Delusional Investing in a Post-Growth World (And a Possible Alternative)

The internet certainly has its faults, but one can’t but admire how it has democratised information. It is now possible to get access to a multitude of private-sector reports that would only have been available to investment professionals a mere 10 years ago.

One example, with a high degree of quality, is the Credit Suisse Global Investment Returns Yearbook. You can get a pdf of the 2013 report here. Within its pages is a wealth of information on cash, bond and equity returns. Critically, the report chronicles a recent revolution in the prospects for investments. Moreover, the ‘new normal’ savers face gives off some telling signals with respect to future economic growth and, unexpectedly, provides some good news for the economics of sustainability projects.

The three authors behind the report—all from London Business School—provide a short introduction that doesn’t pull any punches in its message to the investment community:

To assume that savers can expect that the investment conditions of the 1990s will return is delusional. Many investors seem to be in denial, hoping markets will soon revert to “normal”.

The report covers cash, bonds and stocks, and all three have seen a collapse in expected returns. Let’s take a closer look at bonds, since they dominate pension-related savings in most countries. You can plainly to see that nominal yields have slumped (click for larger image):

Average Yields on Long Bond jpeg

But once we take inflation into account, things are far worse. In the chart below (taken from the full report), the authors have used inflation-protected bonds starting from the year 2000 (or equivalent where such bonds are not issued by a particular country) to see what kind of real returns investors are prepared to accept (click for larger image).

Real Yields jpeg

This kind of chart always shocks me. With traditional bonds, investors are on occasion ambushed by inflation and accordingly have to accept negative real yields, yet, in the case of inflation-protected bonds, investors are locking in negative real yields up front!

I have blogged on this issue before in a couple of different contexts (here and here), but it is worth stressing, to those without an economics or financial background, the extraordinary nature of this phenomenon. In standard text books, an interest rate is a payment to defer consumption. The basic assumption within economics is that, other things being equal, an individual will prefer to consume something now rather than consume it in the future. But, nowadays, when you buy these inflation-protected bonds, you are saying that you will give up the chance to consume something now in order to keep the opportunity to consume something in the future—even if it will be less of that particular thing.

Why should this be? The authors flag two possible factors behind the collapse in real yields: a changed regulatory environment and demographics. Further, they suggest that since neither factor will change anytime soon, don’t think the world of temporary negative yields is an anomaly—so get used to it (although they backslide on this assertion for the very long term right at the end of the report, presumably thinking it is just too awful to be true).

Personally, I don’t think this tells us the whole story. If technology-led productivity was barrelling along at its post-war average pace, then that would be sufficient to overcome a greying society and a tougher financial regulatory environment. Perhaps, real yields should be lower than in the past, but they shouldn’t be negative.

To me, if someone is prepared to buy a 20-year inflation-protected bond that provides a negative yield, then they are saying that alternative investments in something real, for example plant and equipment, are likely to perform even more poorly than loss-making bonds when risk-adjusted.

In what kind of world could that be true? I think the answer has to be a post-growth world. And where would the drag on growth be coming from? Well this blog has three candidates in mind. Maybe, climate change will be gnawing at growth quite aggressively by the year 2033—and so perhaps could resource constraints. Alternatively,  Robert Gordon’s faltering innovation could do the job alone or in conjunction with the other two—we just don’t know.

What we do know, however, when looking at the real returns on cash or bonds is that something pretty revolutionary is going on. It’s been five years since the credit crisis erupted, and things really don’t look like they are reverting to past return patterns. With each passing year, the cliched ‘new normal’ looks, well, just ‘normal’.

So where is the silver lining? For me, the silver lining is that sustainable investments have a far lower hurdle rate to overcome. By definition, many sustainable investments have long time horizons (that is why they are sustainable) and long pay backs. This has traditionally been their Achilles’ heel when fund raising. But far from a weakness, this could now be viewed as a strength: many sustainable investments can do something that traditional cash, bond or equity investments are finding it increasingly hard to do; that is, generate a reliable return far into the future.

Take an example at the individual level. A 50-year old currently has a pretty bleak set of options when saving for his or her retirement. Even if earned income is put into tax-efficient wrappers, a well-balanced portfolio may struggle to get a positive real (which means inflation-adjusted) return. By contrast, diverting some of the retirement savings into home heat-efficiency investments could lock in cost reductions decades into the future—including into retirement.

Such an alternative retirement-preparation strategy would also reduce risk in three dramatic ways. First, it would protect the saver from a government attack on their pension pot through negative changes to the tax system. Second, it would provide some immunity from inflation, keeping in mind that the government may be forced into a stealth inflation tax to deal with its debts. Third, energy efficiency investments would reduce exposure to future fuel prices spikes arising from  resource depletion or adverse geopolitical developments.

Nonetheless, is it possible that we are just in a prolonged downturn, which, by definition, implies that there will one day be an upturn. Indeed, the authors of the report seem to be believe that we are in a tunnel, albeit a very long one, from which we will eventually emerge:

For how long can we expect returns to be low? It could take another 6–8 years for short-term real interest rates to turn positive, and markets are not expecting a return to the high levels experienced since 1980. Instead, markets suggest a drift in the direction of the long-run average of 0.9 percent for the US and UK. For how long are low returns bearable? For investors, we fear that the answer is “as long as it takes”. While a low-return world imposes stresses on investors and savers, it provides relief for borrowers. The danger here is that if this continues too long, it creates businesses kept alive by low interest rates and a reluctance to write off bad loans. This can suppress creative destruction and rebuilding, and can prolong the downturn.

I am not so sure. Just as with climate, with respect to which we are moving from the holocene into the anthropene with no chance of return (at least in any human life time), so could the investment environment be experiencing a similar transformation. But you don’t have to put all your eggs in one basket in such a debate. Sustainable investments, at the very least, can just be viewed as a prudent hedge.

7 responses to “Delusional Investing in a Post-Growth World (And a Possible Alternative)

  1. Hi Justin,

    I’m enjoying your blog, so thought I should leave a comment! As for investment, well it seems to me that there aren’t that many good places for spare cash these days, and even guaranteeing to get virtually all of it back (in real terms) in a few years isn’t that bad an offer when you consider the alternatives. Cash under the mattress is a rather worse bet (though some Cypriots may disagree), and you can’t always just consume extra now – conversion of food to fat stores, and back to useable energy next year, has its own inefficiencies. Inflation isn’t a great measure of a lot of discretionary spending anyway – by not buying a second iPad this year, I’m going to be able to buy a far superior one in a few years, even if my (inflation-adjusted) wealth is a few percent lower. This doesn’t sound particularly irrational to me.

    Home improvement may be a good idea for some home-owners, but it does require the intent to stay in the same place, as otherwise the house price may not fairly reflect the improvement (maybe it should, but that’s not the same as saying it will).

    By the way, it would be really helpful if you could supply the whole article in the RSS feed, rather than just the start (there’s probably a setting somewhere). Makes it unreadable when off-line.

    • Hi James

      The claim that an interest rate is the opportunity cost of consumption is an empirical assertion in economics. The further we go back in time, the more difficult it is to provide evidence of this, but we can go back over 150 years with relative ease; see, for example Homer and Sylla’s “A History of Interest Rates”.

      As with everything else in economics it is an observation in aggregate—the behaviour of any one particular individual doesn’t negate the overall behaviour of a population.

      I am definitely not asserting that negative real interest rates are “irrational” they are just rare. They appear during war, depression, revolution and so on. And I also don’t believe that individuals bought bonds before these events happy in the knowledge that they would get negative real terms.

      So what appears ‘unprecedented’ to me is that investors are accepting negative real interest rates in advance (which inflation-protected bonds show). You give a variety of reasons as to why investors may accept negative real interest rates, but then you have to ask whether such factors are unique to the present. The answer is ‘no’. Next year’s model of product X has always had more features than this year’s model. Back in my MBA days, I also studied the consumer psychology of technology adoption. I haven’t visited that literature for a long time, but I hazard a guess that the feeling of exclusivity that early adopters are happy to pay for hasn’t changed.

      So I guess my key point stands. Something pretty radical has happened with real returns. Is it permanent? We just don’t know. My assertion is that negative real interest rates are perfectly consistent with falling rates of economic growth. So a risk averse individual should think about hedging the possibility that we are witnessing a structural change in interest rates.

      As to whether it is practical to make sustainable investments and whether this would contribute to a reduction in carbon emissions, I think the answer is ‘yes’. The ‘owner occupier’ sectors accounts for over 65% of households in the U.K. according to the Office for National Statistics and the average length of residency is 11 years. However, that number includes young households. Over a third of households have lived at the same address for over 20 years. So, as you point out, the critical question in making long-maturity energy saving investment is intent to stay—which appears to be in the high teens at least. Plus, again as you note, even if you sell, some of the investment should be captured in the price of the property, but I don’t think we have sufficient data to call that one.

      Another thing to note is that housing mobility appears to have collapsed in the U.K. since the credit crisis; lots of people are hunkering down amid the economic gloom and not trading up house-wise at they would have before. Of course, that means less cash to make sustainable investments. But my point is that funds can be redirected from ISAs or pensions into efficiency investments.

      fyi I am in Japan at beginning of April, would be great to meet up if you have time.

      • Well I probably was going off on a bit of a tangent – the inflation debate is currently high profile in Japan, with the govt stating its determination to generate some by any means possible. But they are simultaneously enforcing a rather large salary cut on a large number of workers (not just govt employees, the net is wide enough to includes university employees and people like me) which seems a bit…counterintuitive!

        I would say now (as someone with spare cash) that the unique problem now is that there simply isn’t anywhere else to get a good return. Housing hugely overpriced, the economy facing doldrums…what else is there to do but sit and wait for a few years, hoping to stave off most of inflation in the meantime? Yes, house improvement, but only for those where it makes sense…

        Unfortunatly, early April is just when we head off to Vienna for a science meeting.

      • James.

        It may be unique in the sense that we don’t have much experience of it, but that doesn’t mean it is temporary. If it is a product of a decline in long-term growth rates, the core of this blog, then it is something we have to adapt to. I would say that even 5 years ago, such ideas would have been labelled part of ‘heterodox economics’ (probably the most famous example of which is the work of ex-World Bank economist Herman Daly). Up until recently, these heterodox ideas could be safely ignored by everyone as the province of ‘weirdos’. But now the barbarians appear to have stormed the citadel, with a whole flurry of papers on declining productivity. That is why I have linked in various posts to Robert Gordon’s CEPR paper on the end of growth. Gordon is steeped in the neoclassical tradition, underpinning which is the assumption that markets and technology make supply curves elastic over the long term. For Gordon to recant on this and accept that growth is dying, or at least sick, was extraordinary for me.

        On a more prosaic level, I think the end of growth will make everyone less mobile. A positive real interest rate is a mechanism allowing you to buy future consumption at a discount irrespective of place (ignoring foreign exchange rates). If it is impaired, you need to buy future consumption a different way. Also, if growth ends, you also have far more volatility and uncertainty over your ability to secure future income. Your position in Japan is an example. As Japanese government finances have deteriorated (largely due to Japan’s falling growth), visibility over future real wages has declined, as indeed has future job security.

        And this, I think, is where the Transition Movement is correct (although they wouldn’t word their philosophy in the same way as me): an investment in place, whether physical or social, now pays a far higher relative return than in the past.

  2. I love your blog.. very nice colors & theme. Did you make this website yourself or did you hire someone to do it for you?
    Plz answer back as I’m looking to design my own blog and would like to find out where u got this from.
    many thanks

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