Short bonds? Deutsche Bank believes that we are heading for a new era of low growth and low inflation and falling productivity for the next three and half decades. This conclusion is drawn from the bank’s research which covers over a century’s worth of data and finds that the current economic cycle began in the early 1980s after several years of sluggish post-war growth. Rising productivity, globalisation and improving demographics all helped the global economy power ahead between the 1980s and today, but it looks as if these trends are starting to come to an end. Protectionist rhetoric is increasingly gaining favour with voters; demographics are now working against growth (ageing population and falling labour force participation), and productivity is stagnating.
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Many other analysts support Deutsche’s view, but few others back it up with such as detailed data set. The bank’s data on economic cycles goes back a century and shows the average cycle of improving growth in productivity lasts around 35 years before another 35-year cycle of low growth and stagnating asset prices begins. The data appears to show that we are currently on the verge of a cyclical peak. What does this mean for investors?
Deutsche envisages the next economic cycle — from 2016 to 2050 — to be a tough period for investors. Since 1980, real wages have increasingly tended towards stagnation and labour as a share of GDP has declined although the working age population has exploded. Asset prices have done extremely well during this period. Since the early 80s valuations across three major asset classes, bonds, equity and real estate in 15 key developed markets have moved from being near the bottom of their 215-year range as the 1980s starting point to record high valuations today.
So, globalisation improving demographics and improving productivity have been great for asset prices. On the other hand, this period has not been a great period for developed market growth which has progressively slowed.
With demographics deteriorating it seems highly unlikely that the next couple of decades (possibly longer) will see real growth rates returning close to their pre-crisis, pre-leverage era levels. Obviously, if there is a sustainable exogenous boost to productivity, then a more optimistic scenario can be painted. At this stage, it is hard to see where this comes from and even if it does, time is running out for it to prevent economic and political regime change given the stresses in the system.
Short bonds long equities?
So we are likely stuck with the challenge of how to deal with prolonged low real growth and high (and mostly increasing) overall debt levels. With this being the case, Deutsche sees two likely scenarios for the world going forward:
The best case Put bluntly the best realistic scenario for financial stability in the new era is that bond holders around the world see a slow real adjusted haircut over several years, probably over at least a couple of decades. The best example of this through history was the post WWII period where government debt was at similar levels to that currently seen. Over the next 35 years this debt was successfully eroded by a long period where nominal GDP was notably above bond yields.
The hard break Rather than an artificial reflation and slow successful non-systemic deleveraging, there is a genuine risk of a more binary outcome where a major country (countries) see(s) a hard default on its debt taking a lot of other debt with it domestically and possibly internationally. This is probably most likely to happen via politics – especially in Europe if a country decides to leave the single currency.
Overall, it looks as if the trade for the next economic cycle will be short bonds long equities.