One of the factors behind higher equity prices has been falling global interest rates. To some extent, this was the result of misguided monetary policy in the mature economies that kept policy rates low in order to stimulate the housing sector. Another often-cited reason is that of a global “savings glut” by which is simply meant that investment has been lower than savings. This has kept the cost of capital low.
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Consulting firm McKinsey has now come out with a paper that analyses the reasons for the savings glut and the likely change in trends. Titled Farewell to Cheap Capital? The implications of long-term shifts in global investment and saving, the paper says that global investment will outpace saving in the years ahead, which will lead to a rise in interest rates. That will increase the attraction of fixed-income instruments, while equities will lose some of their shine.
McKinsey is not the first to warn of such an outcome. Others have argued that as China switches to a more domestic-oriented economy, it will save less and that will lower overall savings, leading to rising bond yields and lower equity prices.
But why did the savings glut arise? The McKinsey report says it isn’t really a savings glut at all, but rather an investment deficit. It points out that the global savings rate actually declined from 1970 to 2002, but the rate of global investment declined even more. Why did the investment rate decline? There were several reasons: The end of post-war reconstruction in Europe and Japan, slower gross domestic product (GDP) growth and cheaper capital goods.
The McKinsey paper says, however, that this trend will change soon. It says the world is on the threshold of a global investment boom, comparable to the industrial revolution, an industrial boom that will be fuelled by rapid growth in emerging markets. There are already signs of the impact emerging markets are having on global investment demand— the paper says that the increase in the global investment rate from 20.8% of global GDP in 2002 to 23.7% in 2008 was mainly because of the very high investment rates in India and China. India’s investment rate, for example, climbed from 23.5% of GDP in 2000 to 39.5% of GDP in 2008.
This trend of rising investment in emerging markets will continue, forecasts McKinsey, simply because, on a per capita basis, the value of capital stock in both India and China is still very low. Here’s an example of the kind of investment India needs: “To keep pace with urban population growth…India would have to add 800 million to 900 million sq. m (of residential and commercial space) each year over the next two decades, equivalent to adding a Chicago each year and would have to pave 2.5 billion sq. m of roads, equivalent to 20 times the roads paved in the past decade.”
Nor will emerging markets be the only drivers of growth in infrastructure. The US and the UK have under-invested in infrastructure in the past decades and they have to make good the shortfall.
On the other side of the equation, the rise in global saving will be hobbled not only by China’s switching to more domestic consumption, but also by ageing population, although household savings rates in the US are likely to rise.
In a research paper on ageing and asset prices, Elod Takats of the Bank for International Settlements had said that as the proportion of working people falls in the mature economies, asset prices will decline. Takats says that in the US, asset prices have been boosted by the baby boomer generation. As the proportion of working people increases, savings increase and these are used to purchase assets, raising their price. Writes Takats, “The theory then would imply that asset prices propelled by the boomers’ savings will be under pressure when this large generation retires and starts to sell its assets to the relatively smaller subsequent generation.” A corollary of his argument is that long-term interest rates will rise in the future.
That is also what McKinsey predicts, but it says the fundamental reason for the higher rates will be an excess of investment demand over available saving.
McKinsey’s forecast are for the long-term—the paper talks of trends up to 2030 and forecasting what’s going to happen in the next 20 years is a lot like soothsaying. In fact, Goldman Sachs had brought out a paper that said something quite different. According to that paper, “A purely demographic model of global real interest rates would predict further downward pressure as desired savings globally rise further relative to investment.” For would not a younger population in a country such as India mean higher savings?
The yield on the 10-year US bond has fallen continuously from the late 1980s, from an average of 8.6% in 1988 to the current levels of around 3%. This has been a consequence of what economists call “The Great Moderation”, or a long decline in inflation. But the reason for low inflation during the period was the decline in demand in the ex-Soviet bloc together with lower prices that resulted from China’s globalization. These processes have now reversed and it’s very likely that, after the West recovers from the crisis, inflation will once again be a worry. That too will mean higher interest rates globally.
Manas Chakravarty looks at trends and issues in the financial markets
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