Shifts in the global supply and demand for capital are depressing interest rates over the long term, with momentous implications for investors and borrowers, argues Lawrence H. Summer, former Treasury Secretary under President Clinton and former president of Harvard University.
For many years, it has been the conventional wisdom among managers of pension funds, foundation endowments, and other large investment portfolios that it is prudent to operate on a payout ratio of 5%. That wisdom was predicated on the assumption that funds could earn at least 5% annually on a long-term basis after accounting for year-to-year fluctuations in performance. But Summers contends that the payout ratio should be “somewhere under 3%.”
“Payout ratios should be far less, or expected return assumptions should be far lower, than has been the case historically,” he said at a conference sponsored by the National Bureau of Economic Research, “New Developments in Long-Term Asset Management.”
If global finance is in fact experiencing a capital glut, it is excellent news for the United States government, which is the world’s largest debtor. Interest payments on the $21 trillion national debt are a huge driver of budget deficits, and an increase in interest rates could prove calamitous. If Summers is correct, my Boomergeddon scenario could take considerably longer materialize than I suggested in my recent post, “Moody’s Reaffirms AAA Rating. Don’t Get Cocky, Virginia.”
On the other hand, if Summers is correct, chronic low interest rates could depress returns for the Virginia Retirement System and universities like the University of Virginia. The VRS assumes that its assets will average returns of 7% annually over the long term.
Summers argues that the global economy is undergoing a “de-massification” in which technology substitutes for capital-intensive in investment in equipment and real estate. The trend, which is driven by the declining cost of computing power and the rise of Artificial Intelligence, means that businesses need to invest less capital to achieve economic growth. Thus, law firms have shrunk the office space per attorney from 1,200 square feet to 600. And Apple, the world’s most valuable company, decided recently to funnel $100 billion into dividends and share buybacks instead of investing in new capital projects. “Something very important and structural is happening,” he said, when a global innovation leader is deploying its capital that way.
The average yield on U.S. 10-year Treasury bonds and comparable debt for Japan and European nations arguably has shrunk by 250 to 350 basis points (2.5 to 3.5 percentage points) over the past 10 to 15 years, Summers said. In addition to de-massification, he suggested, slower rates of population growth around the world are dampening economic growth and reducing the demand for investment capital.
Writing in my book, “Boomergeddon,” eight years ago, I argued that aging populations, the draw-downs of pension funds, and the rising cost of government entitlements would lead to higher interest rates over the next two or three decades. I failed to consider that de-massification, slower population growth, and slower economic growth would simultaneously depress the global demand for capital.
I’m open to the possibility that an interest rate-led meltdown of U.S. government finances is less likely in a world awash in capital. Let’s just hope that the politicians never get the message, though: Otherwise, they are likely to ramp up deficit spending and the national debt higher than ever. Meanwhile, state governments, elite universities, insurance companies and people saving for their retirement need to adjust to the reality of lower returns on their investment portfolios.
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