Bank of England governor, Mark Carney, hit the nail on the head in his recent chat with MPs on the Treasury select committee. Whether interest rates rise sooner or later is not the issue. The issue is that they remain low.
Low rates for an extended period of time don’t damage economic growth directly, but they cause damage in a multiple of other ways. A low interest rate environment is damaging for three reasons:
(1) It damages GDP growth because of the effect low productivity has on it. Virtually all the net debt accumulation of recent years is public debt, the debt service burden (i.e. future taxes) could rise significantly, should interest rates begin to move higher.
(2) It tempts investors to take undue risks. Investors (and people in general) not only take on more debt when the debt service burden is low; they also take more risk, potentially leading to further asset bubbles. Investors looking for income chase higher yielding opportunities, as safer bonds no longer offer the income required, and capital appreciation seeking investors allocate more to riskier asset classes such as equities. The net result? Potentially a lot more risk in many portfolios than people are aware of and would be comfortable with, know and/or fully understand.
And (3), the biggest issue we face – It magnifies the risk of a total collapse of our pension system. For most people this will have by far the biggest impact. Given the magnitude of unfunded pension liabilities in the Anglo-Saxon world, something will simply have to give. Political leaders in most countries prefer not to talk openly about it, which is (sort of) understandable, given that it is not the most obvious vote winner one can think of.
However, the fact that David Cameron appointed one of the leading UK experts on pensions – and one with no previous ties to the Conservative Party – as a pension minister when his government was reshuffled earlier this year, is an indication that they are finally beginning to take the problem seriously.
So what could happen? An across-the-board haircut? An extension of the retirement age? A mandatory conversion of DB schemes to less risky DC schemes? (Less risky – at least from the employer’s point of view.) Something else? I have no idea, but something is almost certain to happen. Otherwise entire countries could be forced to default on their pension liabilities, which is in nobody’s interest.
Changing the discount factor is only the beginning of something much bigger to come but, quite frankly, changing the discount factor is akin to financial engineering anyway. No fundamental problems are resolved this way. The best of all worlds would obviously be a material rise in interest rates without a corresponding rise in the debt service burden, and without it having a negative impact on equity prices.
One can only dream.
Niels Jensen is CIO of Absolute Return Partners
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