Outlook 2017 - Rates are back

Justin Curlow, Real Assets
Honyu Fung, Fixed Income
01 December 2016

We examine the fundamentals behind the present backdrop of low interest rates and challenge the dominant idea that this is the fate of our future as investors.

Key Points

  • Rather than focussing on 2017 per se, we take a more thematic, medium-term approach and examine the relative merits of the ‘secular stagnation’ thesis compared to a normalisation of growth and inflation. We review in turn the root causes of the lack of demand, the low productivity growth, the drivers of the saving gluts and the end of globalisation. Ultimately our conviction is that secular stagnation is an over-rated concept.

  • The global lack of demand is fading and can be addressed by an appropriate mix of monetary and fiscal policies. Monetary policy will never be the same as before the Global Financial Crisis: the extension of the tool box is there to last. Fiscal policy has to play its role where possible and this is particularly the case in the euro area, where some, but not all countries, have fiscal space.

  • In the medium term, the saving glut is set to resorb, while productivity will regain some strength and may even be boosted by the digital economy, especially if structural reforms provide a tailwind. We dispute the idea that technology is “everywhere but in the data” and believe the countries investing most heavily in the digital economy will benefit extensively.

  • Taking into account our growth estimates and modelling the term premium, we estimate that US long-term rates should return to 3.4% in the coming five years. This is certainly far from current levels, implying a multi-year normalisation that should radically affect asset allocations..

  • Given that previous episodes of rising rates have scarcely been smooth operations, we also take a deep dive into financial market stability analysis. The key ingredients of another financial crisis are mostly absent at the current juncture but certain elements may be a cause for concern, such as stretched fixed income valuations and constrained market liquidity.