Macro economic commentary – November 2018

Author: Tony Bell

Gibson’s paradox is the observation that the rate of interest and the general level of prices are positively correlated. The term was first used by John Maynard Keynes in his 1930 work, A Treatise on Money. A paradox arises because most economic theorists prior to that time predicted that the correlation would be negative. Keynes commented that the observed correlation was “one of the most completely established empirical facts in the whole field of quantitative economics.” In broad terms, slower money-growth creates slower price-rises. Slower money-growth also means slower growth of loanable funds. On the basis that both these premises are true, slower money-growth should mean lower prices and higher interest rates. However, Gibson observed that lower prices were accompanied by a drop—rather than a rise—in interest rates. Economists generally thought that interest rates were correlated to the rate of inflation, whereas Keynes’ findings contradicted this view.

Why is any of this relevant in the current market environment? For the greater part of the period from 1970 to 2000, bond prices and equity markets were positively correlated. Over this period, total returns in US 10-year Treasury bonds mostly moved in the same direction as the S&P 500 index. This changed in 2002 as the US moved into its first deflationary phase in many years. As inflation fell and the world economy began to deal with repeated bouts of deflation the changes in bond yield in most developed economies were primarily a function of shifts in the real yields rather than inflation expectations. With equity prices primarily influenced by underlying economic growth (earnings) and the low level of absolute interest rates, equities and bonds became negatively correlated post 2002. This picture changed again in 2008 as quantitative easing, deflationary pressures and an adjustment to “term-premiums” in many developed bond markets translated into a lower level of correlation than previously.

While there are a number of technical factors that have contributed to this lower correlation, the excess in the global savings pool together with the excess liquidity pumped into the financial system by central banks have combined to reduce the equilibrium real interest rate to near zero. As happened in Japan post the peak in the equity market in 1989, nominal bond yields have stayed low for most of the past 30 years. Another way of looking at the past decade is simply as a “tug of war” between deflation and efforts by different governments to reflate through fiscal spending. This explains why bond yields have remained low whereas equity markets have taken off.

Now that the Fed has started to “normalise” through raising short term interest rates, and with that the whole yield curve, it is important to ask whether the equity-bond correlation will revert to “normal” or Gibsons paradox will continue to rule. In order to return to a normal positive correlation monetary and fiscal stiumuli would need to contribute to higher levels of inflation in the US economy. As was the case for most of the 60’s and 70’s with some follow-through in the 80’s and 90’s, economists held the view that each bout of stimulus would inevitably lead to higher inflation as low levels of unemployment forced wages higher and increased levels of capacity utilisation.

With current expectations for future inflation low and falling, it seems unlikely that this relationship will return to “normal” anytime soon. In line with lower economic growth forecasts for 2019, commodity prices are weak, the oil price in particular is falling and there is no sign of sustained or rising inflation anywhere in the developed world. We observe that the recent rise in bond yields in the US has largely been driven by the rise in real yields as term premiums have adjusted upwards. Without drawing out the inherent paradox too much a rising real yield is indicative of a healthy, growing economy that is enjoying productivity gains through both technology and a more efficient labour force. Under this scenario corporate earnings growth remains positive albeit at a lower rate of growth than has been delivered during 2018. Recent declines in the US equity market are consistent with the process of Fed normalisation, lower levels of economic growth and some adjustment to term premiums.

If we assume that the longer term steady nominal rate of growth for the US economy is around 3.5% to 4% with the long term GDP deflator averaging 1,5%, the current level of US 10-year treasuries at just under 3% does not seem out of line and may even go a little lower as the US GDP deflator declines into 2019 from current levels of 2.3% driven by lower energy prices, a strong dollar and declining retail prices.

The second major driver of perceptions at the moment is so-called quantitative tightening (“QT”). While it may seem to be intuitively correct to argue that the rise in US equity prices has been directly correlated to quantitative easing (“QE”), corporate profits and the level of interest rates impact equity prices far more. When the Fed or ECB or BoJ provide liquidity through QE the transmission mechanism directly impacts bank reserves as opposed to corporate profits. The key to understanding this link is the credit multiplier. For these reserves to have an impact on the economy or financial markets they must find their way into these markets through credit or money supply. We observe no such correlation between M2 growth in the US or credit growth and the Fed’s balance sheet. The Japanese equity market decline from 44000 in 1998 to 21600 should serve as a perfect illustration.

Given this scenario what then are the prospects for global equity and bond markets as we move into 2019? Our assessment is that growth holds the key to both. Equity markets have, since September 2018, seen a strong rotation of “growth” stocks to lesser favoured “value” stocks. Equity market volatility, as measured by the VIX index, has increased in recent months as has volatility within currency markets. The slowdown in global growth has been exacerbated by global geo-political tensions. Trump has lost control of the lower house which means that he is unlikely to be able to push Trump v2.0 tax cuts through. This leaves him with his ill-conceived trade war with China as his main policy initiative in the arena of global detente. At this stage of the economic expansion tariffs are simply a dumb idea as they create unnecessary imbalances in a world that is already trying to deal with economic normalisation and structural headwinds to growth.