The Value Perspective Podcast episode – with Edward Chancellor
Happy New Year and welcome back to the TVP podcast. We are kicking off 2023 with historian Edward Chancellor, whom you may know as the author of Devil Take the Hindmost: A History of Financial Speculation, which was written in 1999, two years before the dotcom bubble burst, or as the author of Crunch Time for Credit, which was written in 2005, right before the global financial crisis (GFC) ... you may be sensing a pattern here. Juan and Jack Dempsey, a portfolio manager in Schroders’ European equity team, sat down with Edward to discuss his newest book, The Price of Time: The Real Story of Interest, in an episode that will cover Edward’s background in investment banking and his transition into writing after some time in capital markets research; biases that impact central bankers; how even historically minded people miss teachings from the past; excess capacity and its impact on investment styles; and, finally, the ‘topic du jour’ – Sam Bankman-Fried and the FTX case study from a human behaviour point of view. Enjoy!
Chapter headings for Edward Chancellor on The Value Perspective Podcast
Please click on the link below to jump straight to a chapter
* Edward Chancellor, welcome ...
* The behavioural biases of central bankers
* So what did Bernanke and King learn from the GFC?
* Why is it so hard to absorb lessons from the past?
* The cyclical nature of financial history
JTR: Edward Chancellor, welcome to The Value Perspective podcast. It is a pleasure to have you here. How are you?
EC: Very well, thanks.
JTR: For those who don’t know who you are – although I cannot imagine there are too many people in the finance community who have not heard of you – could you offer a little bit of an introduction?
EC: Well, I am a financial historian and author. My first book was called Devil Take the Hindmost: A History of Financial Speculation and my most recent is called The Price of Time: The Real Story of Interest. I also worked as a financial journalist and was a founding member of Breakingviews – now Reuters Breakingviews – the commentary service, where I write a column. I am an investment strategist too – I used to work for the asset allocation team at Jeremy Grantham’s Boston investment firm GMO – and I have edited a couple of investment books on the so-called ‘capital cycle’ theory of investment. That broadly describes what I’ve been doing this last quarter of a century!
JTR: We are going to be spending a lot of time today talking about your latest book, The Price of Time, which is amazing, but before we go into that, I am a little curious – how do you start the 1990s doing investment banking at Lazard yet end up writing one of the most prescient books on financial history a few years before the dotcom crash?
EC: Well, I did a postgraduate at Oxford and, when I left in 1991, I decided not to go into academia but into the City. And, frankly, I actually didn’t know enough about the City so I went into corporate finance and then, after a couple of years, I realised I wasn’t cut out for that. I dare say, had I gone into the investment part of the business, I would have stayed around for longer, but corporate finance did not suit me at all.
JTR: And then, just a couple of years before the dotcom crash, you went on to write a book that is all about financial speculation and the madness of crowds.
EC: Yes. I think, if I have a particular talent, it is that I am able – or at least I try – to see what’s going on in the financial world at any particular moment and find out what historical parallels there are. So, for instance, with the internet bubble of the 1990s, it looked to me very similar in some respects to the British railway mania of the 1840s, which was also a communications revolution and led to a tremendous investment boom and bust. So I have been doing that since – for example, I did work on the credit boom of the early 2000s, which was published as a report for Crispin Odey’s outfit and, there, I was interested in the previous great credit booms and developed a sort of ‘Minsky-an’ idea of financial instability. And then, more recently, I have been dwelling on very low interest rates and what similarly low levels of rates might have done in the past.
JTR: One of the books you are quite well-known for is Capital Returns: Investing Through the Capital Cycle – is it true that is out of print?
EC: Well, there are two books, really. They were collections of reports by the London-based investment firm Marathon Asset Management and they elaborate an idea of a former partner at Marathon, Jeremy Hoskins. He had this, I think, very insightful way of looking at investment, which is not to look at any industry or company demand projections into the future, which he argued were inherently uncertain, but instead to look at supply conditions, about which we know a lot more.
Now, with my background in investor manias, this immediately struck a chord with me. I have already mentioned the railway mania of the 1840s – well, that was a time when the amount of new railways planned in England were roughly equivalent to the existing toll road and were requiring a capital investment roughly on par with British GDP! So you can see, with that much investment, you are going to have serious over-investment and lower returns.
So the first book I did on the capital cycle, which is out of print, is called Capital Account: A Fund Manager Reports on a Turbulent Decade, 1993-2002. And that actually suffers from a shortage of supply because the publisher we used went bust while it was publishing the book! So there don’t seem to be very many copies now – with the result that, when you look online, it sells for anywhere between $600 and $1,000. Then I did a later follow-on book, Capital Returns, which is still in print. But, actually, I quite liked the first one, which is hard to come by, because it tells the story of the dotcom boom from the capital cycle perspective.
JTR: That’s really interesting – and a bit like Seth Klarman’s Margin of Safety, which is also out of print and you can find on eBay for $2,000. You’re not that far away!
EC: That is more of an appropriate price for Klarman, which I suppose is fair!
JD: I think Capital Returns is getting harder to come by too because all the graduates at Schroders keep asking me for my copy – or maybe they just don’t want to pay for it! So maybe we could ask you about the capital cycle approach because the post-GFC period is particularly known for a lack of companies going insolvent and a lack of productivity growth. Do you think the interest rate environment post-GFC has prevented capital cycles from playing out as they would in a more ‘normal’ environment?
EC: I think that is case. In part, this is because with the very low interest rates of recent years – in particular, after the global financial crisis – there was a huge incentive for companies to buy back their shares – often borrowing to do so – rather than invest in new activities. I mean, after the financial crisis, top-line growth was hard to come by and, as you mention, one of the consequences of the aggressive intervention by central banks in both the US and Europe was to impede the creative destruction that normally accompanies a recession.
And, as I point out in the book, what is curious about the so-called ‘great recession’ is that levels of corporate insolvencies were actually lower than in the two previous US downturns – after the dotcom bust and in the early 1990s. So, as you can imagine, if you’re operating in a world with little top-line growth, where your competitors who might normally have gone bust are still operating and you can borrow very cheaply to buy back your shares – and that share repurchase will be accretive to earnings per share [EPS]. And the market is valuing EPS growth with a higher multiple. And your compensation package is linked to the stock price – then you’ll see there was a tremendous incentive not to invest but rather to engage in in financial engineering.
And I think that has happened – and this is also important from a market valuation perspective. Because one of the ideas of the capital cycle is that valuations come down once there’s been a surge in investment. I was working, as I said, in the asset allocation team at GMO after the global financial crisis and our valuation models suggested US equities were very highly valued. And what we saw – what I saw, at least – at the time was US companies weren’t actually investing much.
So you didn’t have a positive capital cycle or an upturn of the capital cycle. And I think that partly explains why the US market continued to do so well over the course of the last decade. Whereas, let’s say, emerging markets that were much cheaper – their on-paper valuation – from 2009 onwards, they actually attracted more capital investment, in particular, from China notoriously, and delivered much worse in investment return. So the capital cycle approach can be applied for an individual company or sector but I also argue it is also a useful asset allocation tool when looking at different stockmarkets.
The behavioural biases of central bankers
JTR: We have explored decision-making and behavioural biases throughout the three years we have been running this podcast. Yet we have always thought about these biases in the context of the market or the investor – never how they might also affect central bankers. So what sort of biases have you observed having an impact on the people that design monetary policy over the last 15 or 20 years?
EC: The biases of the monetary policy community, I think, are twofold. One is simply people adhering to the same academic or intellectual framework. In monetary policymaking they have their so-called ‘canonical model’ that has a number of assumptions that those of us who live and have invested in the real world wouldn’t necessarily adhere to! There are a number of problems, I think, with the monetary policy model but, to my mind, one of its consequences is it creates sort of groupthink and everyone adheres to the same model.
In particular, for instance, there is this belief that what happens in the financial world – whether it is, say, valuation of assets or the level of interest rates – is determined by what’s going on in the real world. Whereas I think there is something a bit more nuanced going on, which involves feedback between what happens in the financial world and what happens in the real world. For instance, a minute ago, we were just discussing the impact of low interest rates driving financial engineering rather than investment. So there is a clear case in which the amount of investment activity in the real world is determined by something financial – and I think the monetary policymakers do not recognise that.
I point out in the book that the US Federal Reserve is the world’s largest employer of PhDs in monetary economics – and I think that probably has a harmful effect because it makes the chairman of the Federal Reserve an extraordinarily powerful person in determining the nature of the research that takes place and the conclusions of that research. For instance, I’m told that during the chairmanship of Alan Greenspan, which went from 1987 through to early 2006, at the Fed you weren’t to mention the word ‘bubble’! You weren’t to present chairman Greenspan with any research suggesting there was a bubble in the US stockmarket.
And under Ben Bernanke – again, I was told by a former state bank governor – you weren’t to mention anything to do with low interest rates prior to the global financial crisis being responsible for the US housing bubble, or for the flood of money into securitised credit. The other day, I was at a conference in New York and I met former Fed governor Thomas Hoenig, who had been president of the Federal Reserve Bank of Kansas City, and was also former head of the FDIC, the bank insurer. He said he had read my book and agreed with everything in it, which is interesting because the only responses I have had so far from, if you will, the monetary policy establishment have been via the pages of the FT and The Economist, which are rather dismissive of what I write.
Anyhow the reason I mention that is, when Hoenig was on the Federal Open Markets Committee – the Fed’s interest rate committee – he was one of the so-called ‘hawks’, who were constantly fretting about the unintended consequences of ultra-easy money. And I think what probably happens at the Fed and other central banks is just what happens, as you have probably experienced yourself, on investment boards – that is, if you hold a view that is not shared by the rest of the investment board, sooner or later you tend to get shown the door! And so all committees have a tendency to come around to a sort of groupthink.
The other thing is ... I have elaborated at great length what I consider to be the harmful, unintended consequences of monetary policy – of, if you will, unconventional monetary policy – across a number of different areas ... whether it is the appearance of financial fragility, which we can discuss later, but also the decline in productivity, rising inequality and so forth. Now, you can imagine that, if you have been unwittingly responsible for some of these unintended consequences, you might not wish to hear the message.
Perhaps in one of your discussions of behavioural biases you have discussed the whole idea of cognitive dissonance, which is the notion that you simply do not hear or pay attention to information that is dissonant to the thesis you hold. In fact, actually, when faced with dissonant information, such as a failed prediction or forecast, people tend to double down and become almost more fervent in their beliefs. And I think that is what has happened to the monetary policy world.
There are, as I mention in the book, these ‘voices in the wilderness’ – and it is particularly interesting that there is really only one institution where you find them, namely the Bank for International Settlements in Basel, which is sometimes known as ‘the central bankers’ central bank’. And there you had William White, the former chief economist, who left in 2007, warning of the dangers of central banks only focusing on price stability and not paying any attention to credit growth.
And you also have White’s former colleague, Claudio Borio, who took over as head of research at BIS and has led a team-research effort over the last 12 years or so into many of the unintended consequences of monetary policy. So you almost have to be outside the establishment, like Borio and White. I mean, it is very notable they weren’t actually within any of the central banks themselves but sort of on the periphery.
So what did Bernanke and King learn from the GFC?
JTR: You mention in your book the case of Mervyn King, the former governor of the Bank of England, who said in 2016 – after he had retired – that interest rates were being kept very low. Yet when he was at the helm of the bank, he didn’t change course – is that correct?
EC: Mervyn King is a very interesting case – and very admirable, actually, because we all make mistakes. To my mind, perhaps the most useful thing about being in the investment world is constantly confronting and having to come to terms with one’s own errors. And bureaucrats and policymakers often don’t actually recognise their errors – and I think that’s largely the case with the Federal Reserve.
Read any of the stuff from Bernanke, when he was head of the Federal Reserve at the time of the global financial crisis, and there’s never anything in his writing that suggests he might have messed up. Whereas, King – he implemented the Bank of England’s inflation target running into the global financial crisis and, at the time, obviously household credit was going pretty strongly in Britain and you had banks like Northern Rock offering new loan-to-value rate mortgages of 125% while also being heavily dependent on the liquidity of the interbank markets for raising funds.
Now, at the time, under King, the bank had coined this acronym ‘NICE’, which stood for ‘non-inflationary consistent expansion’ – so it was a sort of pat on the back. Then, after the financial crisis, King left – I can’t remember when but let’s say sometime around 2011 – and he reflected on his time as governor. He has written a couple of books – one in 2016, called The End of Alchemy, and then, in 2020, an extremely good book co-written with John Kay called Radical Uncertainty: Decision-Making for an Unknowable Future.
And here, I think, we see how King’s experience of the global financial crisis really changed his view about what central bankers were doing; what their targets should be; the dangers of setting these targets; the problems caused by monetary policy; and how to operate in a world of radical uncertainty. So, to my mind, it is a sign of a really first-class mind to have been able, quite late on in life, to have reformed your view of how the financial world and monetary policymaking works – and great kudos to Lord King for doing that.
Incidentally, you may have noticed King was also on the House of Lords committee that put out a report last year, entitled Quantitative Easing: A Dangerous Addiction?, which pointed out some of the problems caused by, well, the addiction to quantitative easing – not least, the massive expansion of money supply during the Covid lockdowns and the fact that, as a result of the quantitative easing, from a corporate finance perspective, the Bank of England had, in effect, swapped long-dated fixed-rate debt for short-rated floating debt at a time when long-dated fixed-rate debt was trading at very low levels. So that was a corporate finance disaster of epic proportions that we taxpayers will live with for years to come.
JD: You have mentioned Ben Bernanke a couple of times and his maybe not taking responsibility for the low rate environment in the US. Yet, in his autobiography, he says he did try to prevent the housing bubble in the US and he was raising rates into the GFC – but that at the long end, basically, the curve flattened and, obviously, mortgages in the US are set off the long end of the curve rather than the short end so there was not actually much he could do about the global savings glut. Plus, I guess, there are other mooted reasons, such as demographics, permanently lower interest rates ... do you buy into that?
EC: Not 100%. Where to start? First of all, Bernanke was the author of what’s called the ‘global savings glut’ hypothesis’ – the idea, as you say, that longer-term rates were coming down because there is a global savings glut. But, in fact, the global savings glut – if one examines it – was really China and a number of other emerging markets intervening in the foreign exchange markets to buy dollars and add to their foreign exchange reserves.
If you look at China, it was running a large current account surplus – I think, over 10% of its own GDP by 2007 – and current account surplus is often seen as the proxy for a nation’s excess savings. If you look at what was happening in China, though, these weren’t household savings – these were corporations boosting their investment and that investment was being driven by bank lending. This is point made by Claudio Borio: when a bank creates money or makes a loan that is then used for investment purposes, it generates saving out of nothing.
So what happened in the early 2000s was a sort of co-dependency between the US and China. The US had these low interest rates, which fed through to a housing bubble – and that housing bubble was accompanied by roughly $500bn a year of mortgage equity withdrawal by homeowners, who then spent the money on goods and, not least, Chinese imports!
So the Chinese were then selling stuff to the Americans and using the dollars they received for their exports to buy US treasuries. To describe that as a global savings glut is, I think, pretty simplistic and misleading. The other thing is, it is simply not the case that the US housing boom was entirely driven off the long end. If you remember, there were a lot of short-dated mortgage loans – so-called ‘option adjustable rate mortgages [ARMs], also known as ‘negative amortisation loans’ – and, towards the end of the housing bubble, those option ARMs played a pretty big role.
I’m not sure if you know about the American craze for flipping houses! I was living in New York in 2005/06, when that was going on big-time – and I think that sort of household flipping was largely funded with option ARMs or negative amortisation ARMs. You could go out, in effect, and raise money with a so-called ‘liar’s loan’ – in other words, you just faked your income or credit credentials, got a loan-to-value mortgage of up to or even exceeding the value of the property you were buying and funded it with a negative amortisation loan.
So you weren’t actually paying any interest on the loan upfront – interest only kicked in after a couple of years – and then you could flip the property six months later. People were doing this in US prisons at the time! So, again, to say the savings glut was responsible for the housing bubble is wrong. And then, we were talking about ‘group think’ – I mention in my book that Bernanke tried to refute suggestions monetary policy was in any way responsible for the housing bubble and bust by referencing internal Fed research that, when you looked at it was, to my mind, pretty partial. I wasn’t at all convinced by its conclusions.
Why is it so hard to absorb lessons from the past?
JTR: When you made an appearance on Jim Grant’s podcast recently, he suggested that, when it comes to the world of finance, there really is nothing new under the sun and we have gone through many of these issues before – sometimes multiple times. Examples in your book include the Mississippi Company and South Sea bubbles up to 1720 and the run-up to the Wall Street Crash in 1929. Why is it that humans and even people who have studied history – I think Bernanke was an expert on the Fed’s reaction in the 1930s, for example – are unable to learn from the past?
EC: So Jim Grant’s comment is that we are always ‘stepping on the same rakes’ in the financial world! He also has this great line where he says that progress in science is linear but in finance it’s cyclical – so that’s just another way of saying we repeat the same mistakes. Why do we repeat them? I suppose there are a number of factors – one, human nature doesn’t change. All those behavioural biases stay the same – greed, fear, fear of losing your job ...
Today I’m writing a piece looking at the whole fraud in the crypto world associated with Sam Bankman-Fried and his collapsed crypto exchange. And, actually, if you look at it, the credulity of the investors who went into FTX – which was valued as a $32bn company, having only been started up in 2019 by a guy who is 30 years old and, you know, sleeps on a beanbag and wear shorts and plays games all day long. And the forming of FTX – the trading in virtual assets that don’t really have any value – it’s a bit like the tulip bulbs in the 1630s.
Or the incredible leverage offered – you know, FTX was offering 101-to-one leverage. Or the cultivating of political connections – Bankman-Fried gave money to the Biden election campaign and, I think, was the second largest donor after George Soros to the Democratic mid-term election campaign. You know, with the South Sea Bubble in 1720, the directors of that scam gave money to the King of England and bought up most of the British Parliament, including the chancellor of Exchequer.
So, with these things, the behaviours are very similar – as are the incentives to make a lot of money or commit fraud. And the way people react – I think it was JK Galbraith, who said there is nothing more disconcerting than seeing your neighbours getting very rich, very quickly. And my old boss, Jeremy Grantham, likes to talk in the investment world about what he calls ‘career risk’ – you know, if you don’t partake in a bubble and everyone else is ... if your peers or benchmarks are, say, Cathie Wood’s Ark Invest and Baillie Gifford’s Scottish Mortgage and if you don’t play the same game as them, you’re going to lose your job.
So you have the behavioural problems – the biases, if you will – and then you have the incentives, like from your career. And what I’m trying to do with this new book, The Price of Time, is to draw attention away from the behavioural aspects of bubbles towards their monetary underpinnings. And the simplest way to explain that is, as you know, to arrive at a current value of an asset, you have to discount the future cashflow – and therefore, if you change the discount rate, you’re going to change the capital value.
Or, as Warren Buffett says, the Treasury yield is to valuation what gravity is to matter. And what we have seen in recent years, obviously, is the lowest ever interest rates in history accompanied by, frankly – across the board – the most elevated valuations. And, again, what I find interesting and a point I make is that, when you have extremely low interest rates, the assets that seem to benefit most of all are those that actually generate no income whatsoever – like the crypto stuff, which are really pure speculative ‘tokens’.
It’s interesting because you go into a casino and you trade your money for tokens and Bankman-Fried was sort of doing the same thing in the crypto space – but with assets that, as he himself said, were fundamentally value-less. What is most curious to my mind – I’m sorry, I am digressing on this because I have been thinking about it – is, if you look at the interviews with Bankman-Fried, he is more or less telling you the whole crypto space is a complete fraud, which turns out not only to be true, but that he was at the epicentre of it.
JD: We have mentioned a few speculative bubbles – the Mississippi Company, South Sea, tulips and I guess tech during the dotcom boom – and then we are probably in the middle of a deflationary bust from more of the speculative assets you were talking about. I was listening to a podcast with Stan Druckenmiller recently and he said an asset bubble has never burst without being followed by a period of deflation. It is fair to say we probably have a couple of asset bubbles bursting at the moment but we are obviously seeing high inflation too. What is your take on that?
EC: Well, I wouldn’t completely discount that view. When I was at GMO during the global financial crisis, I was in two minds – I was aware that all great credit booms and speculative busts tend to have a deflationary impact but then you have a massive response by the central banks doing quantitative easing. It wasn’t clear to me at the time – and I was wrong – that that money would remain, so to speak, ‘trapped’ in the financial system, fuelling asset price inflation but not a broader consumer price inflation.
I think now the situation is different. As QE morphed over 13 years or so into the Covid lockdowns, you had money going much more directly into household pockets, with furlough in the UK and stimulus checks in the US. And, obviously, a lot of that went into the financial world and crypto world and created, you know, the meme-stock boom and so forth – but also a lot of it went out into the real economy.
Now, I think there are several distinctions between now and 2008 – but these are judgement calls, OK? And when one makes a judgement call, you are admitting you could well be wrong! But the difference as I see it is that households were forced to deleverage after 2008 while this latest sort of boom period has not really been on household balance sheets. I think when governments get into debt – and a lot of the debt since the global financial crisis has been on the balance sheets of governments – it tends to be less deflationary, that excess debt. In fact, it actually creates a much greater incentive to inflate away the debt.
Households can’t print money to carry on funding themselves or lean on their central banks to keep interest rates low – but governments can and they can create conditions of financial repression. So I think that’s a pretty big difference. And then there is this other problem, which is that the central banks, having engaged in so much quantitative easing – initially to bring stability to the financial markets – then continued quantitative easing for sort of macroeconomic purposes, such as bringing down unemployment.
More recently, though, they have reverted to QE, after periods of attempted monetary tightening – such as the US in early 2019, when its first period of raising rates was interrupted by convulsions in the US repo market. That led to both a return to QE – although it wasn’t called ‘QE’ as such – and cutting interest rates. And then, if you look at the recent ructions in the UK gilts market, there was a gap, I think, of only four days between the Bank of England’s announcement of so-called ‘quantitative tightening’ – where it was going to shrink its balance sheet – to the resumption of QE in order to protect the gilts market and the UK pension funds.
So we are not at the end of QE and the danger is that the fragilities I described in the book, which have been accumulating in recent years, will, as they are exposed, require central banks to engage with more and more QE. And at some moment, it’s conceivable you could have too much of a good thing – in which case you could see a loss of confidence in the currency. That is the thesis of Paul Singer of Elliott Management, the US hedge fund manager, who put out a note that was cited in the Financial Times a couple of weeks ago. He argues the central banks are just as likely to trigger higher inflation – or what Singer calls hyperinflation, which, depending on how you measure it, is somewhere between 50% a month and 100% a year! – alongside a collapse in the monetary system.
We will see. You were saying we have seen everything before – and that is true to some extent of behaviours – but, to my mind, we have never seen such an extensive sort of global ... I don’t know what to call it ... fragility. And, I say somewhere in the book, if you look at the financial crises of the last 30-odd years, two things are noticeable – one is each costs more in terms of losses than the previous one; and each has a broader geographical reach. So you went from the Asian crisis to the dotcom bust to the global financial crisis.
Now, China is obviously in a much more parlous state than it was in 2008 so the question is what happens with this ongoing crisis, which started at the beginning of 2022? I think it is probably a bit like when the US subprime problems started in early 2007 – or in February, to be precise, when HSBC’s US consumer finance division started showing losses on its subprime lending – but it still took 18 months from that moment through to the Lehman bust. And I think, if you look at what’s going on now, yes, the markets are down in bear-market territory – both bond and equity markets – but, to me, it’s still relatively early days.
And I have to say, if you live through these events, hindsight gives people so much more competence – like they knew all about it. Everyone now thinks they knew the global financial crisis was coming but that is simply not true – the US stockmarket reached an all-time high in October 2007 and most investors and commentators weren’t quite prepared for what was to come. And I think that that’s sort of the state today – obviously, the ‘everything bubble’, in inverted commas, has burst and the markets’ gains since the Covid market mania has largely reversed – especially in the crypto space, with bitcoin being back where it was in early 2020 – but there is probably a bit further to go on this round.
The cyclical nature of financial history
JTR: Going back to the topic of cycles, it might be the case that things do take a very long term to unravel. Many commentators and market participants have been raising the alarm about the fragility of the system for over a decade now – and pointing to the fact that Fed actions in the wake of the GFC have been causing the fragility you refer to. Do you think that is the case?
EC: I was among those commentators! In the end, that is why I wrote a history of interest. Based on my time actually working for GMO as an investor, I thought it wasn’t just that monetary policymakers didn’t fully understand the consequences of their actions – I didn’t think any of us who were interested in finance and investment had a proper handle on what interest did across the board. Jim Grant refers to it as the ‘universal price’ – a price that affects, really, all our financial and economic activities. And I think that this lowering of the interest rate to the lowest levels in history – and negative in Europe and Japan – is really one of the most significant developments in the history of finance.
And, going back to this question of whether we have seen everything before, then the answer is ‘no’. I mean, I don’t know when you started your careers but, over the last 25 years, we have seen really the most extraordinary markets in history, as far as I can see. There is nothing quite as absurd as the peak $2 trillion valuation of the crypto fantasy – but these very low interest rates ... I have to use the phrase of the former Fed governor Jeremy Stein, they have ‘got into all the cracks’ – valuations, leverage ratios, allocation of capital and so forth. And it really will take a while for that to work its way out.
JD: It seems like a lot of the things that have driven low interest rates over the past couple of decades – whether that is globalisation keeping a cap on domestic wages or price deflation from products coming from Asia to the western world – are now in reverse or at least slowing. Do you think that changes the financial landscape for the next 20 years versus the past?
EC: I do. As you’re aware, these bond market cycles tend to last generations – 30 or 40 years – yields go up over 30 or 40 years and then they go down over 30 or 40 years. And we are just off the end of one of the great – probably the greatest – bond bull markets in history, from the early problems in 1982 to last year. So exactly a 40-year bull market. Before that, during the Second World War, the Fed imposes short-term rates and yield-curve control at very low rates and then, after the war, you see interest rates rising for the following 35 years. So I think for, really, the rest of our careers, it is likely – these things are not given, but it is likely – that we will be on a rising interest rate cycle.
The point you make about globalisation is quite right, I think – that, in periods of globalisation, whether it is from movement of labour and immigration into, if you will, wealthier countries, or whether it is globalisation in terms of trade, the effect tends to be to lower real wage growth and to lower the cost of traded goods and therefore to have a dampening effect on inflation. And then, the overall impact of that is lower interest rates – and we saw that in the second half 19th Century.
And then, when it’s gone on for a while, globalisation tends to elicit sort of a political reaction. It is dismissed as ‘populism’ now but, you know, there is a real reason for populism – if workers feel their wages and their living conditions and their quality of life are deteriorating. And so, in the 19th Century, globalisation was arrested at the end of the 19th Century and then you had this movement for populism. You had globalisation fragmenting and interest rates rising up until the early 1920s – until that turned again.
As I say, though, these things are not given – you have the complete blow-up of globalisation in the 1930s and that actually coincided with a period in which interest rates were low and falling. So, you know, I think one can learn a lot from financial history but you also mustn’t fall into the trap of being historically deterministic. You use your knowledge of history to give you a certain understanding and then to see how current conditions are similar and how they differ.
JD: With rates not zero anymore, do you think money having a price or a cost again could actually be construed as positive? You referenced creative destruction earlier and the last 13 years has arguably been quite distinct for having a lack of creative destruction, which shows up in quite low productivity-growth numbers. So do you think that focus on the survival of the fittest or the strongest could actually be a positive?
EC: In an ideal world, that would be positive – and it’s not just a question of so-called ‘zombie companies’ being kept afloat. Frankly, a young person is severely disadvantaged by the low interest rate environment – high asset prices make it harder to get into the housing market and to accumulate any capital. And so, in a way, this very low interest rates environment has suited the older generation relative to the younger one – you know, when you look at the way that, for instance, the government in Britain insists on a ‘triple lock’ on state pension payments, so that pensioners are more or less guaranteed to earn more than working people, you almost feel our political system has a dangerous political or distributional bias towards the elderly.
Anyhow ... so, yes, I think there are a huge number of advantages that can come from setting the ‘price of time’ somewhere closest to what might be considered its ‘equilibrium level’. The trouble is, going back to these fragilities, if you have built debt structures and valuations and so forth on the assumption of very low interest rates, you can’t get back to a ‘normal’ rate without triggering a crisis. Think, for instance, of the UK pension funds – no-one suffered more obviously from the low interest rate environment than a defined benefit pension plan. So you would have thought, hey, the defined benefit pension plans would be absolutely cock-a-hoop when interest rates rise, the return on bond yields rise, the discount rate applied to their future liability rises and therefore their current liabilities decline.
But what happens? In the real world, it turns out the defined benefit pension plans have been taking leveraged bets in the interest rate swap markets on 50-year UK gilts that lose 85% of their value as interest rates even begin to normalise. So the prime beneficiaries – on paper – of a return to normal interest rates turned out to be on the verge of bringing down the financial system. And that, to me, is almost the perfect example of why it is difficult to normalise rates. Some people who reviewed my book said, oh, Chancellor’s calling for higher rates but that’s not actually what I say at all. I just point out the almost inconceivable difficulty of normalising rates under the current circumstances.
JTR: Edward, we are coming to the end of our session and we cannot pass up the opportunity of asking you for a book recommendation.
EC: OK, so what have I read? Or what have I liked in the last year? There is a very good history of sanctions called The Economic Weapon: The Rise of Sanctions as a Tool of Modern War by Nicholas Mulder. Oh – and when I was in New York the other day, Jean-Marie Eveillard, formerly of First Eagle Funds, gave me a copy of his book Value Investing Makes Sense – that seems like a book all investors should have!
There is an investment book I read recently called Simple But Not Easy: An Autobiographical and Biased Book about Investing by a veteran English fund manager called Richard Oldfield, which I thought was very good. He is very wise and that has been recently re-published so I think that would be definitely a good book to read. I did buy the Nouriel Roubini book, Megathreats, on the world falling to pieces but I haven’t read it yet so I can’t recommend it! And, of course, I mentioned earlier John Kay’s and Mervyn King’s Radical Uncertainty – and you should probably try and get John Kay on your show, if you haven’t had him already.
JTR: We tried with Mervyn King but he was very busy in the summer – he wanted some quiet time to sit down and write actually. So we are trying again in the coming months.
EC: Well, I think Radical Uncertainty really is a superb book.
JTR: That’s fantastic. Edward, thank you very much for your time. It was fascinating.
EC: Great. Thanks a lot.
Juan Torres Rodriguez
Fund Manager, Equity Value
I joined Schroders in January 2017 as a member of the Global Value Investment team and manage Emerging Market Value. Prior to joining Schroders I worked for the Global Emerging Markets value and income funds at Pictet Asset Management with responsibility over different sectors, among those Consumer, Telecoms and Utilities. Before joining Pictet, I was a member of the Customs Solution Group at HOLT Credit Suisse.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German, Tom Biddle and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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