What are investors to make of depression economics?


After the RBA Board cut the cash rate target to 2.25% last Tuesday I mentioned to a friend that the best guide to the world economy since 2008 has been Paul Krugman’s brilliant little book The Return of Depression Economics. Krugman explains how the economy can get stuck when everyone is fearful and wants to hold on to safe assets (e.g. bonds), and no one is willing to invest in anything risky. It is fear that has driven interest rates to such low levels worldwide, as investors have been willing to massively bid up the price of bonds to park their money somewhere safe and to receive the guaranteed regular coupon payments.

Much of the fear appears irrational because financial markets are effectively demanding very low compensation for inflation over the long-term. The historical experience and the dependable phenomenon of regression to the mean suggest current interest rates are abnormally low and won’t persist. Indeed, judging by the comments in its box on “The Decline in bond yields and inflation expectations” in its latest Statement on Monetary Policy, the RBA can’t find any rational reason yields are so low.

I don’t expect the fear driving abnormally low interest rates will last forever, and no doubt, before the end of the decade if not earlier, enough positive economic developments will occur for investors to realise their fears are irrational, at which time the bond market will experience a large correction, with bond prices falling and yields increasing sharply. There will be a flood of money into equities, and the sharemarket will experience large gains. Many investors have already realised this, and there is now much talk of the search for yield.

Even considering recent sharemarket gains, there appears much scope for further gains in equities. I agree with the comment by Credit Suisse analyst Hasan Tevfik reported in the Sydney Morning Herald last week (Shares in longest ever winning streak), that “If there is a bubble anywhere in the world, it’s in the bond market, it’s not in the equity market.” When the bulk of investors realise there is an unsustainable bond market bubble, money will flood out of it into the sharemarket. It’s all just a matter of time.

This isn’t investment advice, but it appears to me that the sharemarket remains an excellent investment opportunity over the medium to long-term, probably even better than the property market, but I’ll need to elaborate on that in a future post.

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3 Responses to What are investors to make of depression economics?

  1. Katrina Drake says:

    Thank-you for your post Gene, another exciting tangent for me to think about.

    Good to know my fears are irrational, I’ll sleep better at night. No longer do I worry about, ‘shock and awe’ the unexpected catastrophic event that resounds through the economy – I now know this is actually an opportunity to buy while asset prices are depressed. Even my concerns about lack of stability in Government, and the frequent 180degree rule changes to savings, super and tax laws – I’m learning to ignore these as the accountants and financial journalists will soon have a clever work-around.

    I must admit I do feel very relaxed and comfortable with equities, I feel I know what am buying in well known companies that I am frequently personally exposed to. On-line share trading and ETF’s make it all so easy to invest and research. Win some, lose some, diversification is the key, and time in the market.

    Now you have me researching bonds … and a quick google search on ‘bond market australia’ brings up this little gem for me to think about…….

    Click to access NABPW_a_short_guide_to_investing_in_australias_bond_market.pdf

    First click, quite random, and no recommendation intended. But what caught my eye was the statement …… “ Unlike many other nations, Australia’s non-government bond market is significantly larger than its government bond market, reflecting our low public debt. “ Low Public Debt….. what happened to the Public Debt Bogey Man ? I know these are 2012 graphs – but those graphs of non-government-debt , look rather bubbly, practically effervescent, as you point out in your blog.

    Which brings me to the Queensland Government (whoever it will be) and the quandary of needing to raise $36Billion of Infrastructure over 4 years without selling assets, or borrowing.

    Breaking it down, $36B over 4 years, to around $8,000 per person over 4 years.

    What am I missing ? Mum and Dad investors are borrowing $500,000plus against equity in their own homes, to invest in termite and asbestos ridden post-war homes as ‘investment portfolios’, built by their grandfather’s generation for under $15,000, likely to flood or burn to the ground, or loose their roof in the next storm, chasing 4% yield and capital gain.

    When the government could be offering us direct investment opportunities in building efficient, economy stimulating public assets. They could even throw in tax-free capital gain if we invest for our kids, and hold them for over 10 or 15 years.

    Interested in your thoughts on alternative funding schemes for public assets other than raising taxes and traditional borrowing via government bonds.

    Nor is any of my comment financial advise – as I’m sure you’ll loose everything

    • Gene Tunny says:

      Thanks for the comment, Katrina. Governments typically don’t look to retail investors for funding because it’s easier to get it from the financial markets. Also, for the govt to offer equity in new infrastructure to investors it would have to be commercial infrastructure, but a lot of the infrastructure Govt builds isn’t commercial. That said, thinking laterally, we could always change the model – e.g. make every new road the govt builds or upgrades a toll road – but I don’t think that would be popular.

  2. White Elephant says:

    The Australian economy is essentially hollowed out now to be a property bubble fueled by a private debt bubble.

    Australia’s share market consists of four banks and a Telco. The Telco is 40% more expensive than global peers and pays out almost 100% of its earnings in dividends. The banks are the most expensive in the world – completely focused on funding the property bubble – they have no ‘Plan B’.

    Australians don’t invest outside of these five shares now as the economy is completely uncompetitive due to wages, property prices, over regulation and up until recently, an absurdly overpriced currency with a central bank asleep at the wheel. Setting up a business is a nightmare. The short termism of corporate management paying extreme dividends at the expense of investment is coming home to roost.

    The mining boom is over. Australia is left with record breaking private debt and structural deficits at all levels of government.

    Perhaps Australia will be the first country in history to prosper by borrowing money from overseas to use speculating on each other’s properties and selling coffees to real estate agents and mortgage brokers? Good luck…

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