You’ve heard the expression, “We live in interesting times.” Substitute the words “uncertain,” “experimental,” or simply “scary” for “interesting,” and you will capture the feeling of many investors, especially those who have already retired or are approaching it. As I write, the media tells me that, by almost any standard measure, equity valuations are too high. For example, trailing PE ratios are 20x, 5 points above the historical mean. To a certain extent, high equity prices are due to yield-hungry investors chasing dividends, as I explained in my last column. In what follows, I examine some alternatives that traditional fixed-income investors have shied away from due to textbook cautions, but that now may be worthwhile exploring.
The baby boomers control a disproportionate share of the nation’s wealth. Yet nearly eight years after the end of the financial crisis, the boomers’ net worth is still 13 percent lower than it was pre-crisis. And they had to absorb two 50-percent-equity market corrections in an eight-year period (2001 and 2009). Having endured those corrections, it would be natural for this generation to be indisposed to capital risk; and we find historically, retirees prefer to “clip coupons” (collect interest payments from bonds) rather than be exposed to the capital risk of the equity markets.
The “interesting” part of today’s fixed income market is, in a time when investors need yield more than ever (due to 2001 and 2009), it simply doesn’t exist in traditional formats, and most likely won’t again for many more years. To the retiree, today’s investment world is just scary. The stock market looks way too pricey, but that appears to be the only way to get any kind of return. On the other hand, investors are cautious about investing in any fixed-income financial instrument that is long-term in nature, as they fear the Scylla and Charybdis of inflation and duration risk. Inflation risk is self-explanatory. Duration risk, also known as interest rate risk, occurs when interest rates rise and the value of long-maturity bonds are significantly lowered. To explain this risk, consider that the value of a perpetual bond with a 1 percent coupon is halved if rates go from 1 percent to 2 percent, but the value of a similar bond that matures tomorrow is barely impacted if rates double overnight.
On a daily basis, the media tells investors that interest rates have never been lower in the 5,000 years of recorded history, and the doom and gloom artists are ever-present, cautioning that some unthinkable monetary disaster is close at hand. They warn that we are either going to get rapid inflation, rapidly rising interest rates, or both. Thus, investors must stay away from long-term fixed income investments. Under this advice, things look bleak — the stock market is too high by historical measures, as is the value of long-term bonds with interest rates that can only go one way: up!
But the reality is that experimental monetary policies, like QE, and negative interest rates in Europe and Japan continue to pressure the world’s yield curves lower. And the downward pressure on these yield curves is going to continue for two reasons: 1) the domestic demand of yield hungry baby boomers, and 2) foreign investor demand who look at the 10-Year U.S. Treasury Note yield of 1.5 percent as a bargain when compared to negative rates on Japanese and German 10-year government securities and 0.8 percent on U.K. paper. Furthermore, given worldwide production overcapacity and only slowly growing demand, we can expect continued worldwide monetary ease, with the next experimental monetary policy being something called “helicopter money.” Under this scenario, central banks simply directly monetize government deficits, most likely at or near 0 percent interest. In addition, the issued bonds are likely to be perpetual bonds, so they will sit forever on the central bank balance sheet, as no private investor would ever purchase such an instrument!
The point here is that there are very few economic pressures pushing interest rates up. There is no inflation to fight (the forces of DDT – demographics, deleveraging, and technology are actually deflationary). In addition, the U.S. economy (worldwide too) is struggling for growth. If the Fed made the major faux pas of raising rates again, it would likely tip the already anemic U.S. economy into recession. In 2015, we saw the significant impact of a strong U.S. dollar on the U.S. manufacturing sector, a scenario that would be repeated if the Fed raises rates again. Furthermore, at a 1 percent growth rate, it wouldn’t take a significant shock to knock the economy into recession which would require much more of a monetary policy response than the mere reversal of the rate hike(s). The latest minutes out of the Fed’s FOMC policy committee reveal significantly different views among the vote holders; when there is that much uncertainty, the Fed can’t move.
So, due to the industrial world’s demographics, current low growth and overcapacity, and deflationary forces generally, there is little danger that interest rates can sustainably rise. So the twin bogeymen issues of inflation and duration risk are really nothing more than paper tigers. “Lower for longer,” much longer, means that moving out the yield curve to longer duration fixed-income assets may be a partial solution for the yield-hungry baby boomers.