We're knee-deep in the process of determining changes for 2015 — new allocations, strategy tweaks, content decisions. Inevitably, the process of looking forward requires a look back, so today I thought it would be interesting to look back on the biggest surprise of this past year. For those of you who primarily watch the equity side of the ball, you may not have even realized it was happening. That's because the biggest surprise of 2014 was the totally unexpected drop in interest rates.
Heading into 2014, the greatest consensus among economists and prognosticators was that everyone knew — knew! — that interest rates were heading higher. SMI thought so too (although I did write nervously about an April poll in which 100% of economists were predicting higher interest rates, saying it was usually a good bet to take the other side whenever 100% of economists agree about anything!). The reasoning was sound: when the Federal Reserve had first started talking about tapering their Quantitative Easing program in May of 2013, the bond market swooned for about six weeks, sending interest rates soaring, until the markets realized that process hadn't even begun and wouldn't be completed for a long time yet. But by year-end, the tapering was already underway and it seemed inevitable that rates would rise as the Fed's bond buying diminished from $85 billion per month to zero.
Alas, the best laid plans of mice, men, and central bankers. In 2014, the world economy failed to grow much, despite their best efforts to stimulate. The U.S. growth number in the first quarter of 2014 was horrible (-1.7%), and while that may have been a weather-related anomaly, the rest of the year didn't exactly set the presses on fire. And the U.S. was the world's best growth story! The rest of the world sagged along with even worse growth trajectories.
Here's the big picture view: Since 2008, the world economy has been caught in a deflationary pattern. The demographics of the largest economic powers are largely deflationary, as a result of older people tending to spend less than younger workers with growing families. The debt overhang that was exposed in the financial crisis is deflationary, as people and governments largely try to cut back on spending in order to get their debt levels under control. And while those two factors may be thought of as "negative" deflationary forces, they are joined by a third, more "positive" deflationary factor. Namely that technology is making it cheaper to produce stuff (and perform services). This isn't uniformly positive, of course, as it creates tremendous downward wage pressure as a global work force scrambles to compete with automation, etc. But it drives the cost and prices of many goods and services lower, which is the point we're dealing with directly here.
Given these factors, which aren't exactly new or surprising, why has everyone been worried about inflation since 2008? Mainly because the unprecedented response of the world's central bankers (and governments) hit every inflation-sensitive nerve of a generation conditioned by 40 years of experience to think inflation is the natural state of affairs. Huge stimulus spending, coupled with massive money generation, seemed bound to eventually ignite inflation. That was actually the goal! And history teaches that once ignited, inflation can be very difficult to control.Thus the inflationary concerns.
The surprise of 2014, then, was that the global deflationary forces finally took firm control of the debate away from the inflationary argument. That's not to say inflation can't or won't fire back up at some point, as central banks continue to pile more and more fuel on the fire in a (so far) futile effort to ignite inflation and thereby get some traction for their monetary policy tools.
But in 2014, at least, deflation had the upper hand. And as inflation expectations drop, so do interest rates. The US 30-year Treasury yield fell from roughly 4% at the beginning of 2014 to roughly 3% at the end of the year, despite the expectation rates would rise as the Fed exited QE. The rest of the world's yields are even more ridiculous. As surprising as a 2.2% US 10-yr yield may be, a 0.65% 10-yr German Bund yield is shocking. But again, it's the total lack of inflationary expectation in a barely growing global economy driving those yields.
Will the deflation/inflation situation be different in 2015? Should we expect higher interest rates next year? More on those questions in the soon-to-come January issue of Sound Mind Investing...