The main challenge facing the world economy is a shortfall in aggregate demand, or expressed differently, an excess of savings compared to investment. Some of the factors driving this savings/investment gap are as follows.
The financial market meltdown and recession of 2008 has altered consumer preferences in some fundamental ways. Surveys show that less than half of Americans wished to save more before the crisis, the latest data show that ratio has risen to more than 66 per cent and continues to rise. Given greater awareness of the upcoming pensions and social security crisis, most individuals globally are clear that they have to take greater responsibility for their retirement and build their own savings. With the end of the debt super-cycle, both the willingness and ability of individuals to raise indebtedness is constrained. Even super low rates are not incentivising individuals to lever up their personal balance sheets.
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The democratisation of credit during the bubble years, allowing previously unbanked segments of the population to borrow and spend, concealed the huge increase in income inequality across the globe. As the International Monetary Fund (IMF)'s research shows, the shift in income towards the rich has depressed US aggregate demand by about three per cent of gross domestic product (GDP). Rising inequality corrodes consumption.
On the investment side, beyond short-term headwinds, we have some longer-term demographic and business model challenges. Slower labour force growth reduces the need for work space, both office and factories, with reduced household formation lowering the demand for new housing. BCA Research has estimated that these demographic factors alone have lowered the equilibrium level of investment in the US economy by two per cent of GDP and by an even larger percentage in other advanced economies with greater demographic challenges.
Lower commodity prices have reduced investment spending in energy, materials and mining. These sectors accounted for almost a third of global capital spend. Emerging markets (EMs) have been the other main drivers of investment spend in the last decade. With the end of the commodity super-cycle, lower spend in both EMs and the commodity sectors are here to stay.
The shift to an intangibles based network driven economy has also reduced the attractiveness of fixed investments.
Globally, investment has struggled to keep up with savings, but arithmetically savings must equal investments. In an economy, when savings rise but investments decline, interest rates should fall. Falling rates will bring the two into balance. The problem today is that nominal rates are already at record lows, yet the deflationary pressures are only intensifying. Rates are still not low enough to bring savings and investment into balance. This would imply that the neutral rate (consistent with stable inflation and full employment) is probably negative in many countries. This is believable, as in the last business cycle from 2001-2007, real US Federal Reserve funds rates averaged only one per cent, despite the tailwinds of the housing bubble and fiscal stimulus of two wars boosting aggregate demand. This was also a period when both EMs and Europe were doing well and the dollar was weakening. Despite all the boosters to demand and only one per cent real rates, both inflation and the labour market did not overshoot, implying that we were at or near the neutral rate.
Today, with no debt-fuelled consumption bubble, fiscal contraction and a strong dollar, the economic reality in the US, and more broadly across most of the OECD, is very different. If a one per cent real rate was appropriate in the last cycle with all the consumption boosters, what is an appropriate rate today? It is probably zero, if not negative. If zero, then nominal rates will be around 1.5 per cent, the current level in the US. We may be in less of a bond bubble then the public thinks, these rates may actually be appropriate.
If the neutral rate is so low in the US, it will be even lower in Europe and Japan, given the weaker demographics, higher debt burden and institutional weaknesses. You may need negative nominal rates in parts of the European Union and Japan to get to the equilibrium rate. By this line of reasoning, what we are seeing on yields is fairly rational and needed. Yields in negative territory are the only path to recovery for these economies.
The question investors have to ponder is what next? When an economy is unable to recover even when rates are at zero, what can policymakers do? The easy, maybe academic, option is do nothing. Throw in the towel, say we have no tools left and let the economy contract. An economic contraction will automatically reduce savings and realign the savings/ investment mismatch.
Given the rise in populism globally, it is unlikely that any politician will be willing to accept an economic contraction. The population is unwilling to accept any more economic pain. Get ready for more fiscal support, it is inevitable and coming. This pursuit of expansionary fiscal policies will eventually lay the ground for the re-emergence of inflationary pressures.
With low yields likely to remain for the foreseeable future, the chances of a melt-up in equity markets continue. Given where valuations are in the US today, money will eventually rotate into EMs. The first signs of this are visible. This is a liquidity driven rally and thus impossible to call.
The writer is at Amansa Capital. These views are his own