Searching For Yields? Better To Look For Humility And Patience by Vitaliy Katsenelson, CFA / Institutional Investor Magazine
The following is an excerpt from Investment Management Associates’ second-quarter letter to investors (also published on Institutional Investor)
In this letter we are taking up the ambitious goal of painting a picture of the global economic landscape as we see it, in order to walk you through the investment process that we been fine tuning for this less-than-exciting picture.
The Answer Is Not in Your Econ Book
The Great Recession may be over, but seven years later we can still see the deep scars and unhealed wounds it left on the global economy. In an attempt to prevent an unpleasant revisit to the Stone Age, global governments have bailed out banks and the private sector. These bailouts and subsequent stimuli resulted in swollen global government debt, which jumped 75% from $33 trillion in 2007 to $58 trillion in 2014. (These numbers come from a recent McKinsey study on global debt. They are the latest numbers we have, but we promise you they have not shrunk since.)
A lot of things about today’s environment don’t fit into economic theory. Ballooning government debt should have brought higher – much higher – interest rates. But central banks bought the bonds of their respective governments and corporations, driving interest rates down to… well, today a quarter of global government debt “pays” negative interest.
The concept of positive interest rates is straightforward. You take your savings, which you amass by foregoing current consumption – not buying a newer car or making fewer trips to fancy restaurants, and lend them to someone. In exchange for your sacrifice you receive interest payments.
With negative interest rates something very different happens: You lend $100 to your neighbor. A year later, the neighbor knocks on your door and with a smile on his face repays that $100 loan in full by writing you a check for $95. You had to pay him $5 for foregoing your consumption of $100 for a year. This is what negative interest rates are! Try to explain this logic to your kids. We tried to explain it to ours and failed, miserably.
The key takeaway is this: negative and near-zero interest rates show central banks’ desperation to avoid deflation, and more importantly they highlight the bleak state of the global economy.
In theory, low and negative interest rates were supposed reduce savings, get consumers off their butts, and stimulate spending. In practice the opposite has happened – the savings rate has gone up. As interest rate on their deposits declined, consumers felt that now they had to save more to earn the same income. Go figure.
Some countries resort to negative interest rates because they want to devalue their currencies. This strategy suffers from what economists call the fallacy of composition – the mistaken assumption that what is true of one member of a group is true for the group as a whole. As a country goes to negative interest rates, its currency will decline against others – arguably stimulating its export sector (at the expense of other countries). But there is absolutely nothing proprietary about this strategy: other governments will do the same, and in the end all will experience lowered consumption and a higher savings rate.
The following point is so important we want to repeat it, bold it, italicize it, and underline it: If our global economy was doing great, interest rates would not be where they are today!
As We Zoom in Things Get Worse
Let’s start with Europe, the world’s second largest economy. European political (EU) and monetary (EMU) unions were great experiments that made a lot of sense on paper. Europe, which had roughly the same size population and economy as the US, was at a competitive disadvantage, as dozens of currencies embedded extra transaction costs in cross-border trade, and each currency separately had little chance to compete with the US dollar for reserve currency status.
There were also important noneconomic considerations. Germans were haunted by their past; they had started two world wars in the 20th century, and a united Europe was their way of lowering the chances of future European wars.
EMU sounded like a very logical marriage of all the significant powers of post–World War II Europe. But the arrangement was never really a marriage; it was more like a civil union. EMU members combined their currencies into one, the euro. They agreed to use the same central bank and thus implicitly guaranteed one another’s debts.
Though treaties put limits on budget deficits (limits that, ironically, Germany was the first to exceed), each country went on spending its money as it wished. Some were relatively frugal (like Germany); others (Portugal, Ireland, Italy, Greece, and Spain) went on spending binges like newly hitched college students who had just gotten their first credit card, with an irresistibly low introductory rate and a free T-shirt.
The European Union is a collection of states that are vastly different from each other. They are separated by culture, language (which impedes labor mobility resulting in semi-permanent labor productivity disparity between countries – think Greece and Germany), economic growth rate, total indebtness, and history. (Germany, for instance, suffered through hyperinflation in the early twentieth century and is thus paranoid about inflation.)
Now let’s turn to Brexit – the UK referendum on exiting the EU. Ironically, the UK doesn’t have half the problems that most EU nations are going through. Since it is not part of the European Monetary Union, it has retained its currency and its central bank.
The UK’s main dissatisfaction with EU membership is due to the immigration issue. Since treaties have turned the EU into a borderless union, when Germany accepted refuges from Northern Africa it basically made a unilateral decision on behalf of all EU members to accept those refuges to all EU countries. High unemployment, wage stagnation, and Muslim terrorism are now endemic in the EU, and you can see how the UK citizenry might have a problem with this.
After the Brexit vote, the financial media lit up with opinions on its consequences for the EU and global market economy. They’ve varied from “Brexit is a non-event” to “This is a Lehman moment for the global economy” (referring to Lehman Brothers going bankrupt and almost bringing the financial system to a halt in 2008). The arguments on both sides are quite convincing:
The argument for Brexit being a non-event is simple and straightforward. The UK maintained its currency; thus dis-joining the EU will bring lower complexity. The UK and EU will forge new trade treaties. There is a fear that the EU may impose trade sanctions on UK, not so much to punish the UK as to threaten other EU members that exit will come at a stiff economic cost (effectively turning this voluntary club into a prison). However, the UK is a net importer of goods from the EU; thus any sanctions will hurt remaining EU members more than the UK.
Of course, the UK may never exit the EU. The referendum was not binding; it was there to measure the temperature. The new prime minister may decide to ignore