March madness

Every year, March Madness reminds me of my own storied basketball career. As I transitioned into college at Duke, being somewhat of a high-school star, I decided to try out for the taxi squad on the freshman team. Duke that year was well stacked with three future All Americans and NBA players but they needed some competition in practice and I was a prospective servant for the greater cause — not Duke — but my chance to show off and get a girl into the backseat of a car for the first time. Neither came to pass as I was cut during the first tryout session and cut frequently as well on second and third dates in parking lots behind the sorority houses.

I found my chance to get even when, 35 years later, I came back to Duke on a philanthropic mission and was picked up at the airport by Bucky Waters, the coach who had so coldly cut me from the team. Recognising Bucky but he not recognising me, I said, “Nice to see you again Buck.” “Did we ever meet?” he asked, in hopes for a close personal connection and a bigger cheque. Once, I said, “In 1962, the day you cut me from the freshman taxi squad.” “Ohooooo I’m so sorry”, he said. “I’m sorry too Buck”, I responded: “that’ll cost the university a few bucks!” We laughed and have been friends ever since.

But that’s not the end. Twelve years ago, I attended a basketball camp for middle-aged guys at Cameron Indoor Stadium, the site of my humbling-yet-undeserved dismissal nearly forty years before. The one and only Coach K headed the three-day session and began with a talk followed by a friendly admonition to have fun, concluding by saying that no one who ever attended the camp for the past 15 years had gone home without a basket. Never, that is until Bill Gross signed up. Why my teammates never passed to me I’ll never know — perhaps it was my frequent air balls or the constant turnovers — but I remember during the last game Coach K called a special play — sort of like the one for that little runt Rudy, who was on the taxi squad for Notre Dame, in the movies.

Coach even told the other team to give me a wide berth to the hoop to keep the streak alive. Thirty seconds to go, I got the ball, my great looking legs now covered up by modern-day shorts to the knee; lacking any youthful bounce that as a teenager could dunk a basketball; not hearing any encouragement from cheerleaders from the sidelines; nevertheless, I dribbled the ball confidently to the hoop with no one in my way – I went up for the gimme layup — it rolled in and around and out. The streak had been broken. “That’ll cost you a few bucks, Coach K,” I disgustedly said as we shook hands after the buzzer. We laughed and commiserated about my unique contribution to Duke Basketball. Like I said, a storied career — full of stories but void of points not only in the parking lot of the Alpha Phi sorority but on the court at Cameron Indoor Stadium.

If there ever was an economic concept that currently is not a layup, it would be what the future average level of Fed Funds will be. No one knows and unlike my gimme layup, there are no “gimmes” when it comes to scoring a Fed Funds basket. As we all know, the neutral or natural rate of interest is not a new concept. Irving Fisher, in the early-20th century, hypothesised that while neutral nominal policy rates could go up or down depending on inflation and cyclical growth rates, the real natural rate of interest was relatively constant. I think history has disproved this, not only because central banks and government fiscal policies have suppressed (and sometimes elevated) that real rate but because of structural changes in real GDP growth rates, demographics, and the globalisation of finance amongst others. 

Central bankers used policy rates as a hidden weapon until recovery was assured and Jim Grant’s dreaded inflation reappeared in the 1970s. At that point it was appropriate for Paul Volcker to impose positive — really positive — real rates. The real rate, to my thinking, while difficult to model, can subjectively and commonsensically be assumed to create superdebt cycles and asset bubbles, and then attempt to heal them in the aftermath of the popping. Such has been the experience over the past century of central banking in the US and elsewhere.

I am not presenting anything revolutionary here worthy of a Nobel Prize, but reminding you and myself of why the new neutral real rate of interest may be much lower now and in the future than what it was from Volcker 1979 to Bernanke 2009, a number which Rogoff and Reinhart calculate to be +1.35% in advanced economies and +2.88% in emerging economies.

One can approach an estimated value for developed (and emerging) economy new neutrals in another way. I think it’s informative to measure the spread between policy rates and Nominal GDP growth rates for the post-Lehman experience to get a handle on what rate has been necessary to stabilise certain large developed economies over that period. The complicating introduction of QEs around the globe will muddle that observation but only to the benefit of a more conservative conclusion. My hypothesis is that nominal policy rates need to be lower than Nominal GDP.

If annual GDP is the return on total outstanding credit and implied equity for an economy, then the safest and most liquid asset must be priced lower than GDP to induce investment. That would be the policy rate. How much lower, however, is the question. To summarise, nominal policy rates in the US, UK, and Germany have been on average 350 basis points below Nominal GDP growth since 2010 and 150 basis points below inflation. And these numbers are for the three strongest developed economies! To stabilise the three titans, the real new neutral policy rate there has been (–1.5%) for five years. It is not unreasonable to assume it might be 0% instead of the Feds’ 1.75% even if they return to “normal”. Other developed and developing economies need to reduce theirs in a similar fashion.

If real rates continue to be so low, then discounted income streams are dependent solely on growth and/or inflation instead of capital gains, which in the prior three decades have been substantially influenced by the decline in real rates. The lower real rate/capital gains ocean liner has taken us into uncharted waters, but waters, which we must know, that are hostile to investors. 

— Edited excerpts from Janus’ monthly investment outlook for April