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WHY is the world experiencing perpetually falling bond yields? Globally there are now more than US$8 trillion of government bonds with negative interest rates. With US unemployment rate dropping to 4.7 per cent in May and the Fed struggling to raise rates again, something clearly is different in this economic cycle. There is considerable concern among investors regarding negative interest rates, central bank policies, and the modest global economic recovery. Unfortunately, my economics professors never gave a lecture on how to interpret this new phenomenon! In short, what are negative interest rates telling us about the global economy? Are they causing greater uncertainty or symptomatic of a broader trend?
My professors did however provide clear lessons on what ultimately drives economic growth, being (1) productivity growth and (2) growth in working-age population or demographics. We would argue that negative interest rates are a direct illustration of a more moderate economic growth potential in the global economy.
Importantly, productivity growth has stagnated globally and working-age population growth has also peaked. Hence, blaming quantitative easing or negative rates for the current economic climate is analogous to saying a house fire was caused by someone just because he has matches in his pockets. This is why we have such low rates, low inflation, and as a result, aggressive monetary policy including quantitative easing and negative interest rates as central banks struggle to hit inflation targets.
Firstly, productivity declines have befuddled everyone. US Federal Reserve chief Janet Yellen stated in in a press conference following the Federal Open Market Committee in June: "But there are also more long lasting or persistent factors that may be at work that are holding down the longer run level of neutral rates. For example, slow productivity growth, which is not just a US phenomenon, but a global phenomenon." In advanced economies, productivity growth has declined from a 2.5 per cent annualised rate during the dot-com era in 2000 to just 0.5 per cent this year. While earlier radical inventions such as electricity and railroads have lowered the cost of transportation of goods by 96 per cent compared to the wagon era, the effect of recent technological innovations, such as the smartphone and digitalisation trends, have not shown up in official statistics. Nevertheless, this is still a considerable drop and while there is much debate regarding its measurement, it is clear the trend is lower productivity growth globally, including in emerging economies.
In addition, we know all about the greying of the population in advanced economies. However, even in the largest emerging economy, China, working force population has also peaked in 2014. In fact, the growth in global working-age population has slowed from 2.2 per cent in 1980s, to 1.7 per cent in 2000s, to 1.1 per cent presently. The combined impact of slower growth in productivity and the labour force has likely lowered global growth potential following the Great Financial Crisis of 2008.
So are we resigned to a fate of slower growth? No! While central banks have been tasked to carry the world on their shoulders and with the lessening incremental impact of central bank policy on economic growth, the missing piece of the puzzle is proactive fiscal policy and reform which targets raising productivity and boosting working force population. Lowering borrowing costs is not enough without increased demand for loans. Measures to increase aggregate demand must be boosted.
For example, a study by the IMF/OECD titled Fiscal Policy and Long-Term Growth concluded that fiscal reforms can raise medium to long-term growth. "In advanced countries, excluding Ireland which experienced a significantly higher growth dividend, per capita growth in the post-reform period is about ¾ percentage points higher than the counterfactual. In emerging economies and low-income countries (LICs), the estimated divergence in growth paths reaches almost 2½ percentage points, on average." However, all fiscal reforms are not equal in their impact on a growth dividend. Policies targeted at cutting labour taxes, boosting labour participation of women, youth, older workers, and worker retraining are likely to be the most effective. In addition, investment in infrastructure, investment tax credits, and lowering corporate taxes should have a positive impact.
Furthermore, with low or increasingly negative interest rates, governments can borrow for 10 years and beyond at practically no interest cost for productive spending This issue is expected to become more visible, and during the G-7 meeting in May, while countries did not agree on a plan to revive global growth, most of the G-7 governments favoured action to stimulate end demand.
The fact that this is one of the major agenda items is illustrative of the growing awareness that central bank actions must be complemented with fiscal policy and less emphasis on austerity. Changes in labour reform take time, and notably in Japan, Prime Minister Shinzo Abe has put in measures to improve female labour participation rates which recently hit 15-year highs and this is critical given its ageing population. In emerging economies such as Indonesia, India, and China, infrastructure spending is being increased to boost longer term growth which also aids their equity investment cases.
BNP Paribas Wealth Management sees moderate global growth in 2016. So what should an investor expect in this environment if they are focused on income? There is no magic bullet to finding yield in this environment. We have been overweight investment grade credit in the US/Europe and Asia as well as European high yield bonds. Furthermore, as the spread between stock market dividend yields and bond yields are at attractive historical levels, blue chip companies with a track record of strong cash flow generation might present a profit source. Finally, taking advantage of bursts of volatility and converting them to a yield via the derivatives markets could also be a way to lock in higher income.