Early this year, a Market Watch article, “100% of Economists Think Yields Will Rise Within Six Months,” reported that “economists are unwavering in their assessment of where yields are headed in the next half year.”
Market Watch was referencing the April 2014 monthly survey conducted by Bloomberg in which all 67 economists questioned projected that the interest rate on the 10-year Treasury note would rise over the next six months. Of course, this did not happen. In fact, the rate has fallen considerably, from 2.73% on the day of the survey to 2.35% at the beginning of this week. This prompted a follow-up article by Money Watch: “Yes, 100% of Economists Were Dead Wrong About Yields.”
The obvious question: How can so many economists be mistaken?
While conventional capital market theorists say that markets are efficient because investors are rational, behavioral finance tells a different story. We do not solve problems rationally but tend to make biased decisions using “pattern recognition.”
The way the Keynesian playbook is supposed to work is that an economy will have periodic recessions, followed by economic stimulus, which leads to economic expansion. Economic expansion requires higher rates to keep inflation under wraps, and are a sign that the economy is moving forward under its own steam. If we look “backward” for the “pattern,” that is what we see — cycles forever being repeated.
The fact that the U.S. diverted from its cyclical pattern after this most recent recession is not something that many economists seem to be willing to embrace. In fact, major economists such as Paul Krugman and Anatole Kaletsky are gushing about how well everything is working out and how “Keynes was right.”
In addition to the backward-looking, pattern-seeking aspect of human nature, there is also the tendency to engage in denial. In a world awash in nearly everything financially related (money, debt, workers, capacity and, apparently, oil), it would seem that the road ahead is going to be about slow growth, deflation, growing deficits and zero real interest rates for as far as the eye can see — the “new neutral,” as Bill Gross has labeled it.
Some would argue that the U.S. economy is going down the same road that Japan has been traveling for over two decades. Though some economists — such as the chief economist at the Heritage Foundation — are beginning to discuss the connection between the U.S. and Japan, most mainstream economists are not ready to embrace the idea that, given the current trajectory, this may be the future in the U.S. This may partly explain why 100% of those economists surveyed were dead wrong about the direction of interest rates — no one believes (or wants to believe) that the same forces that have been at work in Japan are now at work in the U.S. economy.
These off-the-mark forecasts do impact investors. Consider the recent lukewarm interest in emerging markets, for example.
One dominant EM investment theme is that EM will greatly suffer when the U.S. raises rates. Additionally, it is hard to find a financial article today that does not assume that short-term interest rates will rise “sometime in 2015.”
The theory is that EM has become addicted to the low rates created by loose U.S. monetary policies and will be at a great disadvantage once it all ends. Hence the “taper tantrum” that caused EM asset prices to plunge in 2013. Though EM is growing at nearly twice the rate of the developed markets and has a much better debt to GDP ratio, EM is trading at a 40% discount to DM. How much of this is the result of factors other than anticipated rate increases in the U.S. is, of course, an unknown. It is known, however, that the perception that rates will rise is having a strong dampening impact on investor’s appetite for investing in EM, an area which could very well be the next growth opportunity.
If it does turn out to be the case that mainstream economists are “dead wrong” about short term rates rising in 2015 and it appears that the U.S. is not going to reach “escape velocity” (without another dose of QE), the investment picture for EM should become more attractive.
Conclusion
Plan advisors ought to take a somewhat jaundiced view of what the mainstream economists are projecting about the future. Prejudices aside, the world economy has become so complex that it is difficult for anyone to make accurate financial forecasts.
It is also not unreasonable to assume that the future pattern will look very different from what it has been in the past. While the U.S. has recently weaned itself off of QE, that may not be the end of the story. At some point, the enormous debt load the U.S. has assumed could very well create a day of reckoning. What that day looks likes no one knows, other than it is a righting of the scales.
It is also the case that the U.S. can kick the can down the road further still. Japan recently embarked on its newly created QE program after fighting the headwinds of deflation for more than two decades. Japan’s debt (relative to its GDP) is about twice the U.S. Perhaps the U.S. is only halfway there?
