The ‘lower for longer’ interest rate environment we currently find ourselves in has some profound implications for investors taking a long-term outlook.
This is because the return generated by cash is also a component of the returns generated by other asset classes. Therefore, for asset allocators, the effective reduction in cash returns means that purchasing real assets, such as property, now appears to be a better value decision. And while nominal assets, such as bonds, are still relatively expensive they too have become cheaper than they were.
Calculating the value of long-term asset returns allows investors to make a comparison with today’s price. After all, “price is what you pay, value is what you get” or so said the Sage of Omaha.
While the approach to do this will vary slightly across the industry, broadly speaking long-term asset returns are calculated by taking the nominal government bond yield, built from nominal cash returns plus a government bond risk premium, to which risk premia for risky assets are added.
For example, the expected UK equities long-term return is currently around 5.6 per cent but buying today would potentially give a 7 per cent return. We can therefore conclude that UK equities are getting cheaper when volatility is factored in.
Events in the macroeconomic environment will of course have an impact on these calculations. Recently there has been a fundamental shift in the longer-term equilibrium level of real cash rates as a result of changes to global spot and forward rates, as well as commentary issued by central banks, particularly in UK and US. We read about this almost daily as ‘lower for longer’ headlines fill our newspapers.
Both the real cash rates and inflation rates for Europe have also reduced, reflecting structural differences in Europe that result in lower real cash rates and structurally lower inflation rates in the medium and longer-term.
While market expectations for a rate hike in the UK have been pushed back from the first quarter of 2015 to the second half of the year, it now looks likely that the US Federal Reserve will be the first of the major advanced economy central banks to hike rates, probably around mid-2015.
By comparison, the Bank of Japan and the ECB are undertaking further monetary easing measures.
Interest rates in the US and UK may rise sooner than expected though currently disinflationary pressures exist, largely stemming from lower commodity prices. Likewise interest rates could rise if central bankers decide that there is less economic slack than they had originally anticipated. This has the potential to result in market volatility as investors react to the short-term noise.
However, in the medium-term the market expects interest rates to “normalise”, but central bankers continue to stress that these are likely to be lower than historical norms.
This is visible in the UK with interest rates expectations moving sharply downwards. At the start of this year the market expected interest rates to stabilise at 4 per cent by 2019/2020 but that expectation has since fallen to 2.5 per cent.
The pre-crisis norm was 4.5 per cent. Even after rate hikes start in 2015, they are expected to remain gradual and limited, such that they will only reach 2 per cent in mid-2018.
In contrast the eurozone curve is pricing rates to remain below 1 per cent until 2020 while the US curve is steeper than that of the UK, with rates expected to be about 3 per cent in 2020.
Accommodative monetary policy in the major advanced economies has helped to dampen volatility and we have seen investors take on additional risk in search of better returns.
However, if the US Federal Reserve raises rates earlier than market participants expect, volatility levels could increase. And even if rates only rise in line with market expectations, there is still a risk that markets could react badly and there is a repeat of the “taper tantrum” that occurred in mid-2013.
This would hit emerging markets hard, although we would argue that they are generally better placed now than a year ago to withstand shocks. Markets are also now more likely to differentiate between stronger and weaker emerging economies than was the case in mid-2013 and again in early 2014.
On this basis, the peripheral eurozone economies will be better shielded from market volatility due to the ECB loosening its policy to ward off the spectre of deflation and stimulate economic growth.
If major central banks tighten too gradually and too late, this risks the creation of asset bubbles that would force a severe economic adjustment.
Where could we go from here?
The continued distortion of asset prices by policy actions makes having a strong conviction around fundamental indicators challenging and the winding-up of several years of highly accommodative monetary conditions is unchartered territory. In addition, the potential for a ‘hard-landing’ in China, as its growth rate slows, adds an additional layer of complexity.
While, of course, the debate around market expectations of interest rates is a complex one and is not something that fund managers or investors can control, its impact on asset return assumptions makes it an important consideration when setting long-term investment objectives.
Andy Brown is investment director of Prudential Portfolio Management Group
Key points:
The ‘lower for longer’ interest rate environment we currently find ourselves in has some profound implications for investors taking a long-term outlook.
It now looks likely that the US Federal Reserve will be the first of the major advanced economy central banks to hike rates, probably around mid-2015.
If the US Federal Reserve raises rates earlier than market participants expect, volatility levels could increase.
