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.
Investors need to adjust to a world of low and in some cases negative interest rates for the indefinite futureIn 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.
There is growing evidence that a similar pattern is now unfolding in other developed markets. Even with incredibly low yields at the beginning of the year, German government bonds have produced a total return of 4.5 per cent so far this year and UK Gilts have returned just over 12 per cent.
For equities, the Japanese template suggests returns will be much less impressive with greater volatility.
While lower interest rates imply a higher present value of future discounted cashflows, if those low interest rates reflect depressed nominal growth expectations, then disappointing earnings will weigh on equity performance.
Within stock markets, banks are clear losers due to weak loan demand and low interest margins. Japanese banks were partially able to mitigate difficult domestic conditions by becoming increasingly internationally focused, but that avenue is no longer available given low interest rates and weak loan demand globally.
Investors need to understand changes that could upset this low growth, low inflation and low interest rate equilibrium.
There is growing recognition that monetary policy alone is unable to reverse declines in growth and inflation in a balance sheet recession.
A radical shift in policy such as aggressive fiscal expansion would ease downward pressure on bond yields and should benefit equities, particularly banks.
However, history has shown that it takes a crisis to prompt policymakers to make profoundly different choices.
As a global downturn takes hold, interest rates are likely to remain under downward pressure and low interest rates will remain an essential part of any fundamental shift in policy.
In this environment, bonds should outperform equities, interest rate sensitive sectors such as banks should continue to struggle and alternative assets to cash should benefit.
Sebastian Mackay is a fund manager at Invesco
