In the wake of the 2008 credit crisis, investors accepted the view that interest rates will remain low for a long time in an environment of slow economic growth. As a result, they accepted zero-like yields on bonds.
But "Trump's election has investors rethinking their worldview" declares a recent article in Bloomberg BusinessWeek. It goes on to say that "important shifts around real growth, around inflation, around policy all suggest that the move on bond yields … can be sustained … we have seen the low point for yields." All this may be true, but I believe the end of the bull market in bonds has nothing do with Donald Trump's election and more to do with demographics.
In fact, I see a long-term (secular) increase in interest rates and a fall in bond prices that will not be reversed any time soon. In my opinion, December, 2015, was the end of the bond bull market of the last 30 or so years.
Let me explain.
Underlying all interest rates are the real interest rate and expected inflation. When they go up, interest rates increase and vice versa. While in the short run, the real interest rate is affected by the business cycle, the long-term trend is affected by factors that change only slowly, namely technology and demographics – it's the outlook for the long-term trend of real interest rates that matters. Expectations about future inflation are affected by the business cycle in the short run, and taxes, economic efficiency and productivity in the long run.
The late '70s and early '80s illustrate how the interaction between demographics and technology can push the long-term real interest-rate trend sharply higher.
Many baby boomers started having kids in the late '70s, fuelling demand for credit to help raise a family. Boomers set little aside for savings and investments. As a result, they restrained the supply of funds available to corporations. This happened just as the personal-computer revolution started, concurrent with the founding of Apple Inc. and Microsoft Corp., and corporations were discovering a growing need for funds to invest in new technologies.
As the demand for funds increased and supply shrunk, the long-term trend in real interest rates increased sharply to about 6 per cent from about 3 per cent.
Additionally, the energy crisis, high consumption by baby boomers and prior underinvestment and inefficiency led to sharply rising inflation and inflationary expectations further pushing rates upward.
The late '80s and '90s saw declining energy prices, marginal tax-rate reductions and productivity improvements along with policies that broke inflationary expectations and led to lower interest rates. Most importantly, as baby boomers matured they started paying off their mortgages just as their kids were leaving home. They started to save and invest, fuelling an explosion in the mutual-fund industry. The supply of funds increased, leading to a decline in the real interest-rate trend, further suppressing interest rates. These were the golden years for bond investing.
Unfortunately, over the next 30 plus years, the real interest-rate trend is going to be up. The key factor is again demographics.
One way to put a number on the demographic effect is to calculate the portion of the population that is not in their working years (people younger than 20 or older than 64) and divide it by the share of the population in their working years (between 20 and 64). A decrease in this ratio suggests that more people, relatively speaking, are in their asset-gathering years. An increase indicates the opposite, namely, that a smaller portion of the population, relatively speaking, is in their asset-gathering years. My research suggests that an increase in the proportion of people in their prime working years, between 20 and 64, (i.e., a decrease in the above ratio) has a positive effect on bond prices (negative effect on interest rates). The opposite is the case when the share of population that is younger than 20 or older than 64 increases.
This ratio is inversely related to bond prices – as the ratio fell since 1990, bond prices shot up. But the ratio reached its long-run bottom at the end of 2015, and has already started its long term reversal, indicating a secular top in bond prices or a bottom in interest rates.
Baby boomers have started to retire (progressively in larger numbers) and have stopped saving; in fact, they are in their de-saving (consumption) years, which reduces the supply of funds. This happens in the face of increased demand by corporations, as well by increase in the government's need to borrow to fund structural deficits. To clear the demand-supply imbalance, the real interest-rate trend is pushed up.
We are also reaching a peak in productivity growth as experienced baby boomers retire and are replaced by less experienced workers who will nevertheless be in high demand. These workers will demand higher wages. This means higher inflation down the road and inflationary expectations starting to build up.
At the same time, oil and other commodities may be stretched to support growth around the world, contributing to inflationary pressures. Investors will demand higher interest rates to lend money as compensation for a loss of purchasing power.
What does this mean for the bond and stock markets? It is bad for nominal and real-return bonds (especially the former). It's good for companies and stocks that can grow profits, but not so good for high-yielding stocks and real estate, because higher payouts on bonds will lure investors away from income-producing investments.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.