive consequences.
“I think we are just seeing the beginning of populism,” Stopford says. “Typically these kind of end-of-era financial events, where you see high inflation or debt inflation, end in armed conflict. Hopefully the world is more sensible, but when you look at Trump, populists in power in Italy and fascists gaining influence in Sweden, it’s a pretty scary world out there if you take a 10-year view.”