Generations of investors have grown accustomed to investing with reference to an interest rate cycle but since the 2008 financial crisis, attempts by developed world central banks to raise interest rates towards pre-crisis levels have been short-lived and swiftly reversed.
The Federal Reserve has come closest to a normal interest rate cycle, hiking rates from close to 0 per cent to just over 2 per cent, but is now cutting rates and much of the developed world has negative interest rates.
Moreover, long-term interest rates have fallen dramatically, with the whole German yield curve now negative.
Investors need to adjust to a world of low and in some cases negative interest rates for the indefinite future while being alert to any hint that a radical shift in policy is underway that might ultimately lead to high interest rates.
When thinking about how to invest in a low interest rate world, it is important to understand why interest rates are so low.
There are two important, connected reasons; high private sector debt and low inflation.
In aggregate, global private sector debt is as high as it was prior to the financial crisis despite shifts between various sectors within economies and between different parts of the world.
As a result, the sensitivity of interest costs to interest rates remains extremely high and any attempt by central banks to raise interest rates towards pre-crisis levels triggers stress somewhere in the global economy.
At the same time, inflation is undershooting central bank targets in almost all the developed world.
The extent of the decline in inflation expectations has been material enough to raise doubts about central banks’ ability to generate inflation unless they consider far more radical policy options.
Fortunately, a template exists to help guide us through the investment implications of a low interest rate world – Japan since 1990.
The period that followed the bursting of the 1980s stock market bubble in Japan has been defined as a ‘balance sheet recession’ in which households and companies persistently attempt to improve the health of their own balance sheets by reducing debt, which subsequently undermines growth, making such efforts futile in aggregate.
In order to ease the burden of high debt, interest rates are cut but fail to arrest the onset of a low growth, low inflation equilibrium while the private sector continues to retrench.
To prevent a vicious circle of deflation and rising private debt, government debt increases substantially but without pro-active policies to shift debt from the private to public sector, it remains impossible to escape the low growth and inflation trap.
In this economic environment, there are several broad investment themes that stand out. First, bonds produce steady, positive returns.
Fears of a sudden reversal in interest rates prove unfounded and despite low yields, floored policy rates ensure positive returns with low volatility.
Since January 1990 the Japanese government bond market has returned about 3.5 per cent annually with extremely low volatility and despite very low yields for much of this period.