Buried deep in the PhD thesis submitted by Milton Friedman in the late summer of 1940 (note 1) are a couple of jokes, which I really love. The first joke is that real wealth can be measured by something he called “the brother-in-law index” – the idea that you are only really rich if you earn more than your brother-in-law.
The second point – which isn’t really a joke, just a kind of throw-away line – is that the amount of money someone has doesn’t drive their investing behaviour. What really drives their behaviour is how much money they can reasonably expect to earn in future.
Friedman is right, of course. Investing – taking stored capital and pushing it into the markets – is at its heart a measure of two things: control and confidence. People seek to exert control over their investment or to be confident in the fact that they will get a decent return for their investment.
The big bet with investing is that assets like houses or businesses (in the form of shares) will be worth more in the future than they are now. If that assumption can’t be made – if assets will be worth less in future than they are now – then there isn’t any point in investing at all.
Economists and investors are constantly looking for clues for the places where future value is going to increase the most, where assets are under-valued and what the future of economies look like.
Most economists and investors would adore it if economics were like physics: an algorithmic science in which Newton, Galileo and Einstein have produced a series of simple formulas by which you could predict how a market is going to act and react to stimuli. But they haven’t. Economics is inexact, illogical and frighteningly irrational, but that doesn’t stop us looking for clues.
The current patterns tell a pessimistic story
In truth there are hundreds, millions or, in a world with perfectly symmetrical information, billions of data points which would allow us to form patterns and try and model out likely future scenarios. But because we are human we can only deal with a few ideas at once.
There are consumer confidence measures, investment confidence measures, business spending measures – which are all pretty good predictors of the future and then there is the big one: the US yield curve.
The US yield curve essentially measures the time value of money, because it consists of two axes: the Y axis (the vertical one) which shows the cost of money; and the X axis (the horizontal one) which shows the effect of time on the value of the money.
If, for example, you wanted to look at how the USA is thinking about money, you might look at the amount a country is prepared to pay for money in the short term and how much it is prepared to pay for money in the long term.
A good proxy for this is the difference between a two-year bond (how much they will pay to borrow your money for two years) and a 10-year bond (how much they will pay to borrow your money for 10 years).
In a healthy economy, a government will pay less to borrow money for two years than it will for 10 years. This is month the yield curve inverted. The US Government is paying less to borrow money for 10 years than it is for two years, which essentially means they think values are going to fall.
Whether you think the yield curve is important or not depends a bit on how much you think that patterns in economics are reliable. But most economists and central bankers think that the yield curve is a highly reliable predictor of a recession and most economists will tell you that an inverted yield curve has presaged every US recession since WW2.
So what? What does the other data say?
It’s not just the yield curve which is telling us that there are rocks on the investment horizon. The business confidence index is down and Australians are now saving more cash as a function of their investments than any other time since just before the GFC. The CoreData High Net-Worth Individual (HNWI) Intention Index shows that 38 cents in every dollar being saved is being stored as cash.
In truth, the lack of confidence is easy to find. Retail stores are closing (Big W for a start is shutting 30 shops), car retailers are reporting record low sales and record high repair business, the European Central Bank has a rate of -0.4 per cent for the interest on its reserves, and Jyske Bank, which lends in Denmark, has interest rates of -0.5 per cent. That’s right: investors will pay the bank to take their money.
What does this mean for clients?
In short, no one knows. The 30-year US treasury bond went below 2 per cent for the first time ever. No one has ever seen this before. They don’t know what to do and there is no user’s manual for when big economies face negative interest rates. And if you think the problem is small or localised to America it isn’t, it’s all through Europe and has been at work in Japan for at least a decade. At the time of writing there are (give or take) $A18 trillion in bonds trading with negative yields (about a quarter of all bonds on offer), which seems almost insurmountable.
So it seems the investment science of controlling what you can control – the cost of investing, the yield you are getting, tax effective structures and lots of communication still hold true – while opportunity hunting should be sidelined, at least for a while.
To try and set a course, next week central bankers from all over the world fly in to Jackson Hole, the premier American resort town at an event hosted by the Kansas branch of the Federal Reserve to discuss the matter. The whole world will be looking for clues.
Here’s a clue worth thinking about: Jackson Hole wasn’t chosen because it’s easy to get to, and it wasn’t chosen because it has great conference facilities. It was chosen because ex-Fed chairman Paul Volker loves fly fishing, and the fly fishing there is great. That tells you a great deal about what you need to know about the policy makers and a great deal about how much luck we will need to get off this crazy ride without losing some skin.
A User’s Guide: How to read the yield curve signals
Negative yield curves have proved to be reliable predictors of future recessions. The bigger the shape of the curve – for example when rates are high – the more reliable the indicator – rates aren’t high at the moment and we don’t know how reliable the indicator is.
• A flat yield curve is a moderate bear signal for share markets
Banks suffer from a margin squeeze, as they pay mostly short-term rates to depositors while charging long-term rates to borrowers and are reluctant to extend new credit.
• A negative yield curve is a strong sell signal
Normally caused by the Federal Reserve raising short-term interest rates to slow the economy, investors may contribute by driving long-term yields down — switching out of shares into more secure investments.
• A steep yield curve is generally a great sign for share investors
This usually means the Central Bank may drive down short-term interest rates to stimulate the economy and investors contribute by selling bonds and buying shares to chase returns, causing long-term yields to rise
1. Friedman submitted his thesis in 1940 but didn’t win the award until 1946 – I have no idea why. Oddly this was co-authored with Simon Kuznets, whose success as an economist is significantly dwarfed by Friedman’s despite the fact Kuznets was a brilliant statistician, got a Nobel Prize in 1971, and did more than just about anyone else to add empiricism to the study of economics. I tend to adore Friedman and think Kuznets was pretty dull. Watch Friedman some time on YouTube, it’s as if Seinfeld was a brilliant economist. Start here: https://www.youtube.com/watch?v=D3N2sNnGwa4