Modern monetary policy (not to be confused with modern monetary theory) has evolved to a point where central banks actively manage interest rates with the goal of maintaining price stability/low inflation and full employment. While this has delivered reasonable GDP outcomes over the past 40 years or so, from the perspective of a long-term savers/investors, this approach is becoming increasingly challenging and unsustainable. While mortgage holders might cheer the RBA’s most recent interest rate cut (and the futures market predictions sub 1% over the next year), this won’t be echoed by Australia’s savers and superannuation fund CIOs.
Over the last 40 years monetary policy in developed economies has typically evolved to an inflation/full employment targeting regime. That is, in the face of a slowing economy, central banks cut interest rates. Lower interest rates encourage higher consumption (less saving) and more investment. This pulls spending forward from the future and supports current activity/employment. This pull forward of spending is manifest in high debt levels – as debt, directly or indirectly, funds the higher consumption/investment during the downturn.
While this is fine in theory – the reality has been that the post-recession equilibrium has involved lower interest rates and higher debt levels than pre-recession. That is, while interest rates rise post recession, they haven’t risen back to pre-recession levels.
The world seems to be trapped in a cycle of:
Lower and lower interest rates
Higher and higher debt levels
Weaker growth
Higher asset valuations. and
The following charts illustrate this phenomena for the US (which amongst the developed world has the highest interest rates).
Chart 1: Lower and Lower Interest Rates
Chart 2: Higher and Higher Debt
Chart 3: Weaker Growth
Chart 4: More Expensive Asset Valuations
All of this is a massive challenge for an investor trying to deliver a 3-4% real post tax yield to investors. When I first started in the industry you could get 4% real on an inflation linked Commonwealth government bond. Today Australian government inflation linked bonds trade at negative yields (yes that’s correct – as I go to print the Australian 10 year CIB is trading at a real yield of -0.015%).
The first point I would make about this environment, is that the past is a poor reflection of the future. In the rear view mirror -the trends of falling interest rates and rising asset values have boosted asset returns (and reduced the size of drawdowns). Looking through the windscreen - these low rates and high starting valuations are a fundamental headwind for investors. Returns will be lower in the future – it is a mathematical certainty of our starting point.
This environment creates a systemic challenge for the Australian superannuation sector (and pension and long-tail insurance investors across the world). From a portfolio strategy perspective there aren’t any easy solutions to this. – The optimum response is going to depend critically on whether the trend of the last 40 years can be sustained or whether instead the global financial system has to go through a global debt reset. Neither of which are particularly optimistic scenarios – but the first step of managing any problem is to first identify what the actual problem is!