JOACHIM FELS shared these views at the Morningstar Investment Conference, India.
Fels is managing director and global economic advisor at PIMCO. Prior to joining PIMCO, he was global chief economist at Morgan Stanley, international economist at Goldman Sachs and a research associate at the Kiel Institute for the World Economy.
After the last pandemic in 1918, the world enjoyed the Roaring 20s. What do you think will happen in this decade? The Age of Uncertainty?
The Age of Uncertainty and the Age of Transformation.
Green transformation - the move from brown to green to renewable energy. Digital transformation, which has been turbocharged by the pandemic. Social transformation, where policymakers put a much greater focus on inclusion and diversity, and address the widening gap between the haves and the have-nots.
These transformations may lead us to a much better future, though the path to that destination will be very bumpy with a lot of pitfalls for policymakers. This is why I believe the uncertainty about macroeconomic outcomes, growth and inflation, and also financial market outcomes, has really increased.
I cannot remember a time in the 35 years of my professional life as an economist that uncertainty has been as high as it is now.
Is the New Neutral still relevant?
The New Neutral was the concept that we came up with in 2014. It describes a world where the so-called neutral rate of interest is much lower than it has been in history. The neutral rate of interest is the level of interest rates that keeps the economy on an even keel, that keeps the economy growing on trend, and that keeps inflation roughly on the central bank's target.
We believed that the neutral interest rate is much lower because of the range of secular forces of fundamental factors that have been depressing the neutral interest rate.
- We live ever longer, life expectancy has been rising in most countries, which means that we can expect to spend more time in retirement because the increase in retirement age is not keeping up with the increase in life expectancy. So, we all need to save more for that longer retirement period.
- We increasingly live in a capital-light economy. Most investments these days are not as much into heavy physical investment; but investments in software, in knowledge.
On the one hand, you have the need to save more, which means a high supply of saving, a high supply of capital. On the other hand, there is very little demand for it. So, these are the first two factors – demography, technology.
- Rising inequality. More income and wealth going to people that have a high propensity to save, the upper 10% or the upper 1%, means this increases the surplus of saving in the world.
- Rising debt levels. We have been seeing this for decades. High debt actually means that the economy becomes more sensitive to interest rate instruments, and that also seems to depress the neutral rate of interest.
Taking it all together, we live in a new neutral world of very low interest rates, very low real interest rates. The pandemic has led to an even newer neutral of even lower interest rates.
Are you saying that the New Neutral implies that interest rates are going to be permanently lower and the cyclicality of interest rates in the 80s is now effectively banished?
I think so, at least in the base case.
None of us have a crystal ball. We have to think in scenarios. There's a wide range of uncertainty about future macroeconomic outcomes. The baseline is that inflation stays relatively well behaved, probably higher on average than it was in the decade before the pandemic, when in most countries, most high-income countries inflation was actually below central bank's targets. So, inflation probably a little bit higher. But I think the uncertainty around that outcome is very uncertain.
So, I would argue that there are both higher upside risks to future inflation and higher downside risks. This may sound paradoxical, but I can easily go through the scenarios where inflation surprises on the upside and through credible scenarios where we might actually end up in disinflation and deflation again.
You've mentioned in one of your recent articles that you feel that inflation will spike but not spiral. Do you think investors have been too complacent about inflation and hence, interest rates also?
Sounds paradoxical, but I think that investors are too complacent about inflation and deflation.
The probability of higher inflation over the 5 to 10-year horizon has clearly increased.
- This transition from brown to green puts upward pressure on energy prices. This is what we see day in day out around the world these days.
- Active fiscal policy. I think many governments saw that they can actually do a lot. They learned this during the pandemic. And that may make them more activist in the future as well, and that could be inflationary.
- A certain amount of deglobalization, which also tends to be inflationary because it puts upward pressure on input costs.
- If you think about central banks, we're asking them to do ever more things that may be mission creep at central banks, and they may take their eyes off the inflation factor.
This is why the upside risks to inflation have increased. At the same time, there are also greater downside risks to future inflation outcomes. I'll just give you two reasons for that.
First, stronger productivity growth, an accelerating pace of innovation, which also has been turbocharged by the pandemic tends to be disinflationary. That's what I would call good deflation. Because things become cheaper, companies find ways to do more with less, right? Many companies have learned that over the past one to two years. So, that's the good deflation that we may get.
Secondly, there's the bad type of deflation, which comes from high debt levels. We have record high debt in many countries, both public and private. If something bad happens, if you get a negative growth shock or if you get a positive interest rate shock, that high debt will weigh on spending. You will move into a balance sheet recession and that could then lead to a disinflationary or even deflationary outcome.
So, that's what I mean when I say both – investors may be both too complacent about upside risks and too complacent about the downside risks to inflation. And the problem for us investors is how do you hedge against those opposite risks.
Ben Bernanke has said that we should never go deflationary because we can just use a helicopter and throw money down to people. So, that will force inflation to start again. Have current events vindicated his line of thinking?
I think he has been vindicated. I mean, the helicopters have been out in force in this pandemic. You could even argue that we've had large aircraft transporters dropping even larger amounts of money more than helicopters can drop. So, in that sense, he's been vindicated.
Quantitative Easing is now viewed as a standard tool of monetary policy, and he helped pioneer this.
This was important during the pandemic because the massive bond purchases by central banks enabled governments to do what was necessary to help households and the corporate sector. Without this support from central banks, we could not have seen these massive fiscal support problems that really helped to bridge the gap and that made this deepest, and the shortest, recession in history.
Will central banks now flood liquidity into the markets?
This is what we are seeing. The Fed is still buying bonds. There's this discussion about tapering the bond purchases at the Fed, which is likely to start this November or December.
The ECB in Europe, the European Central Bank, is still buying massive amounts of bonds to the tune of roughly 90 billion per month. I think this is likely to continue for quite some time.
As economies recover, the Fed and other central banks will reduce the pace of purchases and eventually end it. But I think we will continue to live in a world where central bank balance sheets are elevated.
We learned in the last cycle that it's really difficult for central banks to reduce the size of the balance sheet. The Fed managed to do some of this between 2015 or 2016 and 2018. But they have to stop because bad things started to happen in financial markets. So, I think we're all junkies of liquidity in the financial markets, and whether we like it or not, it's really hard to step back from that.
One person who was bearish on financial markets told me, “you're trying to solve a debt problem in the world with introducing more debt. So, the amount of debt China has, the U.S., Japan - compared to their GDPs – does something give? Does a spike in inflation cause a worldwide economic chaos? Or do you think that this is a strategy that governments can effectively use for the next 10 years?
Debt levels are at or close to record highs in many countries. But it is also true that debt servicing costs are at or near record lows. This is because we're in this new neutral world of very low interest rates, even negative real interest rates. The interest rate that governments pay on the debt are far below the growth rate of their tax revenues, because the economy is growing at a faster pace than the level of the real interest rate. So, for now, I don't think there is a problem.
Having said that, we should not become complacent, because with higher debt levels, you're increasing the vulnerability to shocks. So, if we were to get a major negative growth shock, or if for some reason, interest rates spike, maybe because inflation shows up, or the credit worthiness of governments declines, then I think we have a problem.
Investors must protect against those kinds of disruptions, and I think it argues for a much more cautious investment stance.
What do you mean by a cautious investment stance?
Uncertainty is high. Many scenarios are possible. So be diversified in terms of asset classes and regions.
In the fixed income universe, we have to use the full global opportunities set. In a world where divergence is likely to increase, you may get more opportunities in those global fixed income markets, because you'll probably get bigger swings in exchange rates and more interest rate differentials. So, if you're an active manager in global fixed income, that helps.
I think equities should still do reasonably well in a world where the real interest rate is as low as it is. Investors will seek for yields. Valuations look pretty extended, at least if you look at traditional multiples. I think you can rationalize that with low real interest rates, which is why we think equities will still do reasonably well. And yes, people should obviously also have a decent allocation to equities.
But I think increasingly, it becomes important for investors to also hedge against inflation outcomes. So, that argues for some real assets, like TIPS, commodities, real estate, where we still see attractive opportunities.
For investors who can do this, and this is mostly institutional investors, who can give up some liquidity because they have a longer investment horizon, we think it does make sense to also venture into maybe some of the less crowded areas of the capital market, which we find in private credit.
The most important thing is to have a really broad diversification regionally and across asset classes, because the future is uncertain. It's really hard to say who the winners and the losers will be.
If you could invite three economists, living or dead, for dinner at your place, who would they be?
- John Maynard Keynes
- Friedrich August von Hayek
- Ben Bernanke
