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What Do Low Interest Rates Mean for Equity Investors

October 16, 2019
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Here is what low- and negative- interest rates look like:

A 10-year US treasury: Price $99.50, pays $1.60 per year and $100 on 8/15/29.
A 10-year German treasury: Price €105.86, pays €0 per year and €100 on 8/15/29!

This low-interest-rate environment is the result of multiple factors. Among them are central bank intervention, demographics, and persistently low inflation.

What does this mean for investors?

1. First, it makes bonds less attractive for those seeking material investment profits. There is simply little yield available from safe bonds.

2. Second, it makes other asset classes look more attractive by comparison...but only to a point. Savers could put their money into stocks, real estate, gold, art… the list goes on, but none are perfect substitutes for bonds. Those other investments are either more volatile (which is to say they come with a greater risk of loss) and/or less liquid (meaning you can’t sell them as quickly or easily) compared to bonds. The earnings yield on stocks and the yield on bonds tracked each other for decades. But that relationship decoupled in the post-crisis low‑interest‑rate world, suggesting the “substitutability” of stocks for bonds has reached a limit. 

3. Third, borrowing costs are very low around the world. That may be of little interest to savers who don’t need to borrow, but it does help companies and citizens; their borrowing spurs economic growth which helps all investors.

What is the market telling us?

➢ The power of central bank tools is waning. “Central bank tools” refers to the way the Federal Reserve influences economic growth. For ten years, the Fed has been stimulating the economy by setting short-term borrowing rates low and by buying bonds to also lower long‑term borrowing rates. Low rates work in two ways: encouraging economic activity (the “easy money effect”); and boosting the prices of bonds, stocks, real estate, gold, etc. (The “wealth effect.”) As rates approach zero, the boost to other asset prices is less strong than it was.

Photo of a computer keyboard with the words "Interest" and "Rates" on the Enter and Shift keys

➢ The market may be anticipating deflation. Historically, one dollar buys more stuff today than it will buy in a decade. That is inflation; the price of goods goes up over time, which is to say the buying power of a dollar goes down over time. Occasionally throughout history, we experience the opposite effect, called deflation. Let’s say $10 will buy a lunch today, but you expect the same $10 to buy two lunches in a decade. The purchasing power of your money will be doubling, even if you keep it in your pocket. That is a world in which investors will not demand much interest. It may sound fine, but deflation comes with many ugly side effects and would be a grave concern for our economy.

➢ Future real returns (after inflation) might be low from all asset classes. In a free market, asset prices should settle at levels that are appropriate to each other based on their risk/return characteristics. If indeed equities, real estate, and other assets key off bonds for their valuation, and they have done so appropriately, then future returns from these asset classes will also be low. It is possible that we have “pulled forward” future returns over the past decade, and the next decade will require a catch-up period in which returns from stocks and bonds will disappoint. 

Conclusion

Investors are in a situation with little precedent: central banks around the world have intervened in free markets more than ever. Historically, the side effect of an over-active central bank is that it encourages misallocation of capital. That means investors end up taking too much risk in order to achieve a target return. The best solution for this is to stay properly allocated and properly diversified, to avoid “stretching for returns” into too-risky territory. This is what we do for you at Cabot, we properly allocate and properly diversify your portfolios.

Photo Source: "InvestmentZen" | www.investmentzen.com