Cormac Lucey explains why, after decades of deflation, we could be on the cusp of a financial regime change.
Falling interest rates have been the constant backdrop to my adult financial life. In late 1981, US 10-year government bonds yielded an annual return in excess of 15%. Since March this year, they have been yielding less than 1%. UK and Irish bond yields have followed suit, with gilts now yielding less than a third of 1% and Irish Government bonds offering a negative yield meaning you must pay for the privilege of lending to Micheál Martin, Leo Varadkar, Eamon Ryan et al.
This development was not some mere technical development on arid financial markets. They have propelled property prices upwards – as a given rental stream is worth an even-greater capital sum if its cost of capital keeps falling. The same logic has pushed equity values higher and higher. The US stock market’s cyclically adjusted price-earnings ratio now exceeds 30. That level was only previously seen in the years around the tech bubble peak of 2000.
I fear that we are now on the cusp of financial regime change. A recent study by Man Group, a London-based investment management firm, contends that prevailing economic regimes “reach their apotheosis, and then change, when the extreme conditions they have created lead to permanent policy change”. It then predicts that current extremes in deflation, inequality, debt levels and globalisation may lead to four major transitions in the next decade.
There will be a switch in policy emphasis from monetary to fiscal. With central bank interest rates already at or about zero, there is little scope for further reductions as negative interest rates would only further weaken the commercial banking system without yielding generation of significant economic stimulus.
The owners of capital have pocketed huge gains over the last four decades while the share of national income going to labour has steadily decreased. As inequality here in Ireland may have diminished over that time, it has increased in other states, especially in the US. That has helped breed seething political discontent. One way to abate that agitation is for politicians to favour labour over capital, the second big transition that Man Group predicts.
The third shift that the report expects is one from globalisation to localisation. It has passed by almost unnoticed, but global trade as a percentage of global output peaked back in 2007/2008. Superimpose that on a trade war between the US and China, trade blocs seeking self-sufficiency in personal protective equipment and a scramble to pre-purchase possible COVID-19 vaccines and you can see why this prediction is already unfolding before us.
The final prediction is a consequence of the others: it is a move from deflation (or, strictly speaking, disinflation) to inflation. According to the Institute of International Monetary Research, broad money has grown by 26.7% in the US over the last 12 months, a record in the US’s modern peacetime history. That is an international outlier, but strong money growth has also been evident in India (12.1% growth over the last 12 months), China (11.4%), the UK (11.3%) and the euro area (+8.9%). Nominal national output closely tracks broad money. Real national output has been hit by the pandemic and the consequent recession. Fast-growing nominal income combined with slow-growing real income suggests a noticeable (above 4%) rebound in inflation in 2021 and 2022.
If Man Group’s four predictions come true – and I think that there’s a very good chance that they will – it will represent a complete regime change for financial markets compared to what has prevailed over the last four decades. Get ready.
Cormac Lucey FCA is an economic commentator and lecturer at Chartered Accountants Ireland.
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