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MAY 2016 END OF THE CYCLE OR END OF AN ERA? DEBT, DEMOGRAPHICS AND THE LIMITS OF MONETARY POLICY

> The current era of monetary policy began with the collapse of the Bretton Woods system. Recurrent crises and increasingly experimental policy suggest we may be close to another shift in the monetary regime. Abdallah Nauphal, Insight Investment CEO At best, the time horizon of many investors stretches to the length of the current business cycle and when the next downturn might be expected. Few think in terms of eras. But sometimes a long-term perspective is required to peel away the complexities that we currently confront in order to see the full picture. For economic policy, the current era began with the collapse of the post-World War II Bretton Woods fixed exchange rate system and its replacement with a fiat money regime. There is a lot of value in attempting to understand long-term trends. It is a form of analysis distinct from forecasting outcomes. The value of this sort of analysis is that it helps us to grasp the dimensions and drivers of the risks we face. One of the characteristics of this present era, particularly of late, has been recurrent crises. The most recent unfolded in three distinguishable waves.

The first wave was centered on the US. Figure 1: The three stages of the global financial crisis The bursting of the property bubble led to the collapse of the subprime mortgage Stage 1 Stage 2 Stage 3 market. Eventually, through transmission US housing market collapse mechanisms few understood or predicted, this ended with the collapse of Lehman Brothers. In turn, this brought the global Credit crunch financial system to the brink. Banking crisis Euro sovereign crisis The immediate result was the recapitalization of US banks via the $700 QE/NIRP TARP/QE/ZIRP EM borrowing binge billion Troubled Assets Relief Program + ‘whatever it takes’ (TARP). The Federal Reserve (Fed) also did + Commodity collapse all it could to boost liquidity by the now familiar prescription of a zero interest rate policy (ZIRP) combined with quantitative EM crisis easing (QE). Source: Insight and Goldman Sachs. The second wave broke in Europe. The banking crisis spread globally through the channel of the euro dollar market. THE THIRD WAVE BREAKS There has been a massive increase in The problem for Europe was that many of corporate debt accompanied by some The responses to the crisis in both the the countries could not afford to bail out resource misallocation. The rapid US and in Europe meant that credit their banking systems. The lack of a debt expansion of China, fueled by debt, conditions for borrowers were very easy. sharing mechanism at the EU or eurozone in turn spawned a capex boom among That was intentional. It was designed to level meant that the banking crisis commodity producers. A modest kick-start economies in the aftermath of morphed into a sovereign debt crisis. downturn in Chinese growth has laid the crisis and dispel the threat of bare significant over-supply in many The European Central Bank (ECB) followed deflation. However, it also created the commodity markets. Some emerging the Fed’s playbook. It cut interest rates and conditions for the third wave of the markets face the challenge of both began QE. It also offered further liquidity crisis – a sharp rise in emerging market increased indebtedness and a terms of to banks via numerous loan programs. borrowing. China is perhaps the most trade shock. This crisis is still unfolding. However, it took ECB President Mario telling example. Corporate borrowing It will probably end with another big dose Draghi’s famous promise in July 2012 to increased massively between 2008 and of monetary accommodation, with China do “whatever it takes” to calm markets. the end of 2015. the likeliest source. PROBLEM SOLVED? To find the true causes of the crisis and the working age population as a explain why it is proving chronic rather percentage of the total of a population, it Few disagree with the broad outlines of than cyclical we need to look for looks at the working age population as a this narrative. But there are highly divided underlying causes, the deep-rooted proportion of the non-working population views about what the ramifications are sources of this persistent instability. – it is a ratio of how many workers are and what happens next. There are some Most of the pertinent analyses have supporting retirees and the unemployed. commentators who believe that this is a tended to focus on economic and historic Figure 3 shows that there is a fairly close self-contained series of events and that it assessments of long-term capitalist cycles. correlation between nominal GDP and the is principally a banking crisis. Once the final Another way of approaching this problem dependency ratio. wave of the financial crisis in emerging is from the other direction, thinking about What is underlying the declining working markets recedes we will return to what drove economic growth in 1980s and age population, and dependency on fewer something that approximates to a normal 1990s and asking whether those forces workers to generate growth and pay for environment. The system will revert to are still at work today. There are three the benefits of the retired and unemployed, equilibrium. factors that are most relevant: is a declining birth rate and longer life demographics, globalization and debt. The opposing view is that there is an spans across the developed world. insolvency problem that has been ameliorated by liquidity but still remains. DEMOGRAPHIC HEADWINDS The direction of travel does not look The problem has not been solved. There There are certain demographic indicators promising. Unless there is a significant has been over-investment funded by debt that can be projected into the future with boost to productivity this does not bode that has created a world in which there is a reasonably high degree of certainty. well for future economic growth. an excess of supply relative to demand. One is the working age population as a Unfortunately, productivity trends have That is supported by a mountain of debt percentage of the total population. This is a been heading in the opposite direction collateralized by over-inflated assets. proxy for the labor force. The change in the almost everywhere. labor force and increases in productivity is That is a sort of equilibrium, but it is a One way to address this problem would be what drives changes in nominal GDP. profoundly unstable one. The symptoms to open borders to immigration. After all, include disinflation, weak capex, and Figure 2 shows the working age there is still population growth in the currency wars. This prognosis suggests population for a range of developed and world. The United Nations estimates that that there is still a very long way to go in developing economies since the 1950s. the global population will rise to 9.6 billion the adjustment process. The reforms that Throughout the period between 1950 and from 7.2 billion over the next 40 years. have occurred so far have addressed the 2000, the working age population was The problem is that this population growth illiquidity problem, but that is not a cure growing. It has now gone into decline in is in the “wrong” places. for insolvency. many major economies (the exception is For some, an open door immigration Japan where it was already declining at The banking crisis has largely been policy would represent the logical the end of the 1980s). The baby boomer addressed. Banks are better capitalized conclusion of the process of globalization. generation that boosted the post-war today than they were prior to the crisis But the limits of globalization are arguably workforce is now retiring. and the financial system is on a surer already being reached, in large part footing. The question remains: why do A variant of this indicator is the because it has not delivered what some of the symptoms of the crisis persist? dependency ratio. Instead of looking at its proponents had promised.

Figure 2: Working age population declines as baby boomers retire... Figure 3: ...and US dependency ratio points to declining nominal GDP

80 2016 20% 3.0 75 2.5 15%

70 Dependency ratio 2.0 65 10% 1.5 60 5% 1.0 55 Working age population (% )

Change in nominal GDP (%) 0% 50 0.5

45 -5% 0.0 1960 1980 2000 2020 2040 2060 2080 2100 1950 1960 1970 1980 1990 2000 2010 2020 Germany France Japan US Korea UK OECD GDP US dependency ratio (modelled) Forecast

Source: United Nations population prospects 2012 revision. Source: UBS estimates, Factset, and Haver Analytics. Lower income groups have a higher marginal propensity to consume. Conversely, the richer you are the more likely you are to save. The top 1% of the income distribution saves 51% of what it earns. Greater concentration of income lowers consumption.

Figure 4: Growth in income skewed… Figure 5: …and the richest grab the spoils

Real income gains and global income distribution 1988-2008 Change in US real income Top 10% 90 300 80 250 70 60 200 50 40 150 30 Without China 100 20 90% 10 50

Real PPP income change (%) 0 0 -10

-20 Change in real income from 1948 to 2010 (%) -50 0 10 20 30 40 50 60 70 80 90 100 1950 1960 1970 1980 1990 2000 2010 Percentile of income distribution Top 10 percent 90 percent Source: Pew Research. Source: International Monetary Fund.

INEQUALITY STYMIES approached these levels was in the Roaring earns. For a certain level of aggregate GLOBALIZATION Twenties just prior to a major economic income, greater concentration lowers adjustment. The share of the top decile in consumption levels. That creates a paucity Between 1988 and 2008 growth in real what is widely considered to be the golden of demand which is precisely the ailment incomes was skewed toward the age of American prosperity between the afflicting many developed economies wealthiest. The very poor did badly. 1950s and 1970s was around 15%. today. The middle classes in developing countries There is another way to view this If this relationship was unaffected by other did very well, especially in China. If you take inequality. We can look at the evolution factors we should have seen this lack of China out of the picture, the pattern is of the change in real incomes for the top demand earlier. In fact, lower income similar but the line is shifted substantially decile and the remaining 90% (see Figure 5). groups were still spending, but not lower (Figure 4). Between 1950 and 1980 they were broadly because their income was going up. The middle class in the developed world moving in tandem, the whole of society Rather, this spending was funded by a large has fared poorly, seeing little or no real was getting richer at a similar pace. Starting increase in the availability of consumer change in income over this 20-year time in the 1980s this began to change. A gap debt. When this stopped in 2008, the period. The very wealthy, the top decile opened between the richest decile and the picture started changing. It changed of the income distribution, did extremely rest of the population and it has become politically as much as it changed well. This in itself would not be a problem if progressively wider. economically. the world had been a single homogeneous This has enormous economic and political The middle class has been hollowed out. entity, but the problem is much clearer if implications. Economically, the greatest This group is the anchor of stability in any one introduces a consideration of national impact is in patterns of consumption and society. When that anchor is removed the and sovereign boundaries. saving. Lower income groups have a higher political result is often a swing to the left or The United States is a good example. marginal propensity to consume. right. There is clear political polarization. The top 10% of the income distribution in Conversely, the richer you are the more We can see this across the developed the US owns approximately 50% of all likely you are to save. The top 1% of the world with the rise of populist, nationalist, income. The only time it has previously income distribution saves 51% of what it and often angry political movements. Donald Trump’s appeal is largely based on as the Trans-Pacific Partnership grab this populist agenda. His prescription is the headlines, but behind the scenes simple: close the border to Mexican protectionist and discriminatory immigration, close the border to Chinese measures are becoming more exporters, and that will make America commonplace. great again. There are similar movements The US recently imposed a tariff on across the developed world. These Chinese steel, but that was just one of 43 movements are regularly polling between trade barriers introduced to protect the 20% and 40%. Just three years ago they US steel industry in the past seven years. were struggling to break through the 15% Over the same time period Europe has threshold (see Figure 6). It is difficult to see introduced 14 anti-dumping duties. what is likely to reverse this trend in the The Doha round of the General Agreement near term. on Tariffs and Trade (GATT) has been These new populist forces do not buy into dragging on for 15 years. Given this the consensus that the free movement of increasingly insular mindset and the rise capital and labor is an inexorable process. of nationalist-tinged populism, it seems We are moving into a world in which highly unlikely that open-door immigration globalization is increasingly challenged as will solve the demographic crisis faced by politics becomes more insular and trade the developed world. more protectionist. Agreements such

Figure 6: Populist backlash – the rise of new parties of the left and right

NETHERLANDS SWEDEN Freedom Party Sweden Democrats 24% appeal 21% appeal

UK UKIP 13 % appeal POLAND Law and Justice 39% appeal FRANCE National Front 28% appeal AUSTRIA Freedom Party SPAIN 31% appeal Podemos 21% appeal USA Trump/Sanders1 GREECE 37% appeal SWITZERLAND Swiss People’s Party Syriza/Golden Dawn 29% appeal 40% appeal

ITALY Five Star/Northern League 42% appeal

Source: Citi research, BCA, Insight, as of December 2015. Opinion polls/election results. 1 Average of candidates. DEBT SATURATION particularly telling is that over time the THE ONLY CERTAINTY IS slope of the curve gets steeper. It means MORE UNCERTAINTY The final force shaping the prospects it takes more debt to create the same for the global economy and financial amount of GDP. This process of debt There are a handful of certainties in markets in very profound ways is accumulation must surely become investing that used to hold true. One was debt. The accumulation of debt by unsustainable. The question is: how that policymakers would not impose governments, companies and the close are we to that tipping point? negative interest rates on savers for any household sector has perhaps been the significant period of time. Another was To help answer that there are two relevant defining characteristic of the global that yields on long duration bonds could metrics. The first is debt productivity: how economy since the 1970s. It is by far the not be negative because no investor much can one additional dollar of debt buy most pernicious and dangerous of the would accept the certainty of losing of nominal GDP? If you take the 1970s or three forces that have been outlined. money over a prolonged period while 1980s as your starting point, Figure 8 In isolation, each of these forces being exposed to credit risk. There are shows that you could buy approximately represents an economic headwind. approxiately $7.5 trillion of government 75 cents of GDP for one dollar of debt. But only debt can bring the whole bonds currently trading with negative Today, you can buy approximately 27 system crashing down. yields. In the case of Japan and cents of GDP for one dollar of debt. There Switzerland, this holds true out to The data from the US makes the point, has been a substantial drop in the 10-year maturities. but the picture is similar throughout productivity of debt and this is really the developed world with the possible problematic. How far into negative territory policy rates exception of Germany. Figure 7 shows can go remains an open question. This The second metric to consider is the the growth in total US debt compared to strange investment environment is already interest rate required to support the level GDP since the 1950s. For two decades, creating odd distortions. These range of debt. This story is well known. Interest US nominal debt and nominal GDP from the prosaic, such as people in rates throughout the world have collapsed essentially moved in lockstep. Switzerland not bothering to cash checks, as a result of ZIRP and QE. But ZIRP has not to the profound. For example, how do you This divergence broadly coincides with been sufficient. The Bank of Japan, ECB work out the net present value of an asset the end of Bretton Woods and the and the Danish, Swedish and Swiss central if the discount curve is zero? However, introduction of a fiat currency regime. banks have cut policy rates into negative there are three factors that probably This new regime gave governments far territory. NIRP (negative interest rate would concern policymakers: cash greater freedom to issue debt. What is policy) is the new reality.

If you take the 1970s or 1980s as your starting point, Figure 8 shows that you could buy approximately 75 cents of GDP for one dollar of debt. Today, you can buy approximately 27 cents of GDP for one dollar of debt. There has been a substantial drop in the productivity of debt.

Figure 7: Debt reaches saturation point… Figure 8: …but buys less growth over time

US total debt US debt productivity 0.8 50 45 0.7 40 35 0.6 30

USD tr n 25 0.5 20 0.4 15 10 0.3 5 0.2

- Ratio of change in NGDP to debt 1950 1960 1970 1980 1990 2000 2010

Total debt ex-financials (USD trn) GDP (USD trn) 1962 1965 1967 1970 1972 1975 1977 1980 1982 1985 1987 1990 1992 1995 1997 2000 2002 2005 2007 2010 2012 2015

Source: Datastream and Insight, as of December 2015. Source: Datastream and Insight, as of December 2015. Figure 9: Bank profitability damaged by NIRP… Figure 10: …but savings rates remain high

2.0 6.0 25 24 5.0 1.8 23 4.0 22 1.6 3.0 % 21 1.4 2.0 20 1.0 19 1.2 Swiss savings rate (% ) 0.0 18

1.0 -1.0 17 Swedish banks’ net interest margins (% ) 2011 2007 2008 2009 2010 2012 2013 2014 2015 2016 2017 2018 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Nordea Swedbank Svenska Handelsbanken SEB Sweden repo rate (RHS)

Source: Insight. Source: Datastream and Insight, as of January 31, 2016.

arbitrage, bank profitability, and the effect Sweden was one of the first countries to Demographics, debt and globalization on saving and consumption. implement NIRP. Figure 9 shows the were all very supportive of growth in the decline in net interest margin for its banks. 1980s and 1990s. But those tailwinds If interest rates fall to a level that Banks are unwilling to transmit negative have reversed and are increasingly compensates the holder of interest rates to depositors, because they headwinds. Further, these problems cash for the cost of storage, transport, do not want to risk the erosion of their cannot be viewed in isolation. Take the insurance, and some inconvenience deposit base. They are taking the pain via case of Japan where GDP per capita has premium, there is an incentive to take lower net interest margins. The whole been rising. The population should feel money out of the banking system. Deeply banking sector saw a sharp decline in reasonably good about it, however, overall negative rates would precipitate serial share prices during the first quarter of GDP growth has been far more lackluster bank runs. This is not happening in 2016 largely due to NIRP and investors’ as a result of Japan’s declining population. Europe, partly because banks have been views on its impact on profitability. That means the debt-to-GDP ratio, perhaps circumspect about imposing negative the most widely used proxy for the interest rates on retail depositors, their The goal of any interest rate cut is to sustainability of debt, continues to most stable funding source. In Japan, stimulate demand. The working increase and now stands at over 230% however, there has been evidence of a assumption of policymakers is that lower of GDP for the government sector alone. surge of sales of safety deposit boxes, interest rates act as an incentive to If household and (non- financial) corporate so it is clearly something savers are consumption and a disincentive to debt is included, the figure is close mindful of. savings. Unfortunately, this relationship to 400% of Japan’s GDP. There is no easy seems to have broken down. Switzerland There are steps that central banks can way out of this interlocking problem. has blazed the trail of negative interest take to make this cash arbitrage difficult. rates. But Swiss saving rates are not going There are steps that can be taken which They can withdraw large denomination down (see Figure 10) nor are savings in would help. Reform of the social contract notes from circulation (which may explain most countries. between generations is clearly needed. the true motivation behind withdrawing A combination of a declining birth rate, the €500 note from circulation). It is also This may be partly a function of higher life expectancy, a static retirement possible that all transactions in cash could demographics. If you are retired and have age and ever increasing dependency ratio, be banned. Few people under the age of a pot of savings that you expect to earn is not sustainable. Productivity also needs 30 would probably notice. an income from, negative interest rates to increase though this is proving very effectively cut your future income. You are Bank profitability is another difficult issue difficult to achieve in the developed world. likely to save more to replace it. Another which means NIRP has a limit. Since 2008, It is hard to see what breakthrough explanation could be a change in the net interest margin that banks have technology is on the horizon that will psychology. In the aftermath of the Great been able to earn has declined sharply. provide a sufficient catalyst to improve Depression, regardless of the interest rate, This was initially a by-product of QE which productivity. people refused to spend. They were so flattened yield curves and limited the worried about another downturn that they profitability of maturity transformation – rebuilt their savings. John Maynard Keynes the spread between what is paid out on a became a Keynesian when he realized that deposit versus what is earned from a monetary policy was not sufficient to longer-term asset, such as a loan. stimulate demand under these conditions. THE LIMITS OF The most charitable explanation for the even though this may take longer than MONETARY POLICY actions of policymakers is that they have hoped for. In this environment the best been guilty of reacting to outmoded thing you can do is try to identify assets True reform is difficult, so instead models. It is possible that the ultimate that will perform reasonably well policymakers have been experimenting goal is to generate enough inflation to regardless of the future course of policy with how far they can push act as a wealth transfer between and its impact on growth and inflation. unconventional monetary policy. generations and from savers and Ideally an asset should possess two key But monetary policy is not well suited creditors. That form of financial characteristics: good cash flow visibility to dealing with the problems that we repression may be the democratically and stability; and an embedded inflation currently confront. Monetary policy acceptable way of defaulting on debt. hedge. That tends to lead you to hard cannot solve a deteriorating But it may prove more difficult to create assets rather than financial assets, demographic profile, nor can it deal inflation than policymakers think because though there are parts of securities with insolvency. All that monetary policy of excess supply relative to demand. markets that also have these attributes. does is buy time. But even that comes We are reaching the limits of monetary The challenges we currently confront are with the collateral damage of distorted policy. In all likelihood interest rates will so profound and intractable that it seems asset prices and ever more debt. head further into negative territory. possible we will experience the end of an There is a popular saying that if you When that fails, the likely conclusion era and the rise of a new monetary order. want to get out of a hole, you should will be that a combination of fiscal and In academic circles there are already first stop digging. Monetary policy is monetary policy will be necessary. debates around what form this will take. providing the shovels for the global Because many governments are already These range from relatively modest economy to carry on digging an ever running historically high debt levels this evolution, for example using the SDR2 as deeper hole. First interest rates went fiscal expansion is likely to be monetized. an anchor for exchange rates, to radical ZIRP, then came quantitative easing, The mindset shift towards such an proposals such as an end to fractional currency devaluation, and now NIRP. outcome has become more established reserve banking. But for all of that effort we still have in academic circles and another crisis will Robert Louis Stevenson wrote: “Sooner anaemic growth in the developed world quickly spread it to policymakers. or later everyone sits down to a banquet and emerging markets in varying states Inflation is a monetary phenomenon and of consequences”. That moment is of crisis. in a fiat currency system policymakers coming. will eventually succeed in creating it,

2 Special drawing rights (SDR) are supplementary foreign exchange reserve assets held by the IMF. The weights of currencies in the SDR basket are determined by trade and the prominence of currencies held as reserves by national central banks. FIND OUT MORE

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