Investors on tricky path now Goldilocks economy is gone
NEW normal is the new buzzword. Trying to understand the long-term implications of the "new normal" of very low interest rates is crucial, but it is not an easy task. Financial repression in major economies has in effect resulted in South Africa "importing" low bond yields and loose monetary policy. We’re told this is our "new normal", which is part of the global "new normal".
"Normal" is not an immutable concept, of course. Fixed exchange rates were normal under Bretton Woods, high inflation was normal in the 1970s and 1980s, and the "Goldilocks" economy was normal for much of the 1990s and 2000s.
Although the phrase was not then in vogue, Greece and the other southern European countries were in a "new normal" when convergence was the theme.
Greece entered the euro with debt at about 100% of gross domestic product (GDP), but its "new normal" low bond yields allowed it to keep raising debt for a while. Greece may be an extreme example of how things can go wrong when people think they are operating under a "new normal", but it is instructive nevertheless.
Low yields send signals to governments and central banks that the market approves of their actions. Even if these yields are driven by external factors, the message is the same. At the same time, low yields erode the risk-adjusted return to investors.
Although some investors may be wary of a disconnect between fundamentals and market pricing, it can literally take years of operating under a "new normal" before the chickens come home to roost.
Greece’s debt-to-GDP ratio fluctuated around 100% for most of the period after euro entry until 2008. Yet, for much of 2000-09, the Greek 10-year bond yield was about 5% — even going below 3.5% during the heady days of 2006.
Those investors who had avoided Greek debt, believing that yields did not compensate for the risk associated with those debt levels, could only watch with consternation — or perhaps eventually capitulate. The problem is that a steady accumulation of debt cannot be reversed overnight; bond yields, on the other hand, can move extremely fast. Greece’s bond yields shot up as its debt ratio surged to 129% of GDP in 2009, 145% in 2010, and 165% in last year.
It defaulted. It is noteworthy that having been stable at slightly lower levels between 2000 and 2005, the Greek debt burden began rising following the very low bond yields of 2006. Low yields had sent a signal to the government that it could raise more debt. But that was then; Greece’s "new normal" is now very different from the one that prevailed for the previous decade.
South Africa is not Greece, and we’re not for a moment suggesting that South Africa’s debt will balloon to such unsustainable levels that default is the only option. But South Africa’s debt-to-GDP ratio has already risen by about 13% of GDP since 2009 and is forecast to keep rising for the next few years; the "new normal" low yields appear to have facilitated rising debt here too. Do bond yields signal that the Reserve Bank is trusted to keep its inflation mandate?
In historical terms, South African bond yields are low, fuelled by foreign inflows. But inflation-linked bond yields are also exceptionally low. They’re telling the central bank, via break-even inflation, that while inflation will probably be inside the target range for the shorter term, it is expected above target for much of the time after that.
Will inflation be tolerated above target while growth is low? Perhaps the global "new normal" for central banks is focusing on growth more than inflation. South Africa is not the only country with break-evens above target inflation. But some people (including some within central banks themselves) worry about the longer-term implications of this. The question: if inflation is this high when growth is weak, where will it reach when more robust growth returns?
So when do fixed interest investors go on a buyers’ strike because returns are not high enough to compensate for inflation risks? Where are the bond vigilantes? Apparently, they are being cowed by the huge quantitative easing programmes under way in the big developed markets. "Don’t fight the Fed" has become a "new normal" mantra. The major central banks have been buying large amounts of government debt — to the extent that they now own not-insignificant portions of their government bond markets.
So for those looking around for the bond vigilantes, it’s worth remembering that these are not exactly free markets at the moment. Central banks can’t buy bonds forever. What happens when they stop?
In the meantime though, the very low interest rates of the "new normal" are here to stay, for a while at least.
What does this mean for savers? Low rates hurt savers in ways that are not widely understood. It is well known that people living on fixed incomes suffer when interest rates fall, particularly when they fall below inflation. What seems to be less well understood is how low real interest rates affect the generation of people saving for their retirement. Citigroup has done an interesting exercise on this. Assume an individual aged 40 with existing savings equal to one times his annual salary, targeting 60% current real salary from retirement at 70 until death at 85. At a real return of 6% a year, the individual needs to save just 4% of current salary; if that real rate falls to 1%, the required savings leaps to 22% of current salary.
This presents a challenge for both policy makers and savers. If savers understand that they need to save more, they will reduce spending — thereby damping growth, thus offsetting one of the objectives of low rates. Alternatively, savers might decide to allocate a greater portion of their savings into riskier assets, which offer higher returns. While this might seem logical, especially for people who still have a fairly long time to retirement, the increasing riskiness of a retirement portfolio presents obvious problems.
A third option — possibly arising simply because savers are ignorant of the effects of low real interest rates — is no change in savings behaviour, thus ending up with insufficient savings at retirement, which imposes a burden on either the fiscus or the next generation (or both).
These problems are compounded when governments under pressure try to balance the books, which inevitably means higher taxes. Higher income taxes mean the saver is trying to save more out of less disposable income. Higher taxes on investment income or capital gains mean the amount of the savings is directly affected. Either makes it harder to save.
Goldilocks is gone. There is no easy way out of this. It is not a situation where one can bide one’s time waiting for everything to be all right at the end of it. It is now a situation where whatever is done to rectify one issue will worsen another.
Trying to minimise negative effects will require trade-offs, and these may not always be acceptable politically (for example, raising the retirement age is one way to increase retirement savings, but this is often politically unpopular).
In the meantime, investors need to navigate a tricky route — one that involves accepting the realities of the "new normal" while keeping an eye on the fact that this is likely to resolve into a messier next "new normal" some years down the line.
• Valentine is economic and fixed interest strategist at Coronation Fund Managers.
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