It’s undoubtedly a contrarian viewpoint for many investors, but based on underlying trends, it’s my belief that higher interest rates are on the way. COVID-19 has only stalled these long-term forces. When the pandemic ends we will see the trend of higher rates to begin to establish itself.
Recall that the forces driving the direction of real interest rates and inflation can differ dramatically depending on whether we are talking about the short term or a longer period.
While in the short run, the real interest rate – adjusted to remove the effects of inflation – is driven by the vicissitudes of the economy (the business cycle), its long-term (secular) trend is affected by factors that change only slowly, namely technology and demographics.
Similarly, in the short run, inflation is driven by the heightened intensity of economic activity and the pressures it entails on productive capacity and the labour and commodities markets. In the long term, it is taxes, economic efficiency and productivity that affect inflationary expectations.
Why is the secular trend of real rates on the way up?
- Demographic developments are pushing the real interest rate trend higher. Baby boomers have been retiring and have stopped saving; in fact, they are in their “decumulation” years, which reduces the supply of funds.
- This happens in the face of increased demand for capital by corporations that need to embed innovation and new technologies into their production processes, as well as by governments that need to borrow to fund structural deficits.
- To clear the demand-supply imbalance, the real interest rate trend is pushed up, not unlike what had happened in the late 1970s.
Why is secular inflation on the way up?
- We may be reaching a peak in productivity growth as experienced baby boomers retire and are replaced by less experienced workers who will nevertheless be in high demand because of low population growth. These workers will demand higher wages. This means higher inflation down the road.
- Pandemic-related deficits and ballooning debts will require higher taxes going forward. Many have likened the pandemic to a war. The pandemic, like the two world wars of the previous century, has been expensive and, as with those conflicts, will require higher taxes to deal with the deficits and accumulated debts.
- In addition, there are other structural changes that are also calling for higher inflation in the long run. First, a possible pause of globalization can potentially lead to higher inflation as companies, trying to guard against supply chain interruptions, will be bringing production back to North America, to a higher production cost environment. Second, whereas historically central banks have acted in a countercyclical fashion, in the past 10 to 15 years they have been increasing money supply on a more permanent fashion and this will also add to long-term inflationary pressures. Since 2008, the U.S. money supply has been growing at rate of 13 per cent a year. In 2020 alone, money supply has gone up by an incredible 51 per cent. (It is worth remembering that the rampant inflation of the 1970s was caused by monetary policies, which financed massive budget deficits.) Finally, during the credit crisis of 2007-08, aggressive quantitative easing (bond-buying by the central banks) did not produce higher inflation because QE was basically offset by banks and individuals deleveraging their balance sheets. But nowadays, there is an overaggressive QE program without any offsetting effect, and this will also lead to higher inflation.
After the pandemic, the secular forces behind real interest rates and inflation will reveal themselves, leading to higher nominal interest rates – not to mention the pent-up demand, which will add to economic growth and which in itself will push real interest rates and inflation in the short term up, too.
Such an eventuality will have serious implications for the high growth stocks that have propelled the market higher in recent years. We may be setting up ourselves for a repeat of what happened to the “Nifty Fifty” growth-stock darlings of the 1960s. These stocks had built-in unrealistic growth expectations when rates were lower, but then were punished in the 1970s when rates started to rise. The growth expectations did not materialize, resulting in most of these stocks underperforming the broader market averages.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Ivey Business School, University of Western Ontario.
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