The US Central Bank has a dual mandate to promote maximum employment and stable prices. Originally, this meant the Central Bank would help to smooth the business cycles that tend to occur in an economy. When an output gap emerged, they would lower the interest rate. This would not only lower the debt burden on the economy but would lower the hurdle rate on the next dollar of investment. Instead of firing workers and selling assets, companies got by because they paid less interest on existing debt during the soft patch. Once demand strengthened and the gap closed, firms had a window to borrow and invest before interest rates reverted higher. Additional fiscal measures are sometimes taken by government. They issues tax breaks to put more money out in the economy in the form of extra cash in tax payer pockets. This requires the government to borrow in order to fund their budget in the face of lower tax revenue. Government also takes advantage of low rates and borrows to invest in infrastructure. This investment would not only alleviate some of the current gap, but potentially make the next recovery better than it otherwise would have been.

But, sometime in the recent past, (government) economists decided that it would be easier to meet the dual mandate if you force fed money into the economy.  It appeared that they could magically obtain a faster rate of growth.  What they failed to realize, or fail to care about, is that the increased stock of debt makes it more difficult to smooth the business cycles. The result is the current state of the economy, here we sit, the FED interest rate has been effectively 0 for nearly 7 years. The FED has pulled demand forward and provided incentives that lead to too many poor investment decisions. The result, some say, is a zombie economy, incapable of emerging from the shadows of its own pile of IOUs.

The long term trajectory of such policies will eventually cause us to go backward, the gravity of unchecked debt burden eventually turns into a black hole. So let’s hope we become smarter with policy and get back to a sustainable path. In the short term, we will still get spurts of solid economic performance, and yes the markets will gyrate more violently along the way. In the following graph, you can certainly see the increased public debt load over the last 40 years. This is the result of the force feeding policies described above. If an economy holds twice the amount of debt at half the interest rate, there is certainly no higher burden on the economy in the present  than before. But, the sensitivity of the economy to changes in the interest rate have certainly increased. This is much of what the recent market volatility is about. And as an economy becomes more risky, portfolio theory says to offset this by holding less risky assets. The increased demand for government bonds and slightly elevated spreads is an example of this preference for less risk.

 

govt debt

 

There is room for arguing the extent to which the future economy will under-perform potential, but it is widely accepted that the following factors will cause it to under-perform. The starting point for interest rates, (0%), is very low and therefore asset valuations are currently very high. The economy is saddled with sand bags of debt, the interest burden and long term need to deleverage will be a drag on future performance.

Some might argue that a more leveraged economy can produce higher rates of ROE (return for equity) and ROE is what we care about. This is certainly true in short term time periods. But increased financial leverage in the system does not help aggregate ROA (return on assets) and it increases volatility which also has its costs. 

The consensus is that asset class returns will be underwhelming for the next decade. Our macro economic partner agrees and here is their take on a base case expectations for asset return over the next decade.

 

10 yr return expectations

 

 

risks to base line scenario

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For information on Alhambra Investment Partners’ money management services and global portfolio approach, Douglas R. Terry, CFA is reachable at: dterry@alhambrapartners.com

This material has been distributed for informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Investments involve risk and you can lose money. Past investing and economic performance is not indicative of future performance. Alhambra Investment Partners, LLC expressly disclaims all liability in respect to actions taken based on all of the information in this writing. If an investor does not understand the risks associated with certain securities, he/she should seek the advice of an independent adviser.