The Ec lect ica Fund 31 May 2015

Ten Year Bond Bull Has Second Thoughts

The key question for us right now is whether we are at a

structural turning point in terms of global interest rates. I

attempted last month to set out the case for why this might

be the case. The argument rests on the notion that Europe,

Japan and China have all now adopted the same monetary

policy as the US. No longer is it a case of competitive

devaluation where one block of countries eases policy and

effectively pushes structural disinflation onto the others. Now

everyone is fighting the same global disinflationary force

together.

The following argument is by its nature mainly qualitative,

and can present no hard conclusions as to whether “we are

there yet”. Nevertheless I hope it illuminates the progression

in our thought process since last summer’s Jackson Hole

meeting, and the recent decision to remove our long dollar

and long Treasury positions. Our triple play strategy proved

successful from last August to the end of March. But now,

after so many years, we favour non-US equities as our

largest risk allocation.

Our present risk alignment rests on a particularly remarkable

aspect of the last thirty years that seems largely neglected by

the investment community and may suggest that stocks are

more attractive than you think. As I see it, there are two

mysteries that no one really discusses. Why, on a risk

adjusted basis, have equities proven such an abysmal bet

versus simply holding a lot of Treasuries, especially when

one considers the great innovation and prosperity of the

period? And why were borrowers unable to pay back enough

debt from their commercial endeavours to prevent global

debt to GDP ratios from soaring?

Chart 1: Equity Performance vs Bonds (Risk Adjusted)

XSource: Bloomberg/EAM

I can only conclude that interest rates were set too high for

the period. Initially, the enduring shadow cast by the

inflation from the 1970s motivated cautious investors and

policy makers to persistently overstate future inflation. But

this structural mis-pricing of inflation didn't just stay

around for the 1980s. The opening up of global labour

markets after the end of the Cold War allied with the radical

leaps in productivity made possible through information

technology added huge deflationary pressures to the global

economy which were consistently underestimated in forward

looking models. The rise of China over the last decade only

added to the confusion; rising commodity prices stoked fears

of broad-based inflation but in reality only served to deflect

central bankers' attention away from the real story of

disinflation, at least until the supply response finally caught

up with demand in the oil market in 2014.

This three decade long overestimation of inflation meant that

interest rates were set too high for the real economy.

Excessive real rates meant that productivity gains could not

be adequately captured by those who made them in the first

place; businesses struggled to pay down their debts whilst

the bondholders got richer and richer. In effect, the global

financial system managed to inadvertently transfer an

inordinately generous amount of the real economy’s

entrepreneurial gain from its debtors (the risk takers) to its

creditors (the bankers).

It might seem counterintuitive that debtors should continue to

take on debt when its price is too high. However, with such

attractive returns available from lending it could be argued

(like a hackneyed version of Say’s Law) that supply created

its own demand, and a bubble emerged from the

world’s banking system seeking to capture the excess

returns on offer by issuing ever more loans rather than

businesses aggressively pursuing them. The illusion of ever

lower nominal rates no doubt helped persuade the debtors

that taking this debt on was a good idea; in real terms they

were getting a terrible deal. And as we know, creditors'

desire to lend ever increasing quantities of money was taken

to its limits in the US mortgage market in the

2000s. Risk analysis went out of the window, good and bad

loans became indistinguishable and this precarious

financial engineering, which became so instrumental in

driving global GDP growth, led to and ended abruptly with

the financial crisis in 2008.

Chart 2: Total debt has increased hugely since 1980 as

creditors reaped all of the productivity advances

XSource: Bureau of Economic Analysis, Federal Reserve

0%

20%

40%

60%

80%

100%

120%

1992 1995 1998 2001 2004 2007 2010 2013

S&P vs USTs

DAX vs Bunds

TOPIX vs JGBs

DM equities have lost c. 70-100% of their value

vs bonds (risk weighted) since 1992

The Ec lect ica Fund 31 May 2015

Of course this is ex-post rationalisation but I believe it allows

for a more balanced discussion regarding recent central bank

intervention. As you know, I have changed camp from those

grumpy investors that constantly pour scorn on our monetary

policy makers and implore that you own gold. From my

interpretation of recent history it is quite reasonable

to commend the Fed’s policies since the crash,

especially the policy of abolishing the high carry on fixed

income.

Logically, it seems, they have sought to redress this

enormous transfer of funds from those that have an excess

of money to those that have an excess of ideas (but which

actually led to a flow of wealth in the opposite direction). In

doing so they have truly distanced themselves from their

policy errors in the late 1920s when interest rates

were raised to clamp down on wage growth and protect

corporate profit margins. Today, with prospective returns on

sovereign western debt seemingly eviscerated and equity

values having risen significantly relative to the levels of

global indebtedness, the global economy is heading towards

a more stable equilibrium between the risk takers and the

bankers.

However, whilst the system has stabilised somewhat we are

still labouring under the shadow of the secular stagnation

thesis. Globalisation has produced soaring income inequality

across continents as the wealthy have become ultra-wealthy

rapidly, and with their lower marginal propensity to spend, a

yawning expenditure deficit has emerged as the gains from

international trade have been captured by fewer of the

economy’s participants. And, in the absence of the credit

bubble which kept things stumbling on in the last decade, we

have been unable to rebalance the system and reignite

economic growth. Perhaps this is why we are seeing the

emergence of what might be described as the “Henry Ford”

option at both the sovereign and corporate level.

Back in 1914, Ford confounded conventional opinion by

effectively doubling the pay of his workers. This proved

visionary; instead of the constant high turnover of

employees, the best mechanics flocked to the car maker,

bringing their human capital and expertise and raising

productivity. But more significantly it set an early marker. The

precedent was established for the economy’s workers to

capture a larger slice of the period’s surging productivity.

Slow to take root, it nevertheless developed over several

decades allowing the US to recover from the ravages of the

Great Depression and set in motion a virtuous circle that

produced highly remunerated consumers with a greater

marginal propensity to spend than their elite “Gatsby” like

predecessors from the 1920s. Its heyday was probably the

decades spanning the 1950s and 1960s as consumption

soared and boosted corporate profits; GDP was shared

evenly, everyone was happy. And equities outperformed

bonds.

This happiness had faded by the late 1970s. Bliss had turned

to discontent, especially in the UK where rubbish was left to

rot on the streets and the country came to virtual standstill. It

seems evident now that a tipping point had been reached.

Gone were the days where the consumer

empowered companies to produce more and drive the

economy forward. Emboldened by the persistent wage

gains received since the 1930s, militant trade unionism came

to view higher wages as a right rather than the just reward

from higher levels of productivity. The increasingly lop-sided

nature of the distribution left the corporation empty-handed

and unwilling to commit to new investment; innovation and

GDP growth withered.

Chart 3: Workers haven’t had a real pay rise in 30 years

despite rising productivity

XSource: measuringworth.com/EAM

So much for forty years ago. Today the cycle of GDP

distribution has moved full circle to another extreme, this

time redolent of 1920s style inequality. GDP growth has

again waned and global debt-to-GDP has exceeded its

previous high. Was Adam Smith right after all? Do high

profits occur in only two types of nations, a poor one or a rich

one going to ruin?

Chart 4: Wealth distribution has moved full circle from

the peak in the 1920s via the excessive labour share in

the 1970s. Now “Fordism” is the solution once again.

xSource: Emmanuel Saez & Gabriel Zucman

0

1

2

3

4

5

6

7

8

1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

US real wages US real GDP per capita

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

% of US wealth distribution held by top 0.01%

The Ec lect ica Fund 31 May 2015

Just like in the 1920s, something has to give in order to

address the interlinked problems of a lack of

demand, income inequality and high debt levels. The good

news is that the problem is not intractable; the political

economy has solved this before and we should dismiss the

doomsters who argue that it represents a real barrier to

further human progress. We are not doomed. Labour needs

to be cut a better deal; we may have gone back to the future.

Let me now explain the first tentative steps on the road to

recovery as I see it...

The first prominent sign of the coming

counter revolution emerged out of Asia when China sought to

change its economic growth model two years ago. The

previous system had run its course. If you recall, this was

a stealth programme that punished domestic consumption:

private sector wages rose but never as much as surging

productivity would have justified. The renminbi appreciated

against the rest of the world but again at a pace that failed to

keep pace with the strength of the economy; private sector

households were effectively deprived of the bounty of a more

fully valued currency to boost their wealth vis-à-vis the rest of

the world as imported goods remained beyond the reach

of the many. And finally interest rates were held artificially

low as GDP growth was produced via immense gross fixed

capital formation that by the end probably spawned projects

which contributed negatively to productivity across the

economy. Economic growth dried up and debt-to-GDP

exploded to levels that still threaten the economy.

Source: IMF

Today, improving the lot of the Chinese household is the

centrepiece of the new model. Just like Henry Ford a century

earlier, China’s policymakers have sought to raise wages

and rebalance the economy in favour of higher

consumption. Furthermore their wealth versus the rest of the

world has been boosted by the expanding purchasing

power of the renminbi (see our February monthly

report). Chinese citizens are now less impoverished than,

say, their European counterparts as employment has

remained high, wages have grown and the currency has

gained 20% versus the euro since the beginning of 2014.

And of course by loosening monetary policy and boosting the

stock market the nation’s wealth has surged by some $5trn…

China has become a considerably happier place, where

better remunerated workers are becoming increasingly keen

to consume more and corporate profits are likely to reflect

this in time. Ford would have approved.

Significantly China wasn’t alone. One of the cornerstones of

Abenomics, announced concurrently with the Chinese pivot,

was an overt attempt to push the country’s wages

higher. Japan had stagnated over two decades. Again one

can point a wagging figure at developments in

the labour market: for many years, nominal wages have been

declining despite tight labour conditions and real wages have

fallen and shown no relationship with the nation’s

solid productivity growth. As a result, labour’s share of

national income has fallen from around 66% at the end of the

1990s to around 60% today.

Japan has long proven a riddle. In an economy not known for

an aggressive Anglo-Saxon profit seeking culture,

its labour market has nevertheless had to endure some of

the most relentless “Gordon Gecko” type attacks from a

corporate sector desperate to maintain profitability. This can

be seen in the sharp increase in the use of part-time workers

which has doubled from 16% of the workforce in

1985 to about 33% today. Part-time workers are

paid substantially less: compensation per hour is just 37%

of those in full time employment.

Of course apart from the BoJ’s aggressive monetary policy

that has weakened the yen and boosted share

prices, Abenomics' other reforms have proven mixed. But

even here you can just make out a glimmer of a Henry Ford

strategy beginning to take shape. Hikes in the consumption

tax have been put on hold and a nutty decree to

cut the wages of civil servants by 8% per annum was

scrapped last year and is thought likely to push up salaries of

local government workers. Better still, tax incentives

for raising wages have been introduced: a tax credit equal to

10% of incremental labour costs seems logical. Finally,

Japan’s minimum wage, amongst the lowest in the OECD

countries, is likely to be targeted by reform minded politicians

eager to reverse labour’s lost share of the nation’s

productivity and loose monetary policy bounty.

But it is not just in Asia and the seedy world of needy

politicians seeking to retain power that we can see attempts

to break this impasse and boost aggregate demand by

improving the lot of the global community of impoverished

workers. The US has recently seen a volte-face from the

notoriously frugal Walmart, the largest private sector

employer in America, which recently announced that it

was raising its minimum starting wage to $9 per

hour, 24% above the national minimum wage. Many have

been quick to draw the conclusion that the labour market is

tightening and this will inevitably encourage the Fed to hike

policy rates. But I can only see the shadow of Henry

Ford and the prospect for lower staff turnover, higher

productivity and a virtuous circle of better living standards

boosting the corporate bottom line.

The Ec lect ica Fund 31 May 2015

In summary my argument is that the global economy over the

long run tends to oscillate between excess returns amongst

different interested parties within the economy and that

this correlates very strongly with cycles of global debt. Each

wave seems to take around 40 years, with 10 years of

trauma followed by 30 years of joy before the opposite

extreme is reached once more.

In this cycle we believe enough time has now passed that as

risk takers we should now anticipate better economic growth.

Every major economy has shifted tack and the period of

currency adjustment is likely complete. Accordingly, we are

of the mind set that the changes to the global economy as

outlined above and the lessons learned mean that GDP

growth in developed markets over the next ten years is likely

to prove much better as shifts towards wage increases

create a positive feedback loop from a very depressed base.

Whilst global rates necessarily need to remain low over this

period (especially real rates) to ensure that debtors can

reduce their very high debt burden, they probably can still

rise modestly as inflation picks up. But a wave of efficiency

owing to better remunerated workers underwriting improved

productivity means that we think inflationary pressures will

not be excessive.

This is why we think that despite a return to better growth

and some inflation, gold will not be a good investment. Gold

does best in the years leading up to a crisis situation, either

deflationary or inflationary, and we are moving further away

from crisis thanks to the measures being undertaken.

Hugh Hendry

Tom Roderick

George Lee

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