April 2021 CIO Special

Financial repression: still restraining real rates Policy sustainability and the response CIO Special Financial repression: still restraining real rates Contents

Introduction p.2 Authors: 01 Christian Nolting Global Chief Investment Officer

Gerit Heinz 02 Financial repression: a history p.4 Global Chief Investment Strategist

Stefan Köhling Investment Strategist 03 Policy sustainability and risks p.10 Europe

Gabriel Selby, CFA® Investment Strategist Americas 04 Possible future scenarios p.13

05 What this means for investors p.15

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Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings at the end of this document. Produced in April 2021. 1 CIO Special Financial repression: still restraining real rates 01 Introduction

Christian Nolting GDP growth will return to positive territory in 2021. Reflationary policies in response to the Global Chief Investment devastating economic impact of the coronavirus have already led markets to anticipate some pick Officer up and, in many economies, yields have risen.

No-one, however, expects a quick return of interest rates to their levels of a few decades ago. In a historical context interest rates are still at extremely low levels and major central banks have indicated that they will be tolerant with regards to inflation and keep rates low. “Financial repression” – the use of policy to keep real interest rates very low or negative – is here to stay.

In some ways, it is surprising that “financial repression” is not more controversial. Low interest rates lower the cost of borrowing but, conversely, may also make it more difficult to reach investment goals. They affect debt levels and asset prices. This is an issue of great importance to all investors.

The main reason for general acceptance of “financial repression” is that we have probably just grown too used to it.

“Financial repression” long predates the 2020 pandemic: like some other policy issues, coronavirus has simply accelerated an existing underlying trend. It first came to prominence earlier at the start of the global financial crisis (GFC) in 2007-2008, when many central banks deployed financial repression (in the form of lower policy rates and quantitative easing) as an essentially tactical tool to try and kick start economies. Yields on government bonds been falling for a decade or more, when adjusted for inflation, as shown by Figure 1. They have also been falling in nominal terms.

Figure 1: 10-year inflation-indexed yield comparison

Source: Bloomberg Finance L.P., Deutsche Bank AG. As of April 9, 2021.

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But financial repression has even deeper structural roots. It is linked, as we discuss, to longer-term trends in demographics and productivity which will remain relevant, even as the global economy picks up pace in 2021.

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The tendency for levels to rise has been accelerated by the COVID-19 crisis while inflation rates have remained subdued. While the former creates a conflict of interest for central banks, the latter gives leeway to keep interest rates low. Monetary and fiscal policy are more interlinked than in the past, given the huge amounts of government debt now sitting on balance sheets.

But is financial repression sustainable, or should we expect some (perhaps involuntary) reversal of policy? One major concern around financial repression is that it could result in high levels of inflation. Such fears have not so far been realised and some central banks would in fact welcome a temporary increase in inflation (with several recently changing their objectives to reflect this). In a historic context, nominal yields as well as inflation rates remain obstinately low.

But other issues will arise. While financial repression may help to ensure economic stability in as much as it constrains the cost of government debt servicing, it does not guarantee financial market stability. Low yields may encourage unexperienced investors to take on more risk than suitable or encourage highly leveraged positions. Small market moves may result in higher volatility if leveraged positions need liquidation. This threat of instability is in addition to creeping devaluation of wealth caused by negative real interest rates. We look at how to deal with this.

Financial repression: history and incentives

o Financial repression long predates the 2020 pandemic. The coronavirus has simply accelerated an underlying trend.

o Central banks are likely to keep real interest rates low, and financial repression will continue for the foreseeable future.

o But investors should be aware that a policy designed to promote economic stability will not guarantee financial market stability.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings at the end of this document. Produced in April 2021. 3 CIO Special Financial repression: still restraining real rates 02 Financial repression: a history

Financial repression is a policy of keeping interest rates at very low or negative real levels.

Historically, this has not been seen as a positive concept: the originators of the phrase (back in the early 1970s) were criticising the use of such a policy as a way of obtaining cheap funding for government debt at the expense of savers.

Financial repression, as this implies, is not just due to the coronavirus pandemic. And, while the current market focus may now be on inflation threats and rising yields, financial repression remains in place and will continue to dominate monetary policy for some time to come.

In fact, even nominal interest rates have been falling for decades. Risk-free rates (i.e. U.S. T-Bills) fell from more than 10% in 1984 to below 0.1% this year. In some other parts of the world, nominal interest rates on longer-dated government bonds turned negative years ago, reflecting expectations that short-term interest rates would not increase for the foreseeable future.

The declining natural rate of interest

Various structural forces are pushing down the so-called natural rate of interest (R*) – the rate which brings an economy’s output in line with its potential. This natural rate (sometimes referred to as the neutral rate) is not observable in reality but policy makers around the world estimate its value when they set policy rates – so as to judge whether these rates will stimulate the economy or rein in output to combat inflationary pressures.

R* is affected by numerous factors and estimates of it differ from region to region. In the United States, estimates using the Laubach Williams model indicate that R* has fallen to close to zero over the last decade (Figure 2). Equivalent figures for the Eurozone reveal a similar story.

R* is highly positively correlated to trend GDP growth. Broad shifts in trend growth rates in developed countries over the past few decades may therefore indicate where interest rates are likely to go from here. Many explanations for slower trend growth focus on changing working-age populations, ageing societies and technological progress.

Figure 2: The natural rate of interest (R*) and nominal potential GDP growth in the U.S.

Source: Federal Reserve Bank of New York, Federal Reserve Bank of San Francisco, Deutsche Bank AG. As of April 9, 2021.

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The fall in R* has some immediate policy implications: a low R* has meant that central banks have less room to simply cut policy rates as they approach the so-called "lower bound" in many regions. (The worry is that if interest rates fall below this theoretical threshold, investors will prefer to hold physical cash.) Even if we have not yet reached this level in interest rates, central banks have enhanced their policy toolbox. In a low yield environment, they have introduced unconventional measures such as quantitative easing or yield curve control to achieve a greater monetary stimulus effect than with traditional monetary policy instruments. In the ast,p­ policy rates stood very much higher and therefore a sufficient monetary impulse could be provided by lowering these rates alone. A return to such a situation looks very unlikely for a long time to come.

Central banks use R* in their assessment of the economic situation and then try to adjust the risk free rate (proxied by government bond yields) to set the right impulse dependent on the economic cycle. They can partially influence this risk-free rate implicitly via open market operations (e.g. QE) and explicitly via setting policy rates. R* provides a starting point for such policy calculations.

What this shows is that a seemingly abstract discussion of R* is in fact a contributor to the level of yields we see in fixed income securities every day. By intervening in the market (e.g. through bond buying programmes or setting policy rates) security prices are either directly or indirectly mirroring central bank policy. Rising longer-dated government bond yields could for example be a sign of an anticipated rate hike (by markets) in the near future while a drastic fall would imply the opposite.

Demographics: the example of

Japan is often cited as a real-time example of how long-term shrinkage of the working-age population can translate into a long phase of economic stagnation (which is also closely correlated, as noted above, to lower interest rates). Rising life expectancy and decreasing fertility rates without corresponding compensating migration movements have had a remarkable impact on Japan’s total working-age population (Figure 3). However, Japanese people tend to work even beyond the official retirement age of 65.

Figure 3: Working-age population (15-64) indexed so that January 1, 2004 = 100

Source: OECD, Deutsche Bank AG. As of April 9, 2021.

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Technological progress can only partly compensate for this, particularly if an economy is capital intensive already. The sustained increase in Japan’s median age from 35 in 1985 to over 48 today has therefore pushed down the economy’s growth path. Gross value added for the whole country in general has barely increased while its debt burden relative to GDP has risen significantly.

Most of the developed countries in the Eurozone are experiencing similar demographic trends, with the fertility rates of generations born after 1965 significantly lower than the preceding “baby boomers”. Migration may mitigate the effects of an ageing society in Europe, however.

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Even – as a consequence of the one-child-policy introduced in 1980 – will face a phase of declining population in the coming decades. One study (by the Institute for Health Metrics and Evaluation, IHME) predicts that the population in China will almost halve from more than 1.4 bn today to 730 million by 2100. (Other studies show a less severe decline.) Since 2016 couples have been permitted to have two children, but with a fertility rate of 1.7 the population is still likely to shrink, as it is the case in many industrialized and emerging countries.

Median population ages vary greatly according to United Nations data, with the U.S. (38.3) and China (38.4) slightly above the G20 median of 34.4, but Germany (45.7), Italy (47.3) Japan (48.4) much higher. The latter two also have the highest debt to GDP ratios among developed countries. With fertility rates in long-term decline, global median ages are likely to rise further, and without counter-measures (for example around labour market participation) “Japanification” will spread to other economies. However, trends in working-age populations do vary between countries (Figure 3), with the U.S. managing to increase its working-age population (not least due to immigration) while the Eurozone’s has remained static and Japan’s has declined.

This will have important implications for policy and thus interest rates. Japanese business cycles have become shorter and relative debt levels have risen further, as policymakers have not been able to achieve either growth or inflation to extract the country from its current predicament. The Japanese economy has also proved more vulnerable to external shocks. However, Japan has also had some idiosyncratic events such as the Kobe earthquake or the Fukushima tsunami with their respective impacts on business cycles. Mounting debt levels may limit the ability to counterbal- ance economic downturns in particular if growth is anaemic for a while due to an ageing society.

Ageing populations also have a major impact on savings behaviour and thus interest rates in equilibrium. Ageing populations tend to have higher savings rates during the active working life because they have to save to provide for a longer retirement period than in previous years. There is an argument that increased savings by “baby boomers” in recent decades have increased aggregate savings to an extent that cannot be absorbed by higher investing activity – the so- called “savings glut”. This has pushed down equilibrium rates. A quick end to this imbalance between savings and investment is not expected – although, in the longer run, a growing elderly population could push up spending on goods and (labour-intensive) care services from a shrinking workforce, closing the gap at least partially and possibly finally leading to higher inflation.

But to boost economic activity, growth in the manufacturing sector is also required. Apart from the labour force, higher investment is one way to encourage higher growth. However, many other trends would support the argument that investment activity will remain rather weak in the future. Decreasing labour force growth also means that lower growth in companies’ capital stock is needed to preserve a given capital-employment ratio. Demographic changes over the last few decades have also happened against a background of gradually declining public in many developed economies (at least pre-pandemic) partly because of higher debt burden.

Figure 4: Long-term contributors to financial repression

Source: Deutsche Bank AG. As of April 9, 2021. R* is the natural rate of interest.

Savings to investments imbalance

Ageing populations

Structural trends ow eisting Further stimulus needs reinforce financial interest rates unconventional policy repression

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ower trend P growth uantitative easing

ow productivity Yield curve growth control etc.

Changing economic structures

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Technology and productivity

The other main contributor to long term growth apart from labour is technological change (particularly if the labour force working-age population is shrinking as noted above). This is by its nature difficult to measure, but it is possible to identify some general trends. Economic theory defines productivity gains as the growth residual which cannot be explained by labour and capital (so-called total factor productivity).

So in that sense, technological progress in general help us increase productivity and hence growth and therefore should be one factor pushing up the neutral (R*). So why is this not happening?

Shifts in the structure of western economies are an important factor behind productivity trends in recent decades. The contribution of the often more innovative and capital-intensive manufacturing sectors to total GDP has been shrinking. Use of capital in the form of technological progress has led to productivity gains be it via hardware (e.g. robotics) or software (e.g. processes). The services sector contribution has risen. While productivity gains via technology are possible (e.g. via software), many traditional services tend to be more labour-intensive and thus productivity gains may be more difficult to achieve.

Weaker productivity growth may also be linked to the higher market concentration of companies in some sectors – the emergence of “winner takes it all” firms. Economies of scale from this process may allow for cost savings, but also result in declining competition (as they lead to oligopolistic structures) and rising market entry barriers for new firms, perhaps discouraging innovative approaches.

Finally, the low interest rate environment has allowed some non-profitable companies to survive because of very low financing costs. This may have hindered the process of “creative destruction” and thus necessary structural changes in the economy – holding back technological progress.

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Other factors pushing down interest rates

Other possible explanations for the long-term fall in interest rates include a decreasing demand for capital caused by ongoing digitization, e.g. through a shift from investments in capital intensive goods towards more intangible goods (i.e. software). Other commentators – for example the former U.S. Treasury Secretary Larry Summers – have seen the developed economies as being in a “secular stagnation” phase. They point to a decline in investment opportunities caused by slowing population growth and a decrease in the rate of technology progress. This leads as a consequence to a situation with excess supply of savings and lowered aggregate demand.

Wealth and income distribution may also have contributed to lower rates. Growing inequality is often associated with a lower average propensity to consume as upper income households tend to save a higher portion of their disposable income, which also contributes to excess savings and by this lowering equilibrium rates.

Policy responses

In the past, central banks have tried to set the appropriate policy rate by assessing inflationary pressure in conjunction with the natural rate of interest, the economic slack measured by the output gap in an economy and the inflation rate. During normal business cycles, government bond yields fall in the downturn phase, and then rise during the economic recovery phase, anticipating changes in future monetary policy.

Figure 5: Central banks' total assets

Source: Bloomberg Finance L.P., Deutsche Bank AG. As of April 9, 2021.

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However, the previous correlation between growth rates and interest rates broke down after the start of the global financial crisis (GFC). Government bond yields (taken as proxies for risk-free rates) then fell well below the nominal growth rates of western economies. There were several reasons for this.

In the aftermath of the initial phases of the GFC, private actors started to deleverage, keen to reduce the high levels of debt that had contributed to the GFC, but adding further to already extensive economic slack and deflationary pressures. This has helped keep the natural rate of interest low in the last decade. And just as this economic and labour market slack was being taken in, the 2020-2021 coronavirus pandemic then dashed hopes of an imminent return to economic stability.

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Loose monetary policy, once seen as a temporary measure post-GFC, had become normal before the coronavirus pandemic, despite economic recovery in many parts of the world. Markets and companies quickly got used to the continuous liquidity injections. Low rates have resulted in a classic “liquidity trap” whereby individuals/firms have little incentive to lend money for productive use, preferring instead to keep it as cash balances or invest in financial assets. So while base money (i.e. cash and central bank deposits) has grown, broader measures of money supply which are relevant for the transmission channel from monetary growth to inflation have increased only slowly. The velocity of circulation of money has also decreased. To slightly over-simplify, the new money has been hoarded. Central banks have struggled to normalize their monetary policy in this rather undynamic environment, meaning that interest rates have remained lower for longer than in most other previous business cycles.

2021 and probably the following years too will be characterized by continuous loose monetary policy perhaps with further central bank asset purchases (Figure 5) and policy rates at their present or lower levels – a wording the ECB has been using in its policy statements since some time. Implementing lower or negative nominal interest rates may become easier for central banks if central bank digital currencies are introduced. Further information on this can be found in our CIO Special: Central Bank Digital Currencies – Money reinvented.

Low R*: drivers and implications

o Various structural factors are pushing down R*, the natural rate of interest, which is highly positively correlated to trend GDP growth.

o Demographics, technology and wealth and income distribution are among factors which may have contributed to a lower R*.

o A low R* encourages non-conventional monetary policy easing and markets have become accustomed to liquidity injections: they are no longer simply a tactical measure.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings at the end of this document. Produced in April 2021. 9 CIO Special Financial repression: still restraining real rates 03 Policy sustainability and risks

Debt growth

Fiscal policy has also played an important policy role. Economic restrictions due to COVID-19 led to unprecedented levels of fiscal expenditure. State guarantees, direct money transfers to citizens and furlough schemes have far exceeded in scope the fiscal measures launched in the wake of the global financial crisis (GFC). Extensive governmental support will not end by this year and will go beyond 2021, as shown by the European Recovery Fund and the additional fiscal package under the new Biden administration in the U.S.

As a result, debt has increased sharply, to levels which (pre-pandemic) would not have been classified as sustainable under traditional valuation methods (for example, the Maastricht criteria for Eurozone countries subsequently embedded in the stability and growth pact). Elevated spending does not seem likely to be followed by a period of austerity, given the continuing ravages from coronavirus.

As a result, the “post-pandemic-age” will be characterized by many countries living with their highest debt levels in post war history. Debt levels in many industrialized countries have already surpassed 100% of GDP.

Of course, many economies have temporarily experienced high debt levels before. The question is how sustainable they are, and how they can be reduced.

One traditional resolution of the debt problem has been to grow your way out of debt – increasing growth so that the debt/GDP ratio falls. But, as we discuss elsewhere, potential nominal growth for developed economies has been falling for decades, due to demographic and other factors. Attempts to get around this through other ways (e.g. structural reforms) are difficult and take time. Moreover, the extra spending funded by recent debt seems unlikely to give a classical Keynesian uplift: most of it is replacing income rather than creating extra demand. Falls in demand for many services during lockdowns also cannot be made up for by higher post-lockdown supply. Full or partial debt defaults are not an option for countries wanting to preserve easy access to capital markets.

The IMF assumes that among the largest western economies, only Germany will succeed in reducing debt significantly. The others (e.g. the U.S., , Spain or Italy) will continue to have debt levels well above their annual GDP in 2026.

Figure 6: Debt to GDP rates and IMF medium-term forecasts

Source: IMF, Deutsche Bank AG. As of April 9, 2021.

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In the past, inflation (as one component of nominal GDP growth) has offered another way of reducing debt. At some point, inflation will pick up, particularly in some sectors (e.g. services) and de-globalisation may play a role in pushing up prices of some goods. Temporary increases in inflation are also possible due to the pro-cyclical nature of some fiscal measures (i.e. boosting spending during an ongoing expansion). But dramatic sustained rises in inflation seem unlikely, given the slack in the labour market, meaning that countries will not find it easy to inflate away debt.

This puts the debt management focus firmly on financial repression – holding down interest rates. This can contain debt service (particularly if maturing existing debt can be refinanced at lower interest rates) but will take a long time to reduce debt.

Figure 7 shows that, even with growth rates being 3% above interest rates – which would imply quite heavy financial repression – debt levels would fall by less than 30% over a decade.

Figure 7: Government debt reduction scenarios (as % of GDP) with balanced budgets

Source: Deutsche Bank AG. As of April 9, 2021. Note: The x-axis represents years from when budget is first balanced. In the scenarios, “r-g” is the rate of interest minus the rate of .

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Debt and budget deficit sustainability

One academic approach (Modern Monetary Theory) argues that debt levels are not a problem and some pragmatic government and central bankers (note former Fed chair and current treasury secretary Janet Yellen recently in the U.S.) have indicated that reducing debt levels is not an immediate priority. Low debt service costs in the current low interest rate environment are one important factor reducing pressure to wind down debt.

But there are two reasons why budget deficits are not likely to become eternal.

First, interest sensitivity can become extremely high. As noted, low debt service costs are a great help to indebted countries at present. But in the future markets will start to differentiate more between countries – especially in times of crisis. Low policy rates do not by themselves imply low risk premiums. When things worsen, countries could come quickly under pressure. As the Eurozone crisis of 2009-2012 demonstrated, risk premiums can rise very fast when confidence in one country’s credibility is challenged.

Secondly, we should not underestimate potential inflationary pressures from higher fiscal spending. Economic slack (from higher unemployment levels, subdued consumer confidence and the output gap) is likely to keep price pressures for the months ahead low. But when inflationary pressures start, they can then grow quickly (e.g. when full employment has been achieved). This is most likely an issue for the long term, not the short term. Inflationary pressures may also unfold when the velocity of circulation of money increases.

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For now, the situation appears manageable. In fact, as maturing debt is replaced by lower-yielding bonds, debt service costs as a percentage of outstanding debt in general will decrease. For some countries, like Germany, where the majority of bonds outstanding have a negative yield, it could even turn positive over time. So – paradoxically – by issuing debt, the state is actually earning money.

In the absence of financial stress, even large budget deficits and high debt to GDP ratios can be sustained over a long time period. As long as financial actors believe that outstanding debt will be repaid (and in the absence of other investment with better perceived risk-return profiles) even negative yielding bonds will be bought.

However, other factors need to be considered.

First, while we do not think that governments will want to risk suppressing the business cycle in its early stages, in the medium term the probability of increased is high – and is already being discussed in many countries. This may in part be driven by legislation: in Germany for example the government is forced by law (the so-called “debt break”) to reduce the additional debt taken 2020 and 2021 and to bring it back to levels below 60% to GDP. EU countries with the Euro as their official currency are obliged by EU agreements to have a strategy to reduce their debt to levels seen as sustainable. Higher taxes are a means to increase government revenues and thus ultimately reduce debt and debt payments. Very recently U.S. President Biden has launched an initiative for higher corporate taxes.

Second, faith in further liquidity injections could fade. As we had already seen before the coronavirus pandemic, stimulus amounts had been forced to become more generous due to the reduced marginal utility of each unit of stimulus. There is a fear that monetary policy may stop being an effective tool.

Financial repression, fiscal policy and debt

o Fiscal policy has played a major role supporting economies over the pandemic, resulting in a substantial increase in debt levels.

o "Traditional" options of growing your way out of debt, or relying on inflation to ease the debt burden, do not look viable this time around.

o Heavy financial repression is therefore needed to manage the debt burden – and multiple factors suggest we cannot assume high fiscal deficits are sustainable for ever.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings at the end of this document. Produced in April 2021. 12 CIO Special Financial repression: still restraining real rates 04 Possible future scenarios

As we touch on above (and explain in detail in our report Peak Debt: Sustainability and investment implications), there are in principle six ways of escaping the debt trap: 1) pro-growth policies (e.g. structural reforms); 2) growth because of productivity gains (not driven by governments); 3) expenditure cuts; 4) revenue-boosting measures (e.g. hikes); 5) inflation and 6) debt “hair- cuts”/defaults (e.g. a “bail in” of debt holders).

Of course, in reality some of these can operate in tandem – for example, a combination of expenditure cuts and tax hikes could be seen as an austerity strategy. However, “hair-cuts” and defaults are worth avoiding as access to capital markets will be negatively affected.

With regards to the current financial repression environment, four possible scenarios are worth focusing on – and they are likely to overlap too:

Figure 8: Future scenarios

Source: Deutsche Bank AG. As of April 9, 2021.

Scenario A Scenario B Scenario C Scenario D Policy maintained Structural reforms “Inflation” “Stagflation”

Demanddriven Inflation with No policy shift Structural reforms reforms slow growth

Policymakers manage Low GDP growth, Difficult transition to growth/rates/ Higher interest rates low inflation higher growth inflation balance

Debt levels stable Debt levels reduced Slow growth or higher

High debt levels

Policy maintained; austerity avoided. Without major changes, economic growth may A continue to be low. In an effort to please electorates, governments will avoid austerity (note the recent discussions on the debt brake in Germany). As a result, government debt levels will (at best) stay broadly constant; they are more likely to continue to rise. Central banks will therefore need to maintain a low rates environment (at least in a historical context). As long as inflation does not kick in, putting central banks in a difficult situation, investors will be faced with low rates for some time. Such a scenario can last for a pretty long time, as the example of Japan demonstrates.

Structural reforms and austerity. Governments introduce structural pro-growth B reforms (e.g. de-regulation, postponement of retirement age) and also pursue fiscal austerity (public expenditures shrink and/or taxes are raised). This path can be thorny for politicians as their electorate has to make sacrifices – and there can be a long gap between the implementation of such policies and their eventual success. But resumed growth, along with fiscal control, should pull down debt-to-GDP ratios and result in higher interest rates and the end of financial repression. This scenario is more likely in regions like the U.S. than in the Eurozone, where different national governments are embedded in a common monetary framework.

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Inflation. The ultimate goal of low yields imposed by central banks may be to create C inflation. Higher inflation increases nominal GDP while the nominal debt level remains (ceteris paribus) unaffected. Here financial repression creates a transfer from the creditor to the debtor in real terms. At present, immediate inflation pressures seem moderate, given the still low growth environment. However, over the medium term inflation pressure may pick up when economies reopen, production capacity is fully utilized and pent-up demand meets limited capacity in the services industry. A loss of purchasing power is an obvious consequence and financial repression could even intensify if yields do not follow suit and rise to follow inflation. entralC banks should, however, be willing and able to combat too-high inflation rates by tightening financial conditions and raising rates. Nevertheless, for a certain period of time (and central banks have been unwilling to define this time frame) many now appear willing to accept inflation rates above their previous goals – the Fed, for example, has introduced a long- term average inflation goal.

Stagflation. Rising inflation along with rising yields can, however, result in a very D unpleasant combination from both an economic and investor perspective. If rates rise fast they can dampen economic activity as refinancing becomes more expensive and investments have to yield higher returns. High inflation rates can also result in higher wages creating an inflationary spiral ultimately resulting in stagflation: stagnant output and high inflation. The immediate consequences of rising yields for bond holders are losses. And still if inflation rates are higher than yields, financial repression continues. For equity investors a low growth/high yield environment has multiple challenges.

Looking across countries, it is possible that we will get a combination of these scenarios – some economies lifting themselves out of their current situation and others getting stuck.

Possible future scenarios

In the current financial repression environment, four scenarios (or a combination of them) look possible:

o Keeping policy broadly “as is”, and hoping that this can keep debt levels stable.

o Making radical and painful reforms, hoping that eventual stronger growth will reduce debt.

o Relying on increased inflation to reduce debt levels, which may require a complex policy balancing act.

o Risking stagflation, where high inflation is unfortunately accompanied by static or falling output, pushing debt up further.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings at the end of this document. Produced in April 2021. 14 CIO Special Financial repression: still restraining real rates 05 What this means for investors

Asset class trends

Financial repression in its current form makes capital preservation (even in nominal terms) even more of a challenge. High grade bonds no longer provide meaningful positive nominal yields (in many cases they are even negative). Despite recent rise in nominal yields in the U.S. real yields continue to be negative. For Europe this is even still the case for large parts of the yield curve.

This requires a change in thinking when it comes to asset allocation. Acceptance of risk is a prerequisite for returns, but this implies that investors are able to define their strategic goals and their willingness to accept risks. These parameters can be either temporary or structural in nature.

Falling interest rates have particularly supported equities. As can be seen by the high correlation of real yields and valuations (Figure 9), a large part of the increase of the broad S&P 500 in 2020 can be explained statistically by higher multiples due to lower real yields.

Figure 9: The S&P 500 price/earnings (P/E) ratio and the real U.S. 10-year yield

Source: Bloomberg Finance L.P., Deutsche Bank AG. As of April 9, 2021.

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1 1.0 201 201 201 201 201 201 2020 2021

S&P 500 P/E ratio (NTM, LHS) 10-year U.S. Treasuries real yield (in %, RHS, axis inverted)

Low interest rates have particularly helped boost certain types of equities by changing the extent to which we “discount” the future. “Growth” stocks are companies whose earnings are expected to grow strongly in the long term: such growth can be explained not just by structural reasons (e.g. technology trends) but also by accounting. Such companies’ future profits are now less discounted (by lower risk-free interest rates, i.e. highly-rated government bonds) and are therefore more worth from today’s perspective. So financial repression has led to shifts – by sector and by country – with valuations of specific industries growing more than others, and country indices with a higher proportion of such “growth” stocks performing relatively well.

For fixed income investors the world looks very different. Earning a return that is higher than inflation is harder than ever, especially for Eurozone investors where, even below investment grade, bonds have very low yields. To enhance the return possibilities bond managers have had to increase their risk profile when it comes to duration, credit and currency risk. This makes returns less predictable and prone to volatility.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings at the end of this document. Produced in April 2021. 15 CIO Special Financial repression: still restraining real rates

Real assets, aside from equities, have benefitted from falling yields. The gold price reached new all-time highs in 2020: the fact that gold does not pay any coupon is no longer a disadvantage when overall interest rates are low or negative (Figure 10 shows the link). In relatively illiquid asset classes like real estate or private equity where long-term financing plays an important role, the favourable financing conditions for investors have led to stretched valuations.

Figure 10: Gold and real interest rates

Source: Bloomberg Finance L.P., Deutsche AG. As of April 9, 2021.

2100 1.

100 1.0

100 0.

100 0

100 0.

1100 1.0 011 01 01 01 01 111 011 01 01 01 01 111 0120 020 020 020 020 1120 0121

Gold (in USD/oz, LHS) 10-year U.S. treasury real yield (in %, RHS, axis inverted)

Rising real yields: causes and challenges

As an escape route from financial repression, investors may hope for an increase in real (rather than nominal) yields over the longer term. However, any longer-term increase in real yields would create challenges as well as opportunities. On the fixed income side, an increase in real yields could be driven by rising nominal yields (assuming that inflation does not rise too), and rising nominal yields are associated with a fall in security prices – implying a rather unsettling path to normalization for an investor concerned about future income sources. Conversely, if the rise in real yields is due to a fall in inflation (rather than a rise in nominal yields), then central banks will do “whatever it takes” to combat what they may well see as dangerously low inflation rates, suppressing interest rates even further to encourage economic growth and thus (they hope) demand-driven inflation. Hence financial repression would be likely to continue.

On the equity side the picture would also be complex in a rising real yields environment, but in rather different ways. Real rates and equity prices are generally positively correlated. When the former rises, the latter usually does too: from a fundamental perspective, an increase in real yields can be associated with better GDP growth prospects, which should in turn be advantageous for equities. Swift moves in real rates, however, can lead to this correlation between rates and GDP growth turning negative, posing a short-term risk to equity markets. Negative real yields have resulted, as we can see, in elevated price/ earnings (P/E) ratios. If real yields rise, we should expect a more earnings-driven market, with P/E multiples likely to decrease. As we discuss above (on page 15) the fall in yields had also had differing implications for different sectors, in part because it affects how we discount future earnings. Higher yields therefore could also result in a style rotation from growth to value stocks, as it would force investors to increasingly discount future earnings, reducing the relative attractiveness of growth companies.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings at the end of this document. Produced in April 2021. 16 CIO Special Financial repression:repression still restraining real rates

Investment responses

As we argue above, financial repression is likely to be with us for some years. Investors therefore need to accept it and plan accordingly.

One obvious response might appear to be to allocate a higher portion of your strategic asset allocation to equities. But tail risk events (as we have been brutally reminded by the coronavirus pandemic) demonstrate that diversification remains key to any strategic asset allocation as situations can change unexpectedly and rapidly. For a discussion of diversification within portfolios, please see our report, Diversification: managing eggs and baskets.

Overall, the impacts of financial repression for markets is both powerful yet simple. The lack of opportunities for positive real returns on safer assets forces investors further out along on the risk curve. For those asset classes which are favoured, this stretches valuations to new highs, which can be particularly problematic for certain types of investors that would normally want to target lower weights for risky assets or institutions that are bound to a fixed nominal return target.

In equities, as noted above, financial repression pushes up valuations in a number of ways. Even stocks of companies with above-average dividend yields or pay-out ratios may experience exaggerated performance, being regarded as bond-proxies by traditional fixed income investors who are forced to accept a lower position in the capital structure pecking order. (The negative is that certain rate-sensitive industries, such as banks, may face profitability pressures from an artificial suppression in yields.)

However, the ability of fixed income investors to buy more risky assets may be limited by this or other regulatory hurdles. These restrict certain types of institutional investors (e.g. pension funds) regarding credit quality, meaning that they may not have the flexibility to extend out on the risk curve. Such investors may have to lock in yields at negative real levels and follow a more active approach, depending on additional financial repression in the future to further boost the value of some fixed income investments.

As we have discussed above, repression of interest rates eliminates opportunity costs for non- interest bearing assets such as gold or other precious metals. Historically, the move in real yields goes in step with this, with some now thinking (not convincingly in our view) that crypto currencies may play a similar role. Real assets are far from risk-free, however.

So, in summary, while financial repression may reduce economic risks, a portfolio response to it may involve increasing risk – achieving reasonable portfolio returns may require increasing equity exposure, or venturing into more risky fixed asset investments, or exploring the world of real assets, or a combination of these approaches. This may make for an uncomfortable ride, even if the current problems with the pandemic are dealt with effectively – as the 2013 taper tantrum demonstrated, the process of even slight policy “normalisation” is inherently risky. Financial repression therefore makes effective risk-management in portfolios even more important.

Portfolio implications

o Low interest rates have helped boost equities and some other real assets. Certain sorts of equities have particularly benefited from changes to the extent we “discount” the future.

o For fixed income investors, the world looks very different, but the ability (and willingness) of such investors to increase risk may be limited by various factors.

o Financial repression therefore demands a well-considered portfolio response, or else higher levels of risk may make for an uncomfortable ride, even if current problems with the pandemic are dealt with effectively.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings at the end of this document. Produced in April 2021. 17 CIO Special Financial repression: still restraining real rates

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3. Bernanke, B. S. (2005). The global saving glut and the US current account deficit (No. 77).

4. Brand, C., Bielecki, M., & Penalver, A. (2018). The natural rate of interest: estimates, drivers, and challenges to monetary policy. ECB Occasional Paper, (217).

5. Demary, M. (2017). The end of low interest rates? (No. 17.2017 a). IW-Kurzbericht.

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9. Deutsche Bank Wealth Management (2021): Yields end deep hibernation. CIO Special.

10. Holston, K., Laubach, T., & Williams, J. C. (2017). Measuring the natural rate of interest: International trends and determinants. Journal of International Economics, 108, S59-S75.

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13. Lopez-Salido, D., Sanz-Maldonado, G., Schippits, C., & Wei, M. (2020). Measuring the Natural Rate of Interest: The Role of Inflation Expectations. FEDS Notes, (2020-06), 19.

14. Von Weizsäcker, C. C., & Krämer, H. (2019). Sparen und Investieren im 21. Jahrhundert.

15. Wicksell, K. (1898). Geldzins und Güterpreise: eine Studie über die den Tauschwert des Geldes bestimmenden Ursachen.

16. Schmelzing, P. (2020). Bank of England, Staff Working Paper No. 845, Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311–2018.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings at the end of this document. Produced in April 2021. 18 CIO Special Financial repression: still restraining real rates

Glossary Baby boomers are generally defined as those born between 1946 and 1964.

The European Central Bank (ECB) is the central bank for the Eurozone.

The Federal Reserve (Fed) is the central bank of the United States. Its Federal Open Market Committee (FOMC) meets to determine interest rate policy.

Financial repression is a policy of keeping interest rates at very low or negative real levels.

The G20 is an international forum of the governments and central-bank governors from 19 individual countries—Argentina, Australia, Brazil, Canada, China, France, Germany, , Indonesia, Italy, Japan, , Russia, Saudi Arabia, South Africa, South Korea, Turkey, the and the United States—along with the European Union (EU).

The Global Financial Crisis refers to the financial and economic crisis that started in 2007-2008.

The International Monetary Fund (IMF) was founded in 1994, includes 189 countries and works to promote international monetary cooperation, exchange rate stability and economic development more broadly.

Modern Monetary Theory (MMT) is a heterodox macroeconomic framework that, in some forms, says monetarily sovereign countries like the U.S., UK, Japan and Canada are not operationally constrained by revenues when it comes to federal government spending. Market concentration

Quantitative easing (QE) is an unconventional monetary policy tool, in which a central bank conducts a broad-based asset purchases.

R* is the natural rate of interest, which (in theory) brings an economy’s output in line with its potential output.

Stagflation is a situation where economic growth is slow (or negative) but levels of inflation are high.

The yield curve shows the different rates for bonds of differing maturities but the same credit quality.

Yield curve control is where a central bank targets part of the yield curve, buying (or selling) these bonds to keep yields (and therefore prices) at what it believes to be appropriate levels.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings at the end of this document. Produced in April 2021. 19 CIO Special Financial repression: still restraining real rates

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