So is this it then? The end of financial history?
Deflationary pressures, slow economic growth, ultra-low or negative interest rates, ballooning debt burdens, asset price bubbles and currency wars? GaveKal chair Anatole Kaletsky last week claimed “real interest rates will be negative for the rest of our careers”. Is he right – is today’s state of affairs all we have to look forward to?
In 1989, at the end of the Cold War, American political scientist Francis Fukuyama argued:
What we may be witnessing is not just the end of the Cold War, or the passing of a particular period of post-war history, but the end of history as such: that is, the end point of mankind’s ideological evolution and the universalisation of Western liberal democracy as the final form of human government.
Similarly, your author detects a spreading tide of opinion in books, blogs, media articles, economic research and assumptions in analyst models of companies that the present-day reality of economies and financial markets will last for a very long time, even for the rest of our investing careers, our lives or forever. This opinion invites comparison with Fukuyama’s touchstone phrase because it suggests financial history has ended: that the central tendency of the future is to today’s status quo.
Fukuyama did not argue events would stop occurring in the future, but rather that democracy would only become more prevalent in the long run, though it might suffer setbacks short-term. Similarly, the growing ‘deflation consensus’ sees future events as unable to knock economies and markets off their current deflationary, slow-growth trajectory with all this means: the malaise in our second sentence above.
But at this point we can answer our own question. There is no valid comparison between Fukuyama’s predictions for the final form of government and the predictions of the deflation consensus that ultra-low interest rates are here to stay for good. Financial history did not end with the advent of today’s malaise. While human beings’ aspirations for political freedom and electoral representation are probably eternal and may well make democracy the central tendency of political systems, there are no such permanent central tendencies in economies and financial markets. If anything the history of the former is one of volatility and unpredictability while the latter are swept by participant behaviour driven by a feature of human nature which is similarly eternal to the desire for political freedom.
Backward-looking expectations or recency bias is one of the most common behavioural biases in finance. Economists describe this as ‘adaptive expectations’. It’s human nature to extrapolate recent history into the future, even forever. At a guess our recency bias dates from our early evolutionary history, when humans with the best understanding of the threats and opportunities in their immediate environment were the most likely to survive. We have not evolved to lose this bias and today we project it onto the modern financial world. In your author’s experience all market turning points since the 1987 crash were characterised by widespread opinion present-day conditions were a new normal or the natural state of things. Financial trends tend to be reflexive: they have positive feedback loops in which price trends attract buyers whose actions drive prices further still in the same direction until the process becomes unsustainable and the trend collapses. In your author’s experience the moment the consensus starts to talk about “permanent”, “here to stay”, “new normal”, “new paradigm” or “forever” is usually the moment the reasons for the consensus just ended.
During a strong trend it is never easier to appreciate why the trend can extend indefinitely. The reasons are highly visible because they are plastered all over the financial media in detail and therefore seem plausible. Influential commentators weigh in with views based on the most recent data. Trends in markets form because it is more comfortable to be part of a group of investors than to stand aside; relatively few investors have the temperament to counter the herd.
Similarly, most investment research extrapolates current conditions, is of little value after days or weeks and doesn’t analyse tail risks: those low-probability (estimated probability) events out at the ends of probability distribution curves, for example the 2007-15 GFC, the 1997 Asian Crisis, the 1998 Russian Debt Default, the surge in iron ore and oil prices last decade and the Reserve Bank of Australia’s May 2016 cash rate cut. But tail risks are the most consequential. These are the events which change the game and cause the most volatility in returns.
Readers might be surprised to learn professional investors are uniquely vulnerable to recency bias. Professional analysts, with all that they know and understand, really can see why the world can go over the edge into the abyss, when a bear market is running, or the blue sky can change the world, when optimism abounds. They should be careful their deeper knowledge and analytical skills do not create a bias to extrapolating the present just because it is the present. Behavioural biases are particularly dangerous in professionals employed to manage others’ wealth.
This is why the twin qualities an investor should seek in a fund manager are respect for the power of markets to create and destroy wealth (it’s why we invest, but carefully) but scepticism of the quality of thinking behind how that power is exercised. The smartest investor always questions consensus thinking and never slavishly adopts it. Your author is prepared to bet no consensus opinion about anything stayed unchanged forever. The path to outperformance is working out where consensus will jump next. Good fund managers make this part of their process and develop a culture of wanting to be different from consensus in their views.
This is why we start to be sceptical when we read phrases like “for the rest of our careers”, “indefinitely” and “probably forever” even about something as seemingly entrenched as global deflationary pressures. When US 10-year Treasury yields were 5% no one talked about deflation going on forever (they are 1.8% today). It’s because Treasuries are at 1.8% that people talk about forever. Consensus expectations are backward-looking and adaptive.
So it is to be expected that after seven long years of disinflation, falling bond yields and extreme monetary policy, a large proportion of market participants have adapted to the situation and don’t consider alternative possibilities. In your author’s view markets are somewhere in the middle of a slow-motion, capitulation-driven bond-buying binge based on an increasingly consensus view deflation and slow growth are permanent or semi-permanent. This will continue to the point most market participants don’t question it and then, because the consensus is extrapolating the recent past and financial variables like bond prices became overextended, there will be some catalytic event which shatters those expectations and price levels. Inflation-protected bonds and bond puts have not gone away; they should be on the investor’s watchlist – but only halfway down.
Our call on growth and inflation
Beyond shorter events like wars and recessions, the history of economic growth is one of accelerations and decelerations based on changing rates of population and labour productivity growth. GDP growth is the sum of these two growth rates. We agree with the argument world population ageing is negative for economic growth but think the deflation consensus ignores the potential for new waves of productivity growth from technological innovation. Enormous amounts of effort, funding and R&D are going into new technologies set to revolutionise many aspects of our lives: transport, payments, banking, renewable energy, ordering, location-driven marketing, education, healthcare, entertainment, communications, appliances and more. It is inconceivable disruption on this scale will not accelerate labour productivity growth, but no one is talking about this. In Australia, in the 1990s, the adoption of the new information and communications technologies of that era, like email, mobile phones and fax machines, is credited by the Productivity Commission for contributing up to 30% of the decade’s productivity surge. Australia has not had a similar surge since, partly due to a lack of structural economic reforms like those of the 1980s and early 1990s, but also because there has not been transformational technological change on a sufficient scale. We’ll bet this is about to end.
The reasons to expect further deflation are transparent and plausible because they are part of the consensus view of the world: population ageing, technological change and disruption, historically slow wages growth, commodity price falls, etc.
In our view the world’s deflationary ‘crisis’ probably ended in the March quarter of 2016. There are plenty of reasons to expect disinflation and deflationary pressures to bottom:
The rising tide of protectionist pressures
Unfortunately the story of history is weak economic conditions stimulate a desire for industry protection which finds political support. In the US, the Donald Trump phenomenon is the most prominent contemporary expression of this. In Europe it is getting harder to generate majority support for pro-globalisation measures like free trade and economic integration; even if the Brexit vote fails, the European free-market cause will have been damaged. Free trade zones/treaties and economic integration powerfully propagate deflationary pressures by encouraging the transfer of production to the lowest-cost countries. Roll this back and today’s deflationary pressures hit walls. In Trump’s world Apple would manufacture iPhones in the US but no one can argue this would not be more expensive production than in China. If Hillary Clinton wins, she and the US political system will have to do something about the hidden, disadvantaged demographic which shot to prominence with its support of Trump, and that could mean similar protectionist policies.
The rising tide of corporate lobbying and rent-seeking
An economic rent is a return to a firm greater than that possible in a free market, which clears only at a price consumers are willing to pay. Often this is delivered by some favour from government: a protected market, a subsidy or price regulation which enables the firm to achieve prices greater than those possible in a free market. The US has long been captured by corporate lobbying and Australia is headed the same way. The triumph of vested interests reduces price competition.
The return of fiscal stimulus
Central banks are publicly warning extreme monetary policy is reaching the limits of its ability to stimulate growth. At some point voters and governments will realise there is a solution to the problems of a) inadequate yield for self-funded retirees and asset-liability managers (insurance companies, pension funds), and b) existing elevated general government indebtedness, and that is infrastructure bonds. In 2017 China’s Communist Party will hold its 19th once-in-five years congress, when five of the most senior leadership positions in the regime turn over. President Xi Xinping (who does not retire) obviously won his battle with Premier Li Keqiang earlier this year over traditional credit-fuelled stimulus vs structural reforms to the bloated state-owned enterprises. Xi will want the most favourable environment for ensuring his allies are appointed to the vacant leadership positions and we think this means ongoing Chinese stimulus of the kind which is now supporting commodity prices. This reduces the downside for commodity prices and, as earlier falls drop out of world inflation statistics, inflation measures should stabilise.
Oil has found a trading range between US$30-55/barrel
Towards $55 it becomes economic for US shale producers to increase output, towards $30 sufficient production becomes unprofitable for the resulting production cuts to reduce inventories. The detraction from inflation from the 2014-16 plunge in oil prices is over.
US labour market
We have long looked to the US labour market for the first inflationary impulse. The Fed is obviously softening markets up for the next rate hike because it knows it has to act to prevent the firming labour market from generating too much inflation in time.
Innovation & Disruption
If technological innovation and disruption reduce the cost of some consumer products and services, for example if we switch from traditional taxis to Uber, this increases disposable income to spend on other goods and services. This amounts to real wage growth. The near-term effect is transport price deflation in the CPI but there is a substitution effect which bolsters demand and consumer prices in other sectors where Uber-riders now spend more because they can. We have not seen analysis of this effect by any economist or equities analyst.
Demands for action on inequality
Income inequality slows economic growth because the multiplier effect of a dollar earned by a high-income earner is less than for a low-income earner. The former has a low marginal rate of consumption and a high propensity to save while the latter spends most or all of his or her income. At some point the incomes of the poorest will have to revert higher as a percentage of GDP if the social misery from inequality is to be addressed, and that will be inflationary.
We are also sceptical of the potential for recession from entrenched deflationary expectations, where consumers defer purchases to take advantage of expected lower prices. You don’t defer upgrading your iPhone because you know it will halve in price over the next year; you buy it because you want the upgraded functionality and/or it’s fashionable. Similarly, many of the consumer product/service innovations to come will increase demand and spending. We are entering a cycle of economic growth from innovation.
The argument we stop buying if we think prices will decline slightly is far-fetched. According to former RBNZ Governor Don Brash the last 30 years of the 19th century saw generalised deflation across much of the developed world but economic growth by 19th century standards was elevated.
This is why it is crucial the RBA’s inflation target range is not downgraded from the current 2 – 3% despite calls for this to happen. Lowering the target would be seen as the central bank, and/or its ministerial masters, capitulating to very low inflation whereupon every price and wage setter in the country would similarly lower their own inflation expectations. It was only eight years ago that, after inflation spiked to 5% in 2008, there were calls for the central bank to accept permanently higher inflation and for the target range to be lifted.