What If Low Interest Rates Are Not A Function Of Low Economic Growth? Mark Burgess, Columbia Threadneedle Investments
- Low interest rates have provided a significant tailwind for bonds and equities over the last 30 years.
- Globalization of labor markets, rather than slow growth, could be the main driver for today’s low interest rates.
- If cheap labor really is the cause of low real interest rates, there could be significant implications for all asset classes.
Over the past few months, a lot of column inches have been devoted to the timing of the first Fed interest rate rise. Perhaps, though, that’s the wrong issue to focus on, particularly if you are a long-term investor. What if interest rates have been driven lower by something else other than the obvious variables of growth and inflation?
Of course, some will question why this even matters for investors — after all, if a portfolio holds the right stocks, and the right bonds, at the right time, the “big picture” macro stuff does not matter that much, does it?
Unfortunately, it is not as simple as that. All investments, whether in bonds or equities or property, can ultimately be boiled down to a series of cash flows – the coupon payments from the bond and then a final payment when it is redeemed, or the future profits paid out to equity investors as dividends. To determine the value of those future cash flows, we have to have some sort of “discount rate.” That is why interest rates are so important and why economists love to talk about them so much.
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The consensus view is that interest rates are low because economic growth — particularly in the developed world — has been weak. Low interest rates mean low discount rates, which mean benign conditions for both equity and bond markets. It’s certainly a convenient and easy-to-understand explanation of why bonds and equities have performed so well in recent years.
My colleague Toby Nangle recently presented a very thought-provoking paper that gives a very different explanation of why interest rates have been so low. Essentially, interest rates are low because labor in the developed world has lost pricing power. When labor had power (i.e., was highly unionized or protected by other barriers to entry) there was a major incentive for companies to invest in capital (such as machinery) so that they could replace labor with capital. As both labor and capital are in finite supply, this would push the cost of capital higher. However, as labor has lost power due to globalization, the incentive to replace with labor has reduced. To put it another way: why would a company invest $1 million in a new robot when some workers in China could do the job for $100,000, enabling the company to pocket the rest? Of course, the result is that demand for capital has ebbed, and because demand is low, the cost of capital is low. And that means low interest rates — which, as we have seen above, are crucial in determining asset class returns.
The real losers in this scenario over the last 30 years have been the highly organized and skilled laborers in the developed world (Exhibit 1). Lenin referred to this group as the “labor aristocracy,” and compared to other income groups, labor aristocrats have been crushed, relatively speaking, by globalization.
Exhibit 1: Change in real income (1988-2008) at various percentiles of global income distribution (2005 purchasing parity, in U.S. dollars)
Source: Milanovic, 2012
Of course, the impacts of globalization have not just been felt in labor markets — the internet means that within a few clicks, it is possible find the lowest price for anything — and if you want something that is a one-off or made to your own requirements, you can quite easily find the lowest price for that too, even if the manufacturer happens to be on the other side of the world.
As well as affecting the way businesses operate, consumers have come to expect to find the lowest prices on demand, 24 hours a day, seven days a week. This way of operating is possible because of cheap and plentiful labor, particularly in emerging markets, but the data suggests that China will reach its Lewis point (the point at which the supply of cheap labor from rural areas is exhausted) at some point between 2019 and 2025. Wages will rise, and many marginal or low-cost producers will not be viable without price rises or capital investment.
As China moves up the value chain, and wages rise, it is possible that India or Latin America or Africa could fill the gap, but this is by no means certain (particularly if populist economic policies are implemented) and there are governance concerns as far as Africa is concerned. “Onshoring” the work does not seem to be an option either: in the UK, the current trajectory for the unemployment rate suggests that unemployment will hit 0% in 2019, with the U.S. achieving the same a year later.
If it is the case that low real rates have been driven the globalization of labor markets, the implications for asset allocators are profound. Although equities can cope with higher discount rates to some extent (particularly if earnings and dividends are growing at a decent lick), the same cannot be said for bonds, where higher discount rates erode the present value of the known cash flows. But, whichever way you look at it, the period of ‘investment nirvana’, when it was possible to earn high returns from bonds and equities, appears to be coming to an end. Investors can meet this challenge by adopting a dynamic, active and unconstrained approach to asset allocation, and by zero-weighting long duration assets with fixed cash flows.