As crisis-induced fear fades, companies take on more leverage ... Companies are increasing their borrowing for three main reasons. The most obvious is that interest rates are low, meaning a key cost, borrowed money, can be obtained cheaply. That can result in higher returns to shareholders. Moreover, rates are likely to rise, which is encouraging companies to lock in low rates while they can. ... A second driver is the resurgence of activist investors which, emboldened by a benign economic environment, are pushing firms to return to shareholders cash that had been retained for a rainy day. There are weekly announcements of one hedge fund or another pushing a company to buy back shares, as much for short-term reasons—a large buyer in the market might temporarily push up the price of a stock—as for longer-term ones. ... And then, inevitably, there is tax. Many large companies are quietly following the well-publicised example of Apple by issuing debt to fund dividends or buy-backs rather than repatriating cash held overseas that would trigger large tax payments. Aside from the quirk of holding cash abroad, debt itself offers tax benefits: interest payments are tax-deductible and push down taxable earnings.

Martin Feldstein interviewed Paul Volcker in Cambridge, Massachusetts, on July 10, 2013, as part of a conference at the National Bureau of Economic Research on “The First 100 Years of the Federal Reserve: The Policy Record, Lessons Learned, and Prospects for the Future.” Volcker was Chairman of the Board of Governors of the Federal Reserve System from 1979 through 1987. Before that, he served stints as President of the Federal Reserve Bank of New York from 1975 to 1979, as Deputy Undersecretary for International Affairs in the US Department of the Treasury from 1969 to 1974, as Deputy Undersecretary for Monetary Affairs in the Treasury from 1963 – 65, and as an economist at the Federal Reserve Bank of New York from 1952 to 1957. During the interludes from public service, he held various positions at Chase Manhattan Bank. He has led and served on a wide array of commissions, including chairing the President’s Economic Recovery Advisory Board from its inception in 2009 through 2011.

There are striking parallels between the dramatic recent sell-off in U.S. Treasuries and the Great Bond Crash of 1994. But the summer of volatility now facing financial markets is no doomsday scenario. Instead, it puts the U.S. Federal Reserve in a bind. Higher interest rates will reduce housing affordability, which is especially troublesome since housing is the primary locomotive of U.S. economic growth. That means the Fed, despite Ben Bernanke’s recently announced timetable, may be forced to expand or extend quantitative easing if the housing market’s response to recent events becomes more acute and starts to negatively affect the job market recovery.

Financial repression refers to a set of governmental policies that keep real interest rates low or negative and regulate or manipulate a captive audience into investing in government debt. This results in cheap funding and will be a prime tool used by governments in highly indebted developed market economies to improve their balance sheets over the coming decades. … We should all be familiar with the effects of financial repression by now. If not, compare the declining amount of interest income coming out of your savings account to the rising costs you pay for groceries, gasoline, or (shield your eyes) college tuition. It has been nearly five years since we heard a loud “THUD” as the nominal yield of the short term U.S. Treasury note hit zero percent. The resulting negative real interest rates have become a pervasive feature of our economic landscape, and we expect them to persist for a very long time.

- The Fed is sending a message that the unwinding of its extraordinary accommodation will be done with great care and patience, and will take time – a long time.
- In delaying a taper, not only did the Fed show markets it has little tolerance for any tightening of financial conditions, it also strengthened its forward guidance considerably.
- The Fed’s decision to delay a taper will likely relieve some of the upward pressure on longer-term interest rates.

From the cyclical monthly high in interest rates in the 1990-91 recession through June of this year, the 30-year Treasury bond yield has dropped from 9% to 3%. This massive decline in long rates was hardly smooth with nine significant backups. In these nine cases yields rose an average of 127 basis points, with the range from about 200 basis points to 60 basis points (Chart 1). The recent move from the monthly low in February has been modest by comparison. Importantly, this powerful 6 percentage point downward move in long-term Treasury rates was nearly identical to the decline in the rate of inflation as measured by the monthly year-over-year change in the Consumer Price Index which moved from just over 6% in 1990 to 0% today. Therefore, it was the backdrop of shifting inflationary circumstances that once again determined the trend in long-term Treasury bond yields. ... In almost all cases, including the most recent rise, the intermittent change in psychology that drove interest rates higher in the short run, occurred despite weakening inflation. There was, however, always a strong sentiment that the rise marked the end of the bull market, and a major trend reversal was taking place. This is also the case today. ... Presently, four misperceptions have pushed Treasury bond yields to levels that represent significant value for long-term investors. These are:
1. The recent downturn in economic activity will give way to improving conditions and even higher bond yields.
2. Intensifying cost pressures will lead to higher inflation/yields.
3. The inevitable normalization of the Federal Funds rate will work its way up along the yield curve causing long rates to rise.
4. The bond market is in a bubble, and like all manias, it will eventually burst.

In this essay I want to build on some of the ideas that were developed in my last essay specifically as they pertain to thinking about asset markets. The most obvious place to start is with the idea that the natural rate of interest is a myth. Accepting this idea has many ramifications for the way in which one conducts asset pricing. ... Perhaps the clearest implication from my previous essay with respect to investing is that the cash rate is potentially unanchored. That is to say, without a natural rate it isn’t obvious what cash rate one should expect to see in the long term. ... If, like any number of my colleagues, you don’t believe a word I’ve written (and quite possibly think that I either have escaped from or belong in an asylum), then let me leave you with one last chart. Even if you believe that real interest rates do matter for equity market valuations, and, hence, that lower real rates justify higher sustainable levels of P/E, you still need to ask yourself the following question: Would I need to believe that today’s U.S. equity market valuations represent fair value?

With this general framework in mind, here’s how I’ve been thinking about the global macro outlook for a while: It is driven by the interaction among what I call the “three gluts”: the savings glut, the oil glut and the money glut. While the global savings glut is likely the main secular force behind the global environment of low growth, lowflation and low interest rates, both the oil and the money glut should help lift demand growth, inflation and thus interest rates from their current depressed levels over the cyclical horizon. ... Why is it, to simplify further, that everybody wants to save more but nobody wants to invest? ... The oil glut helps to mitigate the depressing impact of the savings glut on consumer demand by shifting income from oil producers, who have a high propensity to save, to consumers, who typically spend most of their income. ... We expect more monetary easing to come, particularly in China and in many commodity-producing countries, so the global money glut, which is already increasing due to heavyweights like the European Central Bank and the Bank of Japan executing their asset purchase programs, will swell further.

So the Fed has chosen to hold off on their goal of normalizing interest rates and the ECB has countered with the threat of extending their scheduled QE with more checks and more negative interest rates and the investment community wonders how long can this keep goin’ on. For a long time I suppose, as evidenced by history at least. ... zero bound interest rates destroy the savings function of capitalism, which is a necessary and in fact synchronous component of investment. Why that is true is not immediately apparent. If companies can borrow close to zero, why wouldn’t they invest the proceeds in the real economy? The evidence of recent years is that they have not. Instead they have plowed trillions into the financial economy as they buy back their own stock with a seemingly safe tax advantaged arbitrage. But more importantly, zero destroys existing business models such as life insurance company balance sheets and pension funds, which in turn are expected to use the proceeds to pay benefits for an aging boomer society. These assumed liabilities were based on the assumption that a balanced portfolio of stocks and bonds would return 7-8% over the long term. Now with corporate bonds at 2-3%, it is obvious that to pay for future health, retirement and insurance related benefits, stocks must appreciate by 10% a year to meet the targeted assumption. That, of course, is a stretch of some accountant’s or actuary’s imagination.

Fixations are a symptom of Asperger’s, along with social problems, elevated stress, and a propensity for numbers over words. The kids in Winchester bullied him for it. Hayes remained a peripheral figure in college, at the University of Nottingham. While his fellow students took their summer holidays, he paid for school by cleaning pots and lugging kitchen supplies for £2.70 an hour. ... Seeking better money, Hayes won an internship at UBS in London. After graduating, in 2001, he joined Royal Bank of Scotland as a trainee on the interest rate derivatives desk. For 20 minutes a day, as a reward for making the tea and collecting dry cleaning, he was allowed to ask the traders anything he wanted. It was an epiphany. ... On the rare occasions he joined other bankers on their nights out, he stuck to hot chocolate. They called him “Tommy Chocolate” and blurted out Rain Man quotes like “Qantas never crashed” as Hayes walked the trading floor. He was bad at banter, given to taking quips and digs at face value. The superhero duvet was a particular point of derision. The bedding was perfectly adequate, Hayes thought; he didn’t see the point in buying another one. ... Not everyone in finance was a jerk. Hayes made a few friends, and he found that his machine-gun approach to messaging and trading made him a favorite among brokers, who didn’t care where a trader had gone to school as long as he brought them deals. ... His M.O. was to trade constantly, picking up snippets of information, racking up commissions as a market maker, and building a persona as a high-volume, high-stakes risk-taker. ... Libor was a component in securities ranging from U.S. student loans and credit cards to Kazakh gas futures, but it was determined each day by just a handful of distracted, guesstimating individuals.

How will negative interest rates change the rules of the game for investors and policymakers? ... Traditional economic theory says that a com - bination of massive deficit spending and histori - cally low (not to mention negative) interest rates should produce a rip-roaring boom in which work - ers get generous raises, prices spike, and interest rates follow. Theory also says that, even in the rare case of nominal interest rates turning neg - ative, the rates can’t stay there because beyond this “zero bound,” savers and investors will with - draw their cash and store it themselves, emp - tying banks and crashing the financial system. ... Multiple factors provide possible explanations for this curious situation. Three in particular stand out: demographic changes, the impact of debt burdens, and uncertain implications of monetary policy (especially quantitative easing). ... In a June 2015 report, the Bank for Interna - tional Settlements echoed this sentiment by con - cluding that a policy of persistently low interest rates “runs the risk of entrenching instability and chronic weakness.” Such an environment makes several extreme—and, sometimes, mutu - ally exclusive—scenarios at least conceivable.

My point is different. Low interest rates for an extended period of time don’t damage economic growth directly, but they cause damage in a multiple of other ways – a point almost universally missed by the critics. That is what this month’s Absolute Return Letter is all about. ... central bank action has had the effect of de-linking equities from the global growth cycle, as equity investors have chosen to blatantly ignore the fall in global trade in favour of more risk-taking at the back of accommodating central banks. Risk-on, risk-off has miraculously turned into risk-on, risk-on. “Don’t fight the Fed”, as they say, and equity investors have obviously chosen not to. ... First and foremost, returns are going to remain subdued because GDP growth will stay low for a long time to come. Demographic factors, productivity factors and mountains of debt in the majority of countries all point in the same direction, and that is towards below average economic growth. ... The most structural of those factors – demographics – will remain a negative for the U.S. economy for another 10-15 years, whilst economic growth in the euro zone and Japan will be negatively affected by demographics until at least 2050. This does not imply that there cannot be extraordinarily good years every now and then, but the average growth rate will almost certainly be low, causing interest rates to stay relatively low for a lot longer than most expect and corporate earnings to disappoint as well.

Fed Chair Janet Yellen is widely viewed as a dovish central banker, but she is about to lead her institution into a prolonged campaign of raising the policy interest rate. Starting now is a tactical decision on Yellen’s part to achieve her longer-run strategic aim. Hiking the funds rate, even as economic growth disappoints and inflation remains subdued, buys Yellen the credibility with her colleagues and market participants to subsequently tighten slowly. Thus, US monetary policy will remain accommodative for a considerable period. ... That Yellen may go down in central banking history as “The Great Tightener” appears to pose more than a little irony, perhaps to the coming surprise and irritation of Senate Democrats who signed a letter to the president endorsing her Fed-chair candidacy in 2013. Yet, the shift in policy does not reflect a transformation of her beliefs, but rather their pursuit by different means. Tightening now follows logically from Yellen’s understanding of the economic outlook and the dynamics of the Fed’s policymaking group, the Federal Open Market Committee (FOMC). Hiking the funds rate, even as economic growth disappoints and inflation remains subdued, buys Yellen the credibility with her colleagues and market participants to subsequently tighten slowly. That is, Yellen positions herself now as a conservative central banker to ensure that she can be a compassionate one later by allowing Fed policy to remain considerably accommodative for a considerable time. ... An important ongoing conversation is in our future: who is right about rates in the long run, the Fed or investors?

Famous German soccer coach Sepp Herberger once said, “After the match is before the match.” The same can be said for financial markets: After the crisis is before the crisis. The complication, of course, is that while soccer players usually know exactly when the next match will kick off, the timing of the next crisis is always uncertain for financial players. All we know is that, eventually, there will be another one. ... What’s perhaps less obvious is that the global savings glut also helps to explain the occurrence of financial bubbles and subsequent crises of the past few decades. ... the global savings glut plays an important role in explaining this evidence. How? Excess savings not only pushed down r* and actual interest rates but also drove up asset prices and caused serial asset bubbles in equities, emerging markets, housing, credit, eurozone peripheral bonds and commodities. Whenever a bubble burst, it sparked financial distress and crisis. ... there is a feedback loop between financial crises and the savings glut. This is because a financial crisis and the related destruction of wealth leads to even higher desired saving (or deleveraging), and because the depressing impact on growth reduces investment and thus the demand for savings. ... now that exhaustion has set in almost everywhere for many unconventional policy tools, such as quantitative easing, there is a significant risk that central banks may not be able to deal effectively with the next crisis. ... It’s likely the only viable way out would be a joint effort by the major countries to raise public spending on infrastructure, education, and more in order to absorb excess savings and raise r*.

The developed world’s workforce will start to decline next year, threatening future global growth ... Ever since the global financial crisis, economists have groped for reasons to explain why growth in the U.S. and abroad has repeatedly disappointed, citing everything from fiscal austerity to the euro meltdown. They are now coming to realize that one of the stiffest headwinds is also one of the hardest to overcome: demographics. ... For the first time since 1950, their combined working-age population will decline, according to United Nations projections, and by 2050 it will shrink 5%. The ranks of workers will also fall in key emerging markets, such as China and Russia. At the same time the share of these countries’ population over 65 will skyrocket. ... reflects two long-established trends: lengthening lifespans and declining fertility. Yet many of the economic consequences are only now apparent. Simply put, companies are running out of workers, customers or both. In either case, economic growth suffers. As a population ages, what people buy also changes, shifting more demand toward services such as health care and away from durable goods such as cars. ... Demographic forces are assumed to be slow-moving and predictable. By historical standards, though, these aren’t ... it took 80 years for the U.S. median age to rise seven years, to 30, by 1980, and just 34 more to climb another eight, to 38. ... There is no simple answer for how business and government should cope with these changes, since each country is aging at different rates, for different reasons and with different degrees of preparedness.

This memo is my attempt to send the markets to the psychiatrist’s couch, and an exploration of what might be learned there. ... One of the most notable behavioral traits among investors is their tendency to overlook negatives or understate their significance for a while, and then eventually to capitulate and overreact to them on the downside. ... “Everyone knew” for years that the Chinese economy had been overstimulated with cheap financing, and that this had led to excessive investment in fixed assets. … One of the most significant factors keeping investors from reaching appropriate conclusions is their tendency to assess the world with emotionalism rather than objectivity. Their failings take two primary forms: selective perception and skewed interpretation. ... The bottom line is that investor psychology rarely gives equal weight to both favorable and unfavorable developments. Likewise, investors’ interpretation of events is usually biased by their emotional reaction to whatever is going on at the moment. ... in the real world, things generally fluctuate between “pretty good” and “not so hot.” But in the world of investing, perception often swings from “flawless” to “hopeless.” ... There is a general sense among my colleagues that investors have gone from evaluating securities based on the attractiveness of their yield (with company fundamentals viewed optimistically) to judging them on the basis of the likely recovery in a restructuring (with fundamentals viewed pessimistically).

At current spreads, high yield seems to be no worse than fair value and probably better than that, even if we assume (as we do) that we are entering a fourth default cycle. In today’s environment, that makes it one of the best available risk assets for investors. But the nature of the high yield market suggests it is a good candidate for overshooting fair value to the downside whenever defaults begin to rise in earnest. Our response for BFAS at current levels is to continue to search for credit securities offering a superior combination of expected returns and downside protection while augmenting this at the margin with more index-like credit exposure. ... It would be lovely to claim we will be able to time the bottom for credit precisely. We will not, and unlike with equities, even if we did know the timing perfectly, getting material exposure to the asset class quickly would be extremely difficult. This leaves us with the hunch we are probably getting in a little early, the fear that we might not get all the exposure we would like before spreads move to less attractive levels, and the sure knowledge we won’t get the bragging rights of having called the turn. In other words, it seems to be an utterly classic value investing opportunity.

Given the importance of spillovers from monetary policies, especially in the face of globally low inflation, it is important we start building a global consensus on how to get better outcomes for the world. Nevertheless, with economic analysis of these issues at an early stage, it is unlikely we will get strong policy prescriptions soon, let alone international agreement on them, especially given that a number of country authorities like central banks have explicit domestic mandates. ... This paper therefore suggests a period of focused discussion, first outside international meetings, then within international meetings. Such a discussion need not take place in an environment of finger pointing and defensiveness, but as an attempt to understand what can be reasonable, and not overly intrusive, rules of conduct. ... As consensus builds on the rules of conduct, we can contemplate the next step of whether to codify them through international agreement, see how the Articles of multilateral watchdogs like the IMF will have to be altered, and how country authorities will interpret or alter domestic mandates to incorporate international responsibilities. ... The international community has a choice. We can pretend all is well with the global financial non-system and hope that nothing goes spectacularly wrong. Or we can start building a system for the integrated world of the twenty first century.

As we have observed in the past, financial markets appear to solely focus on one major risk/return catalyst at any given time, before, like a bored teenager, turning attention to the “next new thing.” Over the past year and a half, we have seen primary market focus transition from the dramatic decline in oil prices, to economic stresses in China, and most recently to the forthcoming referendum in the United Kingdom and the possibility of “Brexit.” We are not for a moment suggesting that these factors are unimportant, as indeed they are all critical parts to a broader puzzle, but we would suggest that stepping back to apprehend the full image on the puzzle is vital when too many market participants are overly focused on one part of it. In fact, we think that such an overly limited focus in a world of complex market crosscurrents may be part of what leads many to underperform. To that end, we seek to take a broader view with our market outlook. ... In this edition of the outlook we begin by sorting through and evaluating some partial market myths that have recently been promulgated to explain market volatility. These include exaggerated concerns that the volatility is due to bond market illiquidity, or overdone assertions that markets are being driven higher and lower primarily on the back of oil price movements. Rather, we think that secular structural changes involving demographic trends and profound technological innovations are much more important considerations when judging those forces that are truly impacting economic and asset valuation dispersions. Further, we believe these secular challenges should also be the focus of the risk factors that represent the major fault lines in markets today, or the locations of potentially serious left tail risks.

Most significant for future growth, however, is that the additional layer of debt in 2015 is a liability going forward since debt is always a shift from future spending to the present. The negative impact, historically, has occurred more swiftly and more seriously as economies became extremely over-indebted. Thus, while the debt helped to prop up economic growth in 2015, this small plus will be turned into a longer lasting negative that will diminish any benefit from last year’s debt bulge. ... Our economic view for 2016 remains unchanged. The composition of last year’s debt gain indicates that velocity will decline more sharply in 2016 than 2015. The modest Fed tightening is a slight negative for both M2 growth and velocity. Additionally, velocity appears to have dropped even faster in the first quarter of 2016 than in the fourth quarter of 2015. Thus, nominal GDP growth should slow to a 2.3% - 2.8% range for the year. The slower pace in nominal GDP would continue the 2014-15 pattern, when the rate of rise in nominal GDP decelerated from 3.9% to 3.1%. Such slow top line growth suggests that spurts in inflation will simply reduce real GDP growth and thus be transitory in nature.

The New Normal is when plain logic no longer applies; when common sense takes the back seat. I have for a long time been defending the Federal Reserve Bank, and have not at all agreed with all those hawks who thought the Fed was sitting on its hands. Until recently, I felt very comfortable taking that view, but I am no longer so sure. Common sense suggests to me that the Fed ought to tighten a great deal more than they have already done, but does common sense apply? That is what this month’s Absolute Return Letter is about. ... something is not quite right, but what is it? Before I answer that question, let me share one more observation with you. Because the Fed is so inactive, there are signs of moral hazard growing in magnitude. Complacency appears to be sneaking in through the back door yet again. We humans never learn, do we? ... As GDP growth slows, more debt needs to be established in order to service existing debt, which will cause GDP growth to slow even further. I therefore think that, unless it suddenly becomes fashionable to default, debt will continue to rise and GDP growth will continue to slow in the years to come. ... I have changed my view in one important aspect. As debt levels continue to rise (short of any massive debt restructuring), governments will bend over backwards to keep interest rates at very low levels, as the only realistic alternative to low interest rates is default. ... Historically, when central banks have sat on their hands for too long, the end result has almost always been a bout of unpleasantly high inflation, and that has nothing whatsoever to do with the changing demographics.

Over the last six or seven years, most financial assets have done very well. The performance divide has not been between low-risk assets and high-risk assets or between liquid assets and illiquid assets, but between long-duration assets and short-duration assets. Long-duration assets such as stocks, bonds, real estate, and private equity have benefitted from a large fall in the discount rate associated with their cash flows, while short-duration assets have been hurt by the same fall. Investors tend to tilt their portfolios in favor of those assets that have done well, and today that pushes them to be increasing effective duration in their portfolios, just when the potential returns to those assets have dropped. What we believe would be most helpful to investors are short-duration risk assets, as they offer the potential of decent returns over time with less vulnerability to rising discount rates. These assets, generally lumped together under the “alternatives” title, are generally out of favor today given their disappointing performance since the financial crisis, but the characteristics that made them disappoint may well prove a blessing if discount rates start to rise.

Following 17 months of mostly negative equity returns in Europe, very recently, I have noticed an inclination amongst European investors to increase the risk profile in their portfolios. They may not exactly be going for broke (yet), but the willingness to take more risk is clearly on the rise. The rising appetite for risk could be driven by one of two factors. Investors could either be turning more optimistic, or it could be the result of less benign factors, such as a need to generate higher returns, whether they really believe in such an outcome or not. ... In short, I suspect investors are chasing returns that (I think) are unrealistic, and it is not the first time that happens. When investors are under extreme pressure, as I think many are now, they sometimes behave quite irrationally. They do things they would have sworn only a short while earlier they would never do. ... Is there anything else investors could do to raise the overall return level and, in particular, to generate more income without necessarily taking more risk?

Rising macroeconomic and geopolitical tensions are creating both opportunities and risks for global investors across the entire global capital markets. We continue to emphasize our five key macro themes, many of which we think can perform against a variety of economic backdrops. First, we believe that assets with Yield and Growth will continue to outperform. Second, we would avoid exposures linked to China’s structural slowing, though we do finally see some emerging investment opportunities in China’s ‘new’ export strategy. Third, we see the opportunity for a significant and potentially sustained upward revaluation in the securities of large domestically-oriented economies. Fourth, the dismantling of the traditional financial services industry has emerged as both a blessing and a curse for investors; we outline our approach for navigating this complicated segment of the global economy. Finally, given the bifurcation across markets that we are now seeing, we believe folks should consider increasing exposure to complex stories, including earnings misses, restructurings, and/or corporate repositionings; at the same time we would be selling simplicity in instances where future earnings streams appear over-priced.

Americans are bad at saving. In an annual survey by the Fed, almost half said they couldn’t come up with $400 in an emergency. The savings rate of the bottom 90 percent of American households hovers just above 1 percent. ... There are many theories for why Americans don’t save, from poverty to debt to conspicuous consumption. But the most enticing comes from behavioral economics: It’s easier not to. Inertia is strong, and putting money away requires overcoming what economists call present bias. ... The good news, according to behavioral economists, is that we can just as easily be tricked into overcoming that psychology with “nudges” that reframe incentives. Just post calorie counts next to unhealthy food, and people won’t order cheeseburgers. Or, make 401(k) plans opt-out, and more people will save money for retirement. Suddenly, with one oh-so-simple tweak, making bad decisions becomes the harder option. ... At every step of the way, the study ran into a web of competing incentives and pesky human flaws that hurt its goal of getting poor people to save money. ... The problem goes beyond a sheer lack of funds. The psychology of poverty is hard to overcome with a dainty nudge. ... the study’s preliminary results were muddy. They suggested that the nudge method did get some people to save more: Deposits increased when people got some kind of reminder. But they didn’t show whether one type of nudge worked better than any other (possibly because of teller error), and they provided no evidence that the savings accounts helped people build up money over time.