The Bank of International Settlements (BIS) is arguably one of the more attuned regulatory bodies out there. With 60 member central banks from around the world covering 95% off global GDP, the BIS was one of the most accurate forecasters of the global financial crisis – prior to it actually taking place. It may have been luck; or it may have been skill. But we choose to at least consider any perspective the BIS puts out with respect to the global economy.
On June 26 of this year, the BIS published its 86th Annual Report, found here. It is certainly worth the read, for those inclined. For those less inclined, the following describes the one key message that we believe investors should consider carefully.
The Risky Trinity
The BIS has defined a new idea called the “risky trinity”. The risky trinity acknowledges three important (and concerning) dynamics that characterize where the world economy stands today. These are:
- Productivity growth that is unusually low – which the BIS suggests casts a shadow over future improvements in living standards;
- Global debt levels that are historically high – which the BIS suggests raises risks around financial stability; and
- Room for policy manoeuvring that is remarkably narrow – which the BIS suggests leaves the global economy highly exposed.
The fall in productivity growth is an observation many have made. No one, however, has been able to make a clear or convincing articulation of the reason for this decline, in our view. It is certainly odd that, in a world of vastly improved technology, productivity growth has slowed by so much.
Yet productivity is essentially a measure of output per unit of labor input. As the BIS notes, we have observed improving employment but only moderate output growth. But output growth is not simply a function of how much can be produced, it is a function of aggregate demand. And if aggregate demand is weak, then output growth will be weak and reported productivity growth will suffer – plain and simple.
In our view – the primary underlying issue here relates to aggregate demand growth. And the build-up of debt over recent years has essentially brought forward aggregate demand at the expense of future demand. This is, broadly speaking, the concept of a “balance sheet recession” which economist Richard Koo has made relatively famous. Essentially, the process of paying down debt results in a weakening of aggregate demand.
The BIS attributes the continual decline in global interest rates to the risky trinity; and goes on to argue that the global economy cannot afford to rely any longer on the debt-fuelled growth model that has brought it to the current juncture.
We would agree. But it’s not that simple. One of the primary reasons why rates are so low is that monetary policymakers have flooded the world with liquidity to reduce the cost of borrowing (i.e. interest rate levels) to try to encourage borrowing in order to boost aggregate demand (both investment and consumption). And while this might help boost aggregate demand near term, it is resulting in an even higher stock of global debt – which, according to Koo and others, will take an even longer period to repay during which growth will weaken (again).
We have suggested in the past that we may already be past the point of no return. Indebtedness is so high now (both on the balance sheets of households and governments) that interest rates are almost assured to remain low. If rates were to rise, the financial distress amongst so many borrowers would surely force rates back down.
This would suggest we may be in a “lower for longer” interest rate environment for a lot “longer” than most currently expect. And aggregate demand growth may never recover to the levels that prior generations have seen (absent some significant exogenous shock). This has implications for investors – particularly those who are retired and rely on investment returns to underwrite their longevity.