Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Investing themes to watch over the next decade
Christopher Dembik
Head of Macro Analysis
Summary: In a world of QE infinity and lowflation, there is no other alternative than stocks for investors seeking yield.
I recently had the opportunity to deliver a speech about investment returns over the next 30 years at the 5th International Funds Summit. Since then, I have received many requests from clients to have access to the presentation (here). I will try to sum up my main takeaways below. Please accept my apologies if I don’t cover everything and if my predictions don’t always come true. As the Nobel laureate in Physics Nils Bohr said: “Prediction is very difficult, especially if it’s about the future”.
In my view, we are in the middle of a new Schumpeterian cycle of innovation and I expect the process of destructive creation will speed up in coming years, leading to the break up of many companies and sectors, including but not limited to:
- Banking as we know it today
- Fund pensions
- Tesla
- GAFA
- National airlines companies
- The desktop computer
- High oil prices
- FIAT money
This fifth wave of innovation, that began in the early 1990s, is characterized by low growth, low productivity and lowflation. Unlike the fourth wave of innovation that lasted from 1950 to 1990, which has seen among other things the impact of electronics and aviation on the economic system, the current period is characterized by low productivity in most countries that ultimately leads to decreasing potential GDP growth. There is no single explanation for low productivity, but it is certainly partially linked to the fact that current innovations do not create new industrial sectors, as was the case in the past.
Our main call for the coming years is that lowflation is the new normal. Below, this is one of my favorite charts. You can see that US birth as a % of total US population leads US Core CPI by 30 years. It shows the direct impact of ageing on the evolution of inflation. On the top of that, new technology, oligopolies and global debt accumulation are other strong structural forces driving inflation lower. In the developed world, we are getting used to CPI under 2% but what is probably most striking, and less commented, is that inflation is also decelerating at a very steady pace in Emerging countries, where it used to be very high. Based on the latest data, average inflation in the BRICS + Indonesia is around 3.5% YoY versus an average of 7% in the immediate post-GFC.
I used to be skeptical about the risk of Japanisation of the economy but, as a matter of fact, we are facing this issue. Like in Japan, ultra-accommodative monetary policy has little positive effect on growth, negative rates mostly cause financial disruption, inflation is stuck to very low levels and structural factors, such as ageing, are becoming the most important drivers of long-term growth. And, like in Japan, the cost of pretend and extend is increasing. We are all well-aware that monetary policy is not the right tool to stimulate the economy and the disadvantages of negative rates surpass the advantages, but we are doing more of the same and we are slowly reaching the point where central banks are becoming market makers in some market segments. This is already the case in the euro area sovereign bond market. Based on our calculations, central banks at the global level (including the ECB) own around 70% of France’s public debt and around 80% of Germany’s public debt.
At some extend, I tend to agree with some of my colleagues that consider the stock market is the economy. We – and I mean mostly policymakers – cannot afford the stock market falls, as it would lead to contagion effect to the real economy. So much liquidity has been injected in the stock market over the past years, it is now almost impossible to withdraw it. The only solution is to keep injecting liquidity, which explains why around 60% of central banks are easing globally. This is the highest level since the GFC. Higher interest rates and QT are virtually impossible in a world of debt. Looking only at USD-denominated EM debt, it is reaching 3.7 trillion USD, which represents an increase of 156% since 2008. This debt burden is not manageable if interest rates considerably increase. Policymakers are not ready to accept the social cost resulting from the end of the expansionary monetary policy.
What does it mean for investors? If Japan is an example of what the future may hold for many countries, notably in Europe, it is likely that investors will favor the equity market over the bond market. In the chart below, you can see that equities have become the most attractive investment over the past 30 years in Japan. It is easily explained by the fact that the BoJ’s monetary policy has fueled the stock market, especially export companies that have benefited from lower JPY. This may sound paradoxical but, in coming years, it is highly probable that the stock market will continue to perform quite well, and that PER will keep increasing. It does not mean that financial imbalances do not matter anymore. For instance, it is worrying that hedge funds continue to be crowded into just the same 5 tech stocks (Microsoft, Amazon, Facebook, Alibaba and Alphabet) but, in a world of QE infinity and lowflation, there is no other alternative than stocks for investors seeking yield.
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