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Intended and Unintended consequences of negative interest rates

26 August 2019 Rob Price, Head of Asset Allocation at Alexander Forbes

Central banks have once again dominated asset class returns in the first half of 2019. After one of the worst quarters for global equity markets in Q4 2018, the Fed came to the party in early 2019 with a noticeable change in its interest rate trajectory. At the start of 2019, the market expected the Fed to raise interest rates 4 times. Now, the market is pricing the potential that rates could fall 4 times over the next year. The Fed is mandated to focus on economic growth and inflation but the marked change in tone from Q4 2018 to Q1 2019 suggests equity markets might be slipping into focus. Interest rates are the price of money, the most important variable in the global economy, so the change in interest rate trajectory is impactful. Equities responded positively because investors use the lower discount rate to price a more optimistic future. Bond markets have rallied aggressively as investors become sceptical about the potential for interest rates to rise in the future. Given the inability of the Federal Reserve to fulfil on its promise to “normalise” interest rates, who can blame them?

Equity party but what about the economy?

The performance of Emerging Market (EM) equities relative to Developed Markets (DM) has been disappointing in 2019 thus far but the valuations of EMs relative to DMs are compelling, which, combined with the overvalued nature of the USD, suggests good return prospects from EMs over the coming years. South African equity markets have gained, in line with global peers. Going forward, our real, CPI-adjusted, return expectations from global equity are reasonable (around 5% p.a. over five years), but not comparable with historical levels. Lower interest rates can keep equities more supported than otherwise, which is what central banks intended. But what about the unintended consequences? Economic growth remains a challenge and lower rates are unlikely to dramatically improve the prospects because the global economy is already saturated with debt. Will people really be emboldened to save and invest at these rates of interest? This question is important because savings and investments are the real drivers of long-term growth. If we’re unable to generate savings and investments, then the global economy really needs to question whether these unorthodox economic policies are really achieving the desired outcomes. We’re concerned with the long-term growth prospects because low rates encourage capital consumption, rather than production.

Figure 1: Long-term trend in US rates remains lower 

Figure 2:  SA Equity return expectations contained

Source: Alexander Forbes Investments

SA Equity constrained by local growth


South African equity has also benefited from the lower interest rates in the developed world. Long-term South African equity return expectations are lower than developed and EM due to the weak economic growth prospects offered by South Africa (as well as more expensive valuations). It’s pretty noteworthy that South African equity has barely produced positive real returns over the last 5 years, highlighting the challenge for South African funds. Private markets can extract pockets of economic outperformance and contend against the volatility we expect in listed financial markets. Unlisted credit, bonds and infrastructure projects are also a potential opportunity, given that they have a slightly lower risk relative to private equity and often offer returns that are linked to CPI.

While the SARB is under pressure to assist the local economy, lower interest rates are unlikely to provide significant support. SA’s economic constraints are not due to a lack of debt, but due to poor economic policy and capital allocation. Using low interest rates as a tool to paper over the cracks through a short-term increase in credit card debt would be slipping into the same trap as many developed markets.

Negatively yielding bonds isn’t healthy


Global bonds might continue to benefit from lower growth, inflation and interest rate expectations in DMs but we aren’t enamoured by this asset class for long-term focused portfolios. Bond yields are incredibly low (negative in some regions), which doesn’t bode well for long-term returns when yield should be the primary determinant of bond performance.

Figure 3: Developed Market real yields are falling again 

Figure 4: 24% of the Barclays Aggregate Bond Index is negatively yielding

Source: Alexander Forbes Investments

Approximately 20% of the $50tn global bond market has negative yields, which is an increasingly troublesome factor for capital allocators. The first aspect to consider is the “search for yield.” Low rates in the developed world implies that investors will likely seek out higher returning assets elsewhere. Equities and EM debt are two of the beneficiaries of these flows. Unfortunately, the flows don’t necessarily imply an improvement in the credit risk of the recipients. South Africa is a prime example. South African bond markets have performed incredibly well this year despite the ongoing fiscal risks posed by the SOEs and the increasing debt burden. We continue to expect reasonable performance of SA bonds because of the attractive yield differential between South Africa, its global peers, and the still contained domestic inflation outlook, but we are also cognisant of the continued fiscal risks on the horizon.

Greece is another example where yields don’t reflect risk. Greek bond yields have converged in US yields. The divergence between underlying risk and actual financial market performance can be difficult to reconcile in a world of ultra-low interest rates and can lead to increasing volatility. Volatility remains a long-standing asset allocation theme and we’re focused on asset classes that can benefit from volatility.

Where do people store their value?

Another noteworthy development is a strength in a store of value commodity like gold. Gold doesn’t earn any interest and isn’t used much in economic production. Its scarcity and durability merely means that it has been a good store of value through the ages, i.e. held its purchasing power. This store of value attribute becomes attractive when it’s difficult to store value in cash and bonds. Luckily, the SARB’s policies imply that South Africa isn’t contending with the negative rates seen in the developed world but we’re obviously influenced by global market developments.

Low return theme intact

Strength in gold, negative bonds and further troubles in the European banking system with Germany’s biggest bank, Deutsche Bank (who recently announced that it would cut as many as 18 000 jobs or 20% of its workforce), are not signs of a global economy firing from all cylinders. We take this as another signal that economic growth prospects are constrained and a further confirmation of our low long-term return theme.

Difficult to store value in cash

Lower US interest rates also imply that US cash, an asset class that served portfolios well during 2018 when it was the strongest performer, has become less attractive. US cash could still perform well during times of financial market distress, but it’s clearly less attractive than it was. Lower US interest rates are also a factor supporting the South African rand. Attractive yield differentials between SA and the US could extend this trend towards the rand for a while, but we do not expect an extended rand strengthening cycle to ensue.

Summary and outlook

Global economic growth risks remain on the horizon, which is exactly why central banks have turned more supportive again. If global economic growth deteriorates further, it could cause a re-pricing of risk so it’s not the time to go gung-ho into risk assets. That being said, we’re aware that lower rates will keep equities more elevated than otherwise. Our risk management lens continues to focus on the low long-term returns and the capital protection mind-set required at this stage of the cycle. This balanced approach to risk management implies that portfolio returns have remained strong through both the 2018 market weakness and the H1 2019 recovery.

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