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Zest’s outlook on interest rates and growth drivers


We start the January newsletter wondering where the rates may go in the medium to long run using the assumptions of the Fisher equation and breaking down the long period growth drivers. We’ll focus our attention on three of the drivers of interest rates, which are population, productivity, and GDP growth.

So, starting from population growth we can see clearly from the graphs below that for two of the main economic regions such as China and the EU, the population rate of growth has been contracting almost relentlessly for 60 years and the CAGR forecasted to 2050, starting from 2021, will become negative; this situation can be explained largely by the so-called “one-child policy” for what concerns China, while the Old Continent is affected by a reduction of birth rates especially in Germany. This scenario however is present also on a much wider scale for the fact that even the world population rate of growth is declining over the years with an important negative contribution from Russia and Japan. So, one of the growth factors, which is population growth, will be contributing negatively to long-term economic growth; this partly explains the stability of long-term interest rates.





Productivity is another important driver that we have analyzed, and it is interesting to note that while the US economy had a spike in productivity over the past quarters, Europe had none. One reason is the much wider number of tech companies present in the US compared to Europe, with higher marginal productivity but this fact is not the one and only.



Taking a closer look at the evolution of US productivity CAGR (graph below) over the years with different time spans, we see a surge in the late nineties that normalized over the following years and the previously mentioned spike in the last 5 years.



But breaking down the productivity factors it is clear that technology is not the only driver of the recent surge; fiscal incentives and changes in labor composition played an important role as well. Since the beginning of the pandemic, the entertainment, hospitality, and service sectors, in general, were disproportionally hit by a dramatic reduction in employment. This labor composition change in favor of more capital intensive or technologically advanced sectors has generated an artificial spike in productivity, which we believe will not be sustainable. The capital intensity in the “non-service” sectors is much higher and explains the pick-up in total factor productivity.

During “traditional” recessions, the service sector is the most resilient, but during the Covid crisis, it was the hardest hit (figure below) and, considering that consumption makes up circa 70% of the US economy, the impact on productivity is not trivial, in our opinion.



At this point, after having outlined the main drivers of growth, it is interesting to zoom out the focus and assess the regional contribution to the growth of global GDP. Comparing the two main world economies we see that China’s contribution to GDP growth after peaking in 2015, a period where they invested billions in CAPEX for the industrialization of the country, is declining and we can see from below that China’s GDP contribution went from more than 30% in 2015 to less than 20% (and it will decline further thanks to the current real estate crisis) which means a contraction of more than ten percentage points in just 5 years while on the other hand, the US’s GDP contribution has been relatively stable over the last decade.



For what concern inflation, being a driver of growth, we agree with the FED that blames the current spike in inflation on the huge shock to the global supply chain caused by the pandemic. In our opinion, this thesis is underpinned by the fact that the velocity of money has reached new lows notwithstanding the pandemic; this reinforces the fact that inflation is not “demand-driven” but supply-driven, because otherwise, we would be seeing a surge in the velocity of money as consequence, in our opinion.



Considering what was just mentioned, we found interesting the comparison between the 10Y US yield with the US PCE Deflator. Focusing on the orange dots, which represent the last two years (’20-’21), it is interesting to note that even if inflation meaningfully spiked over the last two years, long-term rates did not increase proportionally. If the historical relation held we should have experienced a much stronger rise in 10-year yields, which did not manifest. In our opinion, the reason why the yields are currently low could lay in the long terms drivers’ expectations of the market.



Moreover, from the graph depicted below, we have another confirmation of what just claimed; the spread between the TIPS (inflation-protected bonds) and the 10-year yields has widened because of the rise in yields and not due to a pick-up in long term inflation expectations. Normalization of the Global supply chain will bring more clarity on the inflation front, in our opinion.


Finally, we want to show for all the factors expressed in this newsletter the comparison between the 10Y us rate and the natural rate of interest (estimated by the US Federal Reserve); it shows that at the end of 2020 monetary policy was still extremely loose and that there is room to raise rates without big impediments to the growth trajectory of the economy.