Up and Down Wall Street
Ultralow Interest Rates Pose Long-Term Challenge
To garner better returns investors will need to take on more risk and wander further afield—say, to emerging markets.These are the days of miracles and wonder, even more so than when Paul Simon wrote those lyrics three decades ago.
We carry the equivalent of a supercomputer of that era in our pockets and the world of communication, data, and entertainment in our hands. We also witness the steady conquest of diseases and maladies that have beset mankind for millennia.
There are other miracles in what’s being eliminated. We’re referring, of course, to driverless automobiles, which eliminates the tedium of dealing with today’s traffic. But the real miracle is featured in a local advertisement, which touts the sale of (brace yourself) gluten-free vodka. Not that there would be any gluten left after the fermentation and distillation to produce ethanol, the alcohol in all spirits. But that’s marketing for you.
The similar miracle of the modern investment world is the negative-interest-rate instrument. Investors have always expected to be paid to let somebody else use their money to buy a house, build a business, and the like. No more.
Negative interest rates have taken over the world, with an estimated $7 trillion in government bonds around the globe yielding less than zero percent. Deutsche Bank Asset Management likens receiving negative interest on a bond or bank deposit to a parking fee for investors’ funds. But that still has given rise to some bizarre situations, such as the instance reported last week by The Wall Street Journal of a Danish homeowner receiving a check from his bank— rather than sending the bank a check—for his mortgage.
But, asks Jason Trennert, head of Strategas Research Partners, how can something be a risk-free investment when one has to pay to own it? A bond with a negative yield guarantees a loss if held to maturity, which doesn’t jibe with most folks’ idea of a safe investment.
Even though negative rates haven’t reached U.S. shores, ultralow bond yields and high-priced stocks have put investors in a kind of “purgatory,” says Matt Kadnar, a member of the asset-allocation team at Grantham Mayo van Otterloo. Every asset class—from bonds to stocks, domestically and globally, plus some alternative investments—offers paltry real-return opportunities, according to GMO’s seven-year forecast.
The best that can be expected in these circumstances is to “eke out returns, hopefully with a positive sign in front of them,” adds Quincy Krosby, chief market strategist at Prudential Annuities. Japan’s experience with two decades of near-zero (and now negative) interest rates offers a chastening example of their potential effects on those trying to save for their retirement. In an extreme anecdote that Krosby relates, various press reports tell of elderly Japanese shoplifting—with the intent of being arrested and jailed, in order to obtain free housing, food, and medical care after their savings had been exhausted.
It’s unlikely that fortunate Barron’s readers would face such a fate. Yet they cannot count on the historic returns to which they have become accustomed. It’s unclear how a traditional 60/40 stock and bond portfolio would provide returns even in the 5% to 6% range in the future, says Adrian Grey, head of fixed-income at Insight Investment Management. That is a far cry from the 7% to 8% future returns assumed by many public pension plans.
A normalization of interest rates, he continues, would lift yields on cash and bonds with a widening of credit spreads, all of which would make for equity head winds. With major gauges such as the Standard & Poor’s 500 index within “spitting distance” of their records, that would mean inevitable capital losses.
Similarly, GMO’s seven-year projections look for a negative 1.2% real (that is, after inflation) annual return from U.S. large-capitalization stocks, owing to their high current valuations resulting from previous appreciation. With gains having been pulled forward by central banks’ stimulus, “we’ve gotten 10 years’ of returns in five years,” GMO’s Kadnar comments. U.S. bonds are likely to do worse, by GMO’s forecast, with a negative 1.7%, and Treasury inflation-protected securities and cash faring slightly better, at negative 0.2% and negative 0.3%, respectively.
To garner better returns requires going further afield, to emerging market equities and bonds, which GMO forecasts will return a real 4.6% and 2.4% per annum, respectively. Their better future return prospects are the product of their battering in recent years, he explains. One alternative investment, timberland, is expected to do the best of GMO’s asset classes, 4.8% in real terms. Still, all of those are well short of the 6.5% real return that U.S. equities historically have provided.
This is the market we have, not the one we want, Prudential’s Krosby observes. But that has resulted in a number of coping mechanisms to deal with low returns.
Ultralow interest rates reflect the global disinflationary head winds, writes Chun Wang of the Leuthold Group. At the same time, tepid nominal economic growth is restraining corporate profit margins; they have limited pricing power but are facing a cost squeeze from increasing wage demands. CEOs’ obvious solution has been to take advantage of cheap money and leverage up, which is the quickest way to boost returns on equity (as the share counts shrink via buybacks). But the market has seen through this financial engineering ploy, he says, rewarding less-leveraged but higher-margin stocks more.
From the investment standpoint, Strategas’ Trennert says, economic historians will probably look upon negative interest rates as a policy error. Also, “It’s certainly causing us to make certain sector calls that feel unnatural and risky to us,” he continues, “like overweighting the consumer-staples sector, trading at 21 times forward earnings, and dropping to neutral the financials, trading at a discount to book value.”
PNC Asset Management Chief Investment Officer Thom Melcher says that ultrahigh-net-worth clients are philosophical and may leave $10 million in cash earning nothing out of a $100 million portfolio rather than risk all of it. A high-class problem, to be sure.
For the rest of us, low returns will mean a combination of working longer, retiring later, and calibrating a lifestyle to cope with longer life expectancies, he says. In other words, a Zen approach—that suffering is inevitable and the result of craving—rather than hoping for some miracles and wonders to escape purgatory.
IN LAST WEEK’S COVER STORY, Janus Capital’s Bill Gross offered a few ideas on how to cope with ultralow yields, including investments where companies borrow cheaply on your behalf, as in the case of mortgage real estate investment trusts. The closed-end municipal-bond funds featured in that issue’s Current Yield column utilize the same tack.
Leverage is always a risky tool, boosting returns when the cost of the borrowing is low or declining, but wreaking havoc when borrowing costs rise. That risk is minimized by the low likelihood in coming months of the Federal Reserve following up on December’s quarter-point increase.
Indeed, according to Bloomberg’s calculations, there is a greater chance of a rate cut at the April 27 meeting of the Federal Open Market Committee—albeit at 2%, a small one—but greater than the zero probability of a hike priced into federal-funds futures market. Punk numbers released last week on retail sales, industrial production, and consumer confidence further argue against a rate hike anytime soon.
Only by the Dec. 14 FOMC confab does the futures market put an over 50% probability of an increase from the current target of 0.25% to 0.5%. Not coincidentally, the aforementioned muni closed-end funds make up a large part of the New York Stock Exchange’s new-high list in recent days, along with other bondlike stocks such as preferred and REITs.
As for the overall market, the S&P 500 added 1.6% for its seventh winning week in the past nine, bringing it within 2.4% of its peak touched last May. Moreover, the big-cap benchmark may be understating the overall market.
Bespoke Investment Group notes that the cumulative advance-decline line of the S&P 500 (the daily tally of the number of rising stocks minus declining ones, going back to the birth of the bull on March 10, 2009) did make a new bull-market high. “That suggests the S&P is actually stronger than what the index’s price is telling us, and the expectation is that price will catch up with breadth and a new high will be made,” B.I.G. comments.
If so, a cynic might wonder if the bull’s run could be his own undoing. A new high in time for the June 14-15 FOMC meeting could raise the (negligible) odds of a hike. The long-awaited initial rate increase last December came as the S&P hovered near its highs, while the decision to push out future rate rises at the March 15-16 confab followed the market’s swoon in the first six weeks of the year.
Then again, even if stocks are at new highs by June, BCA Research notes geopolitical events around the time of the FOMC meeting that would induce the panel to hold off on hikes, including the United Kingdom’s Brexit vote on June 23. Of course, global considerations have figured increasingly in the deliberations of Yellen & Co.
Back in the U.S., the June 7 California primary will tell whether there will be a contested (and contentious) Republican convention, BCA adds, although it’s unclear what impact the potential political turmoil would have on the Federal Reserve. The stock market, however, may be another story.