Desperation in yield land
Developed market bond yields are melting. No matter where you turn yields are hitting low levels again and central banks continue to shift toward an even more dovish stance. If you are one who believes money and lending should have a “price” and want some return in fixed income, here are a few concerning aspects:
• The US three-month/ten-year slope inverted for first time since the global financial crisis. The probability of recession according to the Federal Reserve Bank of Cleveland is now about 33 per cent. I wouldn’t panic on this one though as it is no longer inverted, and this metric doesn’t guarantee anything.
• Rate move expectations, as per the median forecast of FOMC member projections for the future path of the fed funds rate, showed no rate adjustments for 2019 and only one hike in 2020 which is significantly lower than the December expectations.
• Japan’s ten-year yields have fallen to the lowest level since 2016 and are negative again.
• German ten-year bund yields turned negative … again.
• Yields in Australia and New Zealand, typically seen as high-yielding nations, have now slipped to record lows. New Zealand’s central bank even signalled its next move may be a cut.
• As of now, there is over $10 trillion equivalent of negatively yielding debt globally. The German, Swiss, and Japanese yield curves are all negative out to ten years.
All of this could, of course, change quickly and maybe we have seen the recent lows: to be honest, no one knows. But there are a few implications worth pondering:
1. Can the world handle even modest interest rates? It is becoming increasingly obvious that the sheer level of leverage in the world and the rather pathetic level of productivity is slowly leading us into a position where even miniscule yield increases have the effect of slowing growth and/or depressing animal spirits. If this is truly the case, we may be in for a longer period of anaemic yields simply because the market and the poor fiscal plights of governments simply can’t handle much higher rates.
2. The neutral rate, or the rate at which the Federal Reserve sets rates that don’t inhibit or promote inflation, may be much lower than initially believed. This would also portent to have a much lower interest rate environment overall. This is especially the case if inflation, which has not shown up in any material way for a decade, remains firmly anchored. Maybe now inflation ticks up. But haven’t investment professionals been saying this for years now?
3. Central bank accommodation is truly epic. As Joel Duffy, our head of fixed income recently noted: “After years of this accommodation, markets have been accustomed to central bank support, which has artificially held down interest rates and forced money into equities and corporate credit. A consequence of this ‘reach for yield’ phenomenon, ‘zombie’ companies have had easy access to the debt markets and remained in business longer than would have otherwise been the case.
“This has led to a misallocation of resources and, in turn, negatively impacted productivity. The global central bank experimentation has distorted risk asset pricing and eroded the market’s failing business clearing mechanism.
“Case in point, in March the European Central Bank announced a third ‘targeted longer-term refinancing operations’ where they will offer three-year funding to European (Italian!) banks… the very banks struggling with the European Central Bank imposed policy of negative interest rates.”
I don’t necessarily agree that money was “forced” into risk assets – earnings, for example, have been growing as well as margins so fundamentals have been the main contributor of returns here. I do, however, think we are beginning to push on a string yet again.
Free money is not capitalism and does perpetuate losers and halts the creative destruction needed to boost profitability in some sectors. There needs to be a fair price for money – free is not it. The end game cannot be even more leverage and even lower rates without something breaking.
So what bad actions tend to happen? Complexity. One of the first things you are likely to see as an adviser or consultant is the desperate need for a solution to low yields. This is often seen in pension plans for example.
While low rates tend to depress the liability of the equation for pensions it also depresses expected returns. The easy solution is to change what you buy.
As an example, if consultants tell you the only way to get 8 per cent returns is through private equity or some other esoteric and complex strategy many will resort to shifting allocations in that direction.
Rather than factor in increased contributions or restricting benefits, which are politically unpalatable, it’s much easier to adjust the spreadsheet allocation to more investments that are “expected to yield better outcomes”.
Sadly, as the late Peter Bernstein once said: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.” Private equity seems to be the “solution” lately to this problem. Dan Rasmussen, of Verdad Advisers in Boston, has written a series of pieces including Private Equity: Overvalued and Overrated? that can be found in the American Affairs Journal*.
It offers a very thorough case on considering why this asset class may not offer the answer. In my opinion, private equity with $1.8 trillion in dry powder is likely to underwhelm as an asset class going forward. This surge in capital has created an intensely competitive deal environment and we are likely to see much higher multiples paid as a result.
Higher multiples paid usually means much lower returns. Complex trading strategies are marketed as another option – many involving a semblance of market timing.
These are often theoretically appealing but are unlikely to offer much in terms of enhancement overall if one’s time horizon is sufficiently long. The complexity bias is a huge factor that will almost inevitably pop up frequently going forward (more on this in another article).
It is very difficult for people to accept an environment of slightly lower returns and they will do everything in their power to mitigate this including taking on a much higher levels of risk than they should under the guise of excellence bread from complexity.
So, what is one to do in a world of low yields and rather anaemic growth or expected return? The first thing is to adhere to the serenity prayer: “God, grant me the serenity to accept the things I cannot change ... courage to change the things I can, and wisdom to know the difference.” You cannot change future market returns.
You can increase savings, change your lifestyle, or amend expectations – you just need to choose to do so. You should be wise enough to realise that flashy PowerPoint decks and slick sales pitches do not guarantee great returns and that sometimes making a change doesn’t make a difference.
* Private Equity: Overvalued and Overrated? by Daniel Rasmussen, American Affairs, Spring 2018/Volume II, Number 1, https://americanaffairsjournal.org/2018/02/private-equity-overvalued-overrated/
• Nathan Kowalski CPA, CA, CFA, CIM, FCSI is the chief financial officer of Anchor Investment Management Ltd and can be contacted at email@example.com
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