Investors Throw a Taper Tantrum

Fall 2013

Quarterly Commentary

The Challenges of Oversupply

In This Issue:
Policy makers have been attempting to boost economic
growth with cheap capital (easy money, or liquidity).

his edition of our newsletter takes a look at a topic that we think deserves more attention from investors and policy makers. Since the end of the last recession, there has been much debate around the topic of why the global economy has not been more responsive to the more than 500 interest rate cuts and massive injections of monetary stimulus by the worlds central banks. Many of the explanations that have been offered to explain why economic growth has been sluggish since the end of the last recession are explained by the idea that there is a global deleveraging underway. Governments, consumers and businesses that became too deeply indebted during the boom times are focusing on paying down debt instead of consuming. The focus on debt repayment means that governments and consumers are not willing to spend money on goods and services effectively holding the economic growth in check. For a different perspective on what ails the global economy, author Daniel Alpert argues in his book The Age of Oversupply that due in part to the effects of a more globalized economy, there is simply too much capital, too much labor and too much productive capacity producing too many goods. Against this backdrop, Alpert argues that simply flooding the financial markets with

Some argue that the abundance of cheap capital for

more than a decade is actually the root cause of the problem, rather than the solution.

This abundant liquidity has come not only from central

banks but also from emerging economies whose citizens have a propensity to save rather than spend.

Developed economies have relied on this abundance of

liquidity to maintain their spending levels and to make up for stagnating incomes brought on in part by low productivity and wage growth.

Low interest rates resulting from cheap capital have

helped assets such as real estate and the financial markets, but the rise in wealth must be ultimately supported by stronger economic fundamentals.

central bank generosity in the form of easy money and low interest rates will make the problem worse not better. The prevailing belief had been that globalization would usher in a period of unrivalled prosperity. By the late 1990s, some had begun to boldly question aloud whether the business cycle and recessions were a thing of the past. This belief seemed reasonable given how fast the global economy had begun to accelerate. However, by the turn of the century this optimism was being questioned. Europe began to show signs of persistent slow economic growth and the US economic rebound was being seen as a debt fuelled experiment that would eventually have to be reckoned with.

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The bursting of the real estate bubble globally ushered in a period of persistent economic sluggishness and a reassessment of the real impact of globalization. Perhaps Alperts thesis is best illustrated by his statement: The Cold Wars end was widely seen as a triumph for liberal free-market democracies, ... In fact, in a grand irony, the demise of the socialist experiment set the stage for the greatest threat yet to the supremacy of the United States and other advanced economies.

labor and capital. In order for a nation to improve its standard of living and for incomes to rise, it must be able to raise its productivity so that more wealth can be generated for a given level of wages and industrial capacity. An abundance of labor and an economic model devoted to growth through exports has been one of the main reasons for the high economic growth rates of developing markets. As a result, the incomes in the developing world are rising faster than the global average but much of this income is being saved at a much higher rate than expected. Part of the reason that their savings rates are so high is that there is no significant social safety net such as national pensions or health insurance programs. In addition, some Asian nations such as China are seeing their populations becoming older and these societies are less interested in consumption and more focused on funding retirement and general well being by enhancing their savings levels.

A Rising Pool of Workers

To better understand the mechanics of Alperts argument, a key ingredient to economic growth must be examinedlabor. Economic reform in developing nations has allowed nearly 2 billion more workers to be brought into the global labor force. The developing world has used its advantage of cheap labor to enhance economic growth. Their formula for the most part was to use this labor force as a competitive advantage to export their output to wealthier developed nations. For developing economies, the expectation was that lower wage nations would provide cheaper manufactured goods and in turn they could transition towards more value added industries. All was expected to be well as new consumers in developing nations would emerge and begin to spend like those in the developed world. Therefore there could not be too much capacity, too much labor, or too many goods. Unfortunately, the outcome and the theory diverged. The reality has been that for many individuals in developed nations, wages and incomes have been largely stagnant. Meanwhile debt levels of governments and consumers have risen to exceptionally high levels. It is the repayment of this debt that many believe is holding the economic growth engine in check today. Therefore, the problems of today have their roots going back to overspending that began over two decades ago. To summarize: There has been too much spending in the west and not enough spending in the east.

Capital: Asias Largest Export

The question that now arises is If the income from emerging markets isnt being spent, where is it? The pool of savings from the developing nations of Asia and other parts of the world has actually made its way into North America and Europe in the form of debt. As the income earned by the developing nations is recycled into borrowing (debt) by the governments and consumers of the developed nations, downward pressure is exerted on interest rates. After all, interest rates are really the cost of moneyif money is in ample supply from the emerging nations then borrowing was cheap. The chart above demonstrates just how ample the supply of money has been. Foreign currency held in reserves of developing economies now have surpassed $7.2 trillion USD which is equivalent to 10% of the global economy. This has increased 224% over the last several years. Stagnant incomes in the west have been offset by this cheap credit from abroad. The lower the interest rates went, the easier it was to borrow and buy goods and services. To make a rather simplistic summarization developed nations borrowed and consumed and emerging nations produced and saved.

Why Arent They Spending?

Policy makers and academics are forever talking about productivity. The simplest definition of productivity is the amount of economic output achieved from an amount of

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The problem is that for too long, the developed world has been borrowing faster than its income has risen creating a debt burden that is rising faster than the economies of these nations can pay back. Alpert states that as long as the charade continued everybody won until events such as the Financial Crisis brought the problems of debt out into the open.

was quoted telling her fellow Fed Governors that my concern relates to the tremendous amount of liquidity ... in the banking sector, in the U.S. financial markets, and ... globally. ...this liquidity is something that we really need to think about. I do worry that liquidity is, ... causing a lot of transactions to occur that economically perhaps wouldn't otherwise occur."

Building Bubbles
The optimists will argue that cheap capital can be beneficial. It can be deployed as indeed into the economy through lower borrowing costs that enable the construction of everything from new factories and infrastructure to consumers being able to buy bigger houses, cars and other discretionary items. The problem now is that after a prolonged period of cheap capital and low interest rates going back for over a decade, there might be too much plant and industrial capacity that has already been built. Any further expansion will only make the situation worse. The concerns over cheap capital have been echoed before. When the US real estate market was approaching its 2006 peak, US Federal Reserve Governor Susan Bies

Governor Bies was basically saying that this tide of cheap money was inducing people to take risks or make purchases and investments that they would otherwise have foregone. If so, then you have the makings of a bubble if it goes on long enough. So the question policy makers must ask themselves is whether their solutions are creating new problems for the future. In short, Are bubbles forming as a result of liquidity (money supply) being higher today than at any other time in history? As of September 2013, the global money supply has reached an astounding $66 trillion.

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Low Interest Rates Have Limits
The go-to solution from central banks thus far is really the only one that they can come up with lower interest rates and inject even more money into the financial system. It has worked to help stabilize the housing market and the financial markets globally. But it has not solved challenges facing global labor markets nor can central banks provide the legislative changes needed to confront these challenges. That is work that only government policy can do.

the incentive to enter into the US. So the US has achieved a victory over this long standing border security problem with its southern border but the economic implications of an ageing population are not talked about very often. A shrinking work force coupled with stagnating productivity growth inhibits a nations ability to generate wealth and prosperity for its citizens. There are no easy answers and perhaps these concerns will prove over the long term to be without merit. But at the very least, they should be considered.

Aging Populations
One of the most important underpinnings of a strong economy is a population with a growing working age population (labor force). In much of the world, the working age population is either close to peaking or has peaked. This is not something that an interest rate cut or cheap money can fix. It will require countries with ageing populations to modify their immigration policies to attract younger and more educated workers. The issue is that there are a number of countries facing this challenge so there could be a growing competition amongst countries for these types of individuals. According to updated census data in the US, it is now expected that the US population growth will slow more than expected over the next several decades due to less individuals coming to the US from abroad and a slowing in the birth rate forecasts. For example, the US used to receive a steady flow of workers from Mexico but in recent years, net immigration from Mexico is thought to be close to zero as tighter border security and slower economic growth reduce

Summary
The first part of the job of policy makers was to stabilize the financial markets. To that end, Mission Accomplished would be an appropriate slogan. The other challenges and imbalances will take time and policy making that rises to the level of the challenge. However, one thing is clear, ultra low interest rates and excessive money supply increases are not without risk. Stocks markets appear to be fair valued and bond markets can only deliver decent future returns if interest rates were to decline significantly from current levels. That would take another economic downturnwhich at this point is not on the horizon. A meaningful rebound in economic growth globally would begin to set investors at ease that the world can wean itself off of the liquidity spigot. While that may take some time, it is a necessary reset that policy makers should begin to focus upon.

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