The ‘New Neutral’ Is Here

That’s bad news for those who manage public money.
April 2015
The old rules may no longer apply when it comes to borrowing for new projects. David Kidd
By Justin Marlowe  |  Columnist
A research professor at the University of Chicago’s Harris School of Public Policy

The great philosopher-turned-catcher Yogi Berra once said, “It’s tough to make predictions, especially about the future.” Apparently he knew finance like he knew baseball. This past decade we’ve seen a parade of financial developments that few people predicted, starting with a real estate crisis and continuing through today’s sluggish and uneven economic recovery.

Even when financial soothsayers are wrong about the future, they force us to think about why it will look the way it will. In other words, they challenge the conventional wisdom. A recent financial prediction -- known as “the new neutral” -- is no exception.

The new neutral is brought to you by the folks at the Pacific Investment Management Company. PIMCO is one of the largest investment companies in the world. It manages about $2 trillion in assets, including an enormous amount of government bonds. So when they talk about our financial future, finance people listen.

In 2011 PIMCO made a bold prediction. It said that over the next several years central banks around the world, including the U.S. Federal Reserve, would keep interest rates at record low levels, but economies would grow much more slowly than before the Great Recession. This seemed to violate the basic laws of financial gravity, namely that lower interest rates are supposed to fuel economic growth. PIMCO called this contradictory state of financial affairs “the new normal.” Its prediction was mostly right, the phrase stuck and the rest is history.

With its latest prediction, PIMCO is arguing that for the next three to five years, central banks will expect slower economic growth, and will manage interest rates accordingly. This could mean low rates and stable financial markets to come, but also slow economic growth and weak profits for investors. If it’s true, the new neutral thesis challenges some core pieces of conventional wisdom about state and local government finance today.

The new neutral is bad news if you manage public money. Most public pension funds assume annual investment returns of 7 to 8 percent. Under the new neutral, pensions can probably expect annual returns of 2 to 3 percent for the next few years. That could mean more pressure on states and municipalities to increase their annual pension fund contributions, or move more money assets into riskier investments that might produce higher returns.

It’s a conundrum for capital investments as well. Throughout the past three years, hundreds of state and local governments seized on what looked like a brief window of opportunity to refinance their old, high-interest-rate debt. After all, they thought, interest rates could only stay so low for so long. At the same time, they and other governments tried not to borrow new money for new projects until their revenue forecasts improved. The new neutral suggests they’re wrong on both counts. It turns out rates can and probably will stay low for some time.

And in the meantime, slow economic growth will mean flat revenues for at least a few more years. So if you accept the logic of the new neutral, strange as it sounds, now is the time to suspend disbelief and take on some new projects.

It also means “relative value” matters more than ever. When interest rates are low and there’s little or no volatility, investors’ options are limited. But one option they do have is to buy and sell bonds that should trade at comparable prices but don’t. Prices on otherwise similar bonds can diverge because of subtle changes in tax laws, differences in local financial management strategy, changes in pension or retiree health-care obligations, or countless other factors. For state and local financial managers, this means knowing who investors consider are your peer governments, and how you stack up to those peers.

Of course, the new neutral could be the latest failed attempt to make sense of an uncertain future. But if it’s right, even a little, it will have done soothsayers proud.