Are we drowning in negative rates?

Monthly Investment Letter

Sub-zero rates
Stock markets responded positively to the introduction of quantitative easing. But investors have been more skeptical of negative rates, fearing that unintended consequences may overwhelm any positive effects

Here to stay
Low or negative rates are here to stay in many parts of the world. That further reduces the appeal of high grade bonds over coming years

Investment concepts
Some alternative investment concepts, pioneered by institutions such as hedge funds or endowments, can be applied by private investors to help achieve their objectives in this low yield environment

Asset allocation
We remove our underweight position in emerging market equities relative to Eurozone stocks. We also close our short position in the Japanese yen, and add to our short position in the Australian dollar

Negative rates in Denmark mean that some people are receiving mortgage interest payments from their bank. Certain cantons in Swit-zerland are asking residents not to make monthly tax payments. And in Japan, peo-ple have taken to buying home safes for fear of paying interest on their bank de-posits. But this era will be remembered for more than a few quirky anecdotes.

The unexpected decision by the Bank of Japan (BoJ) to push rates below zero has rekindled fears that central banks are run-ning out of ideas to stimulate growth and inflation. While central banks in Europe have taken that route before, the move has solidified the markets’ perception of desperation – and perhaps helplessness – among policymakers after more than half a decade of quantitative easing. Investors are no longer just worried about the tenac-ity of slow growth; they have also become concerned about the potential effects of negative rates on financial stability.

In the months and years ahead, negative interest-rate policy will present both a key danger and opportunity for investors. The short-term outlook will be driven by the measures to revitalize growth, and long-term return assumptions are undergoing change as markets price in an increasing likelihood that rates will remain low or negative long into the future.

The plunge in yields across the debt matu-rity curve indicates that the already muted long-term outlook for high-quality bonds, such as US Treasuries, has gotten even worse. In our view, this raises the attrac-tiveness of hedge funds, which could pro-vide higher returns over the long term with only limited additional risk to the portfo-lio. We also advise investors to diversify their bond holdings across a wider range of monetary regimes to mitigate portfolio risks that result from variation in global policy settings and successes.

Meeting the challenge of negative rates will be a key determinant of success in the years ahead. I am hopeful that our thinking around proper diversification and a well-structured strategic asset allocation can help to protect and grow your wealth in a difficult environment. 

Unexpected reactions

The markets reacted positively to quantitative easing when it was first deployed by the US Federal Reserve during the global crisis. And when the European Central Bank and the Swiss National Bank introduced negative interest rates in 2014, it caused little upset in financial markets. But the Bank of Japan’s surprise move to sub-zero interest rates in January marked a change in the historical reaction function to central bank policy.

The Bank of Japan’s surprise move to sub-zero interest rates in January marked a change in the historical reaction to central bank policy

Usually greeted with equity market cheer, the rate cut precipitated a sharp decline in Japanese banking stocks. This reaction was repeated in March, when Eurozone financial stocks fell after the ECB cut rates more deeply into negative territory. These reactions demonstrate the growing unease about the impact of negative interest rates on bank profitability. Lower long-term yields are also now raising questions about the health of the insurance and pension industries, which may need to take excess risks to meet their obligations.

On the other hand, the bond market reacted with perhaps too much cheer. Short-matu-rity bonds received a boost, as can be expected, but long-dated bonds staged an even sharper rally. These reactions suggest that markets are skeptical about the long-term positive effect of negative rates on growth and inflation.

Zero or negative bond yields indicate markets are not priced for a pick-up in growth or inflation

Currencies have also stopped behaving by the book. Instead of depreciating, the Japa-nese yen appreciated in response to the BoJ’s rate cut, while the euro is up 4.4% since the start of the year. A variety of factors are at play, but part of this unusual performance could be the result of action from the central banks themselves. The Eurozone’s targeted long-term refinancing operations – which now reward banks for borrowing from the ECB – and the potential for a similar measure in Japan, designed to help support bank profitability, might act as de facto capital controls, given that loans made domestically are subsidized, while those made overseas are not.

The recent rise of the yen has marked a shift in the market reaction to additional monetary easing

Despite the uncertainty over the positive impact of negative rates, there is little sign that central banks are losing faith in this experimental policy. Both Mario Draghi of the ECB and Haruhiko Kuroda of the BoJ have mounted staunch defenses of negative rates in recent months. We do not expect either one to reverse course anytime soon. 

Dealing with an uncertain world

The interplay between negative interest-rate policy, its second-order effects, and the cen-tral bank retort to those effects is complex and requires a considered investor response.

The decline in global rates means that we now expect many sovereign bonds to deliver negative returns over the medium term. High-quality bonds have insurance value, but the asset class is becoming expensive. We therefore advise investors to consider moving some portion of their fixed income holdings into hedge funds. While hedge funds have been buffeted by regulatory changes, stock-specific issues, and sudden reversals of mar-ket trends, the industry still attracts the strongest investment talent able to deliver excess returns. We expect hedge funds to generate solid single-digit percentage returns over a longer time horizon.

Portfolio shifts can help investors adjust to an uncertain market environment, but the fundamental issue of finding higher returns in a low-return world, without taking undue risks, remains. To help address this, investors may choose to adopt one or more of the following strategies: 

Beyond benchmark fixed income investing 

Investors who are uncomfortable with taking any equity risk at all are presented with very limited options for higher returns in the traditional fixed income uni-verse. We expect the Barclays US Government index to return 2.2% and the Bar-clays US Corporate Index to return 3.5% over the medium to long term. Yields in non-US bond markets indicate their returns may be even lower over the same period.

Fixed income investors have the potential to increase returns through greater
diversification

But by accessing some less traditional and less liquid instruments in the fixed income universe, investors looking to invest purely in fixed income have the potential to earn higher returns. A fuller fixed income universe could include securitized asset-backed securities, subordinated financial bonds, senior loans, and private debt, alongside more traditional corporate and sovereign bonds. The ideal bond portfolio would have exposure to a wide range of geographies and monetary regimes to ensure necessary diversification.

Endowment style concept 

Extending the idea of using less liquid asset classes to earn higher returns, inves-tors may draw upon the approach of successful endowment funds to allocate a higher proportion of their assets to illiquid alternative asset classes, including hedge funds, private equity, private debt, and real estate. 

Tactical asset allocation

In the months ahead, uncertainty over the impact of negative interest rates will be a key market driver. Our tactical view remains that negative rates may be imperfect, but they demonstrate the willingness among central banks to continue to innovate and supply liquidity to global markets. We believe this is, overall, supportive of risky assets.

We maintain an overweight position in US equities and US investment grade credit

We maintain an overweight position in US equities. We expect US profits to improve after the current earnings season, as the oil price recovery, dollar weakness, and ongoing strength in consumption feed into profits.

We also maintain an overweight in US investment grade credit. Low interest rates will continue to drive a thirst for yield. The low risk of a US recession and a resumption in credit market stress from earlier in the year make this a risk worth taking for diversified investors.

Finally, we maintain an overweight in European high yield credit relative to high grade bonds. Negative rates will continue to drive a thirst for yield, and liquidity from the ECB should help keep default rates low.

We are making three changes to our House View this month:

First, we  are neutralizing our underweight position in emerging market equities relative to Eurozone equities

China’s stimulus package, a more dovish Fed, and progress in Brazil’s political saga have improved sentiment in emerging markets. We have reservations about earnings growth and the long-term impact of China’s stimulus, but the rally has scope to continue in our view, so we move emerging markets to neutral from underweight.

In the Eurozone, negative interest rates have soured banks’ earnings outlook. Economic growth remains decent, but with the prospects for earnings expansion now being more limited, we move the Eurozone from overweight to neutral.

Economic data is improving in EM, but has soften in the Eurozone, where headwinds are increasing

Second, we are introducing an underweight position in the Australian dollar versus the US dollar.

We believe that the recent recovery in the Australian economy is unsustainable, while US growth is likely to rebound after a soft patch over the last two quarters. This divergence in economic performance is likely to be reflected in monetary policy decisions, which we expect to weaken the Australian dollar.

Finally, we neutralize our underweight position in the Japanese yen relative to the US dollar.

The latest Bank of Japan meeting suggests that the central bank is in a wait-and-see mode, in spite of weakening economic data. The recent strength in the yen means that Japanese investors in foreign assets, including the government’s pension fund, are now considering whether to hedge their foreign exchange exposure. Such risk management measures could prevent the yen from weakening in the near future, and we move to neutral.

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