Debate has recently been raging between economists over the theory of ‘secular stagnation’ and what impact it could have on markets.
The term was coined by Alvin Hansen in the wake of the Great Depression. He warned slowing industrial innovation and population growth would lead to a chronic excess of savings over investment, preventing a return to pre-crash rates of growth.
Though these predictions were scuppered by the demographic and technological explosion in the second half of the 20th century, many economists, led by Larry Summers in the US, have claimed the theory is applicable to today’s developed-market economies.
Recent research conducted by the International Monetary Fund (IMF), for instance, forecasts declining potential growth in both developed and emerging markets over the next five years.
If that were true, the low-growth, low-inflation, low-bond-yield environment that investors have recently faced would be a structural feature of the modern economy, and not just a cyclical one.
For advisers, there are some key questions over secular stagnation. Do we really face it and, if we do, will bond markets eventually normalise regardless, or stick at their current low-yield position?
David Stubbs, global market strategist at JPMorgan Asset Management, believes there is some evidence to support secular stagnation.
“If you look at the future growth of the labour force, at where German productivity is going, at debt levels – all of them suggest it would be difficult to get growth to be sustainably at the levels enjoyed in the 1980s, 1990s or 2000s.”
However, there are some signs developed economies might be set to pick up.
Frances Hudson, global thematic strategist at Standard Life Investments, suggests a lack of confidence may be more to blame for investment lagging behind savings.
“The Bank for International Settlements did some work in the last quarter, looking at why investment has been weak. And they identified some other things such as economic uncertainty.
“The reason it might be turning around in places like the UK is the expectation that growth is on a sustainable upward path, in which case the stagnation would appear to have been at least part cyclical.”
Some economists have worried the so-called ‘hysteresis’ effects, whereby the labour force becomes deskilled and demotivated after a long period of under-employment, could put a brake on any upswing.
However, prospects vary widely between different European economies. Mr Stubbs is optimistic about the prospects for the UK labour force when compared with the situation in other developed markets.
“Russia, Japan and Germany have all got big declines in their populations coming in the next couple of decades. Even if they raise productivity, the nominal growth rate will still be fairly low.
“The UK’s demographic outlook is better than that of many countries, and participation is stable. So labour force growth should be okay, and if you add some productivity on top you should get a decent number.”
There is also some hope that capital productivity might improve off the back of technological progress.
Joshua McCallum and Gianluca Moretti, both fixed income economists at UBS Global Asset Management, have suggested this process is already taking place.
“Potential output in developed markets has actually been accelerating since the end of the financial crisis,” they argue in a recent report. “Capital spending has started to recover only slowly, but total factor productivity is now adding gains similar to those of the mid 2000s.
“At this rate, potential growth will be returning to pre-crisis speed over the next four years.”
Though this is starkly at odds with the predictions of the IMF, Messrs McCallum and Moretti claim the research has neglected the likelihood of further innovation.
“If the IMF staff were good at predicting technological change,” the UBS economists declare, “they would be working as venture capitalists in Silicon Valley.”
Not all strategists think tech innovation is unequivocally good news. Ms Hudson worries about improvements in productivity “hollowing out the labour force”.
“The other thing which feeds into growth is demand,” she says. “If the labour force isn’t being paid or workers’ jobs evaporate because they can be replaced largely by computers, this could be disruptive.”
The implications of these issues for fixed income investors are somewhat murky.
Mr McCallum says “financial market participants use secular stagnation as an excuse to justify the current environment of near-zero bond yields”.
However, the chain of events running from a cyclical upswing to a bond market reaction is a knotty one. The European Central Bank and the Bank of England will raise rates only after the Fed has acted, and will also need to see a rise in inflation.
“Even when [rates] do start moving,” says Ms Hudson, “they’re not likely to move very far or very fast, because the biggest beneficiary of having near-zero interest rates is the UK government.”
Once bank rates pick up, fixed income assets could start to look comparatively unattractive and their yields ought to rise. Mr Stubbs says, however, that bond markets are not always reliably this responsive.
“There’s no guarantee bond rates will rise along with short-term rates, and therefore you don’t know what kind of tightening of financial conditions you can expect.”
