How far will interest rates rise? What will this mean to my portfolio? What will this mean to my mortgage? Normal triggers for rising rates, a positively sloping yield curve, and most pundits expecting rate rise to continue.
While this may be true, I guess the more compelling question is whether this is the start of a recovering economy, or just a blip within a secular weak environment. This question is an important one, as unlike economic recoveries and recessions which typically happen every five years, inflationary cycles typically last for 20 years.
The key aforementioned word is “secular,” given the long lifespan of inflation. What’s interesting, however, is that even the highly-trained academics and market pundits have had a horrible track record in forecasting secular trends, as all too often they’ve misread short term cyclical blips as indicative of longer term secular moves.
As the joke goes, the market has forecasted seven of the last three recessions. With inflation cycles, this forecast is even more exaggerated.
While we are all vulnerable to such a misread, my perceptions of current secular economic environment are founded on what has been called the “Three Ds”: deficits, demographics and democracy’s demise (or, if you prefer, the rise of populism). While I will explain further into these three Ds, as I present each D, consider how general monetary policy (moving interest rates and lending requirements) could impact such secular issues.
While corporations have moved to a more defensive - cash rich and low debt levels – position following the financial crisis, the same cannot be said for most governments and households.
Most middle class households have historically been the bread and butter for tax raising and consumer spending habits (a component which represents near two thirds of GDP). And in an effort to further “stimulate” the economy, most conservative governments have implemented further tax cuts, thereby adding to the already high government deficit to GDP levels.
As any borrower will attest, not all debt is bad. Adding debt to improve viable infrastructure, or any other government projects with ongoing benefits, is one such example of “good debt”. But adding debt through tax cuts favouring the asset-rich minority, who have yet to show signs or reinvesting the excess cash flows, is one which perhaps falls outside the realm of “good debt”.
As for demographics, enough material has been written and aired regarding the ageing baby boomer, and how the number of retirees to working age populace rising will be a hindering influence on economic stimulus.
With the exception of “SKII-ng” (an acronym for “spending the kids’ inheritance” by recent retirees), spending patterns for retirees is noticeably lower than for working households (with and without children at home).
It should equally be remembered that most super funds are now moving to net outflows, whereby there are more retired members extracting their retirement savings over contributing employed members. And while the media keeps telling us that falling interest rates are good for Australian households, the same cannot be said for retirees, whose preference is to live off the interest income.
Democracy’s demise, or rise in populism, relates to fewer and fewer governments willing to take difficult and long-term decisions for fear of alienating the voters. Populists often raise the flag of external fears over addressing internal matters.
This is understandable, as measures addressing external fears are easier to implement, as households generally don’t bear the brunt of such measures. But the internal domestic challenges are often postponed as they often alienate voters in the short term.
In Australia, for example, consider how many Royal Commissions we’ve had on tax (yet very few meaningful changes to our tax policy have occurred). As for the Royal Commission into super, let’s please not forget that this is already the third commission on super, and be assured the fourth, fifth and sixth will happen in my lifetime.
Bringing this all together, and how the Three Ds impacts inflation, relates to two fundamental questions: first, is inflation a secular or cyclical rise? And second, how effective will monetary policy be in combatting secular drivers?
The Three Ds, at least in my opinion, fall outside the domain of traditional monetary policy. They will require governments to make significant changes to how they themselves manage the economy (through tax policy, savings and spending patterns).
It will require government to throw out past rules which favoured a segment of the population and focus on the segment which are looking for full-time and rewarding employment. If you consider the Three Ds are one variable, it hopefully highlights how difficult this situation is, and how it will most likely take until the country looks down the dark rabbit hole before action is taken.
Monetary rate rises will no doubt influence the speed of the cyclical changes that occur, but they’re unlikely to derail or influence the secular ones.
In short, while it’s highly likely that interest rates will rise from current anaemic levels, I for one don’t believe that this is the start of any major tightening of monetary policy, at least not for the long term.
For the sake of my adult children, I truly hope I am wrong, as the picture I paint is admittedly not a bright one. But make no doubt here, we are truly in a unique environment.
I have yet to read any material justifying how T Bills can yield a negative number, or how dividend yield can show a higher nominal figure than 10-year bond yields (and without considering franking credits), or how one can immunise a pension portfolio whereby defensive assets nominally yield a figure under long term central bank inflation targets.
We have truly morphed from a period of volatility to one of uncertainty, where the former is a statistical figure one can forecast to one where forecasts themselves become meaningless.
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