With a great deal of interest, I’ve been thinking a lot lately about the lack of interest.
There’s a sense that interest rates throughout the western world have – to paraphrase famed Economist Irving Fisher’s famous last words prior to the Great Depression – hit a permanently low plateau. Indeed, the US 30-year bond has recently been yielding less than 2% – a record low. It’s certainly been a one-way street since the ‘80’s:
The Global Financial Crisis is often blamed as the start of our low interest world – a slashing of official interest rates to zero by several of the world’s major central banks and the commencement of “unconventional monetary policy”. However, as can be seen above, the trend was well entrenched long before the GFC.
The business cycle in most nations has certainly been quite different to “normal” since the GFC. Typically, during this phase of an expansion you have relatively full employment, rising inflation and central banks tightening to avoid a possible overheating, resulting in a decline in lending activity. Little of this is the case this time around.
The reasons why interest rates have been on this downward trajectory has surely been the subject of many a PHD thesis. And like many economics subjects, slightly differing theories exist. The simple explanation I’d like to provide at the moment is that it’s a function of the “maturing” of the global economy and western nations in particular. Inflation has been minimal, the growth outlook stable (not necessarily “positive”) and the policy outlook is quite certain. Further, whilst many are unwilling to admit it may be true, central banks have had a positive influence on economic stability. Finally, the creation of significant debt (aka “money”) has created its own demand for risk-free debt securities.
The market is saying “lower for longer”. Surveying the global economic landscape, it’s difficult to say that the market has got this wrong…
I realise that the above statement will enrage quite a few people. Many hold the view that bond yields are being artificially suppressed by central banks, desperate to keep rates low because the “system” is broken and if central banks let yields rise governments would be screwed.
This is simply not true. Whilst central banks may be active traders of bonds across the entire curve, it’s the short end that’s their focus. We’re seeing record inflows into bond ETF’s – these are real investors – Insurance companies, banks, others with restricted investment options – at the long end, this is all legitimate market forces.
At least there’s still yield here in Australia! How about the Swiss:
That’s right – the yield on Swiss government bonds is now negative going out at least 50 years!
Of course, what these yields represent is our “risk-free rate” – our benchmark rate from which to evaluate alternative investment options. We’ve never had such low risk-free rates as we have now and assuming this continues it stands to have a significant impact on investors. What’s captivating me is what this means with respect to prospective returns on other assets. Are traditional wealth creation strategies still going to work in this new world?
I don’t hear a lot of fuss being made about this in Australia. In the US and Europe, a lot of esteemed commentators are talking about this as a new paradigm that stands to have meaningful repercussions throughout the economy. I know that “this time is different” is a dangerous and generally foolish attitude. But there’s real evidence to suggest that when it comes to interest rates we have entered a different world. And not necessarily a “bad” world.
Are these rates “fair”?
Focusing on Australia, here’s 10 years worth of price action on our 10-year bond:
It seems the market is basically saying two things – the economic outlook is not great and the inflation outlook also benign.
Despite recent volatility, it’s fair to say that share markets globally are telling a slightly different story – many major indices are a strong few weeks away from yearly highs – some all-time highs.
Here’s 10 years worth of price action in the ASX200 versus 10-year bond yields:
Or is there another way to look at it? According to many observers, the narrative the stock market is telling is “the growth outlook remains robust, interest rates have come down thus reducing borrowing costs for the corporate and household sectors…the stock market is not at odds with the bond market and is in fact being supported by the bond market.”
It’s true that business and consumers globally are enjoying lower interest rates. Indeed, Denmark’s third largest bank, Jyske Bank recently launched the world’s first negative interest rate mortgage – an interest rate of -0.5%! That one still hurts my head a little. Banking is about collecting a spread between lending and borrowing rates – I can’t quite understand how a bank can turn a profit on such a product.
Its here where we stumble on a key dilemma in terms of interest rate policy. I’ve discussed the mechanics of monetary policy at length in recent months. If the economy isn’t performing as solidly as the central bank wants, they have one, blunt tool – cut interest rates.
The reason I describe this as a “blunt” tool is that whilst they can reduce interest rates (either via “conventional” or “unconventional” policy tools), they have incredibly little control over what impact it has – specifically, what sectors of the economy are the biggest beneficiaries.
RBA Governor Phil Lowe has commented quite specifically on this in recent weeks – his warning to the government is that they need to take fiscal policy action to help the economy…that monetary policy can only do so much and an acknowledgement it can even be counterproductive – robbing savers of interest income and inducing speculation in nonproductive assets.
Speculation certainly is a factor at the moment. One of the most obvious effects of low rates as been to induce yield-hungry investors to bid up the price of anything with any prospective return. This more than anything explains the decoupling of debt and equity markets. It is also logical that during this search for yield, investors are taking risks they wouldn’t normally take – for a prospective return they would normally not be satisfied with.
Whilst I’m not willing to go out on a limb and call this economic and market cycle at an end just yet (although there’s mounting evidence we are close), I believe that hindsight will show that we are very close to the end of the “easy money” trade – with the benefit of hindsight, the continued falling in interest rates has made it easy to make money with simple investment strategies such as being long shares and bonds.
Indeed, many observers believe the trend has caused a bubble in “passive” investing strategies. It’s true that a number of the major index Exchange Traded Funds now own a staggering amount of shares. Its still unclear what the ramifications of this will be when investor appetite declines.
Whilst we may see some continued push higher in risk assets and/or some prolonged sideways action, my expectation is that the returns are going to be much more muted on a medium-term basis.
Let me remind you about one of the iron laws of investing:
The higher the price you pay for an asset, the lower its prospective returns.
This brings me to the big question that’s on my mind. What do prospective returns look like over the medium/long-term?
There are a few “rule of thumb” tools that are often used to estimate prospective returns for various assets. For shares, dividend yield plus nominal GDP growth is seen as a reasonable guide. For property; rental yield plus inflation. For bonds; expected return is seen to be the yield – i.e. if you hold the bond to maturity you get reimbursed its face value thus no capital growth achieved.
These tools have been a relatively poor estimator of potential returns in recent years – investors have enjoyed returns quite a bit above what these models would predict! That’s cause for concern.
Again, the higher the price you pay for an asset, the lower your prospective returns. It doesn’t matter what valuation tool you use, how accurate it is or isn’t – the higher price you pay the lower your prospective returns.
Prices are high in many markets we here in Australia typically focus on – Australian shares, Australian property, US shares… At the same time, the growth outlook is not good. The inflation outlook is not good.
Drilling down into some examples, our banking sector has experienced dramatic growth over the past 20 years or so. CBA for example, has seen its “assets” grow by around 10% per year. “Assets” for a bank are of course largely loans it has made. Then we have BHP, Rio Tinto and Fortescue – riding a wave of higher commodities prices.
It’s these companies that have driven our share market over the past 10 and 20 years. Can they continue their performance against the headwind of low growth and inflation? Can CBA continue to grow its loan book at a pace vastly beyond GDP? Can the banks continue to generate strong profit growth in a falling interest rate environment while its margins begin to get eroded? Will Rio continue to enjoy buoyant commodity prices against a backdrop of slowing global growth? Sure, new leaders will rise up, mature businesses will stagnate, but the economic winds are not in anyone’s favour and our investment managers (be it ourselves or our advisers) need to find the opportunities and bravely shun those investments that have proven so good for so long.
What about residential property? Should we expect price appreciation to continue at a clip that out-paces wage growth and GDP/inflation? From a point in time when we’ve experienced stellar growth for 20+ years?
The typical Aussie investor has enjoyed much success over the past 20 or 30 years with a strategy of “buy a home, buy an investment property, set the super fund to “growth”. My suspicion is that it isn’t going to be as easy over the next 10 to 15 years.
It’s fascinating to study long-term returns – for the stock market in particular. Calculating a long-term average is of course easy. What’s fascinating is to observe how often the return for any given year actually matches the average – very rarely! Indeed, there have been multiple occasions in the past 100 years or so where the 10-year average return on major markets has been negative.
We can think of every day as the new start of a new investment journey. Surveying the economic landscape of today, where we’ve come from and where markets are at right now, it’s an uncomfortable time to be starting a journey.
I believe investors will need to be more focused. A more creative approach will be required to generate what most of us would consider an acceptable return.
I wish us all well on our journey…
This document contains information which is the copyright of Aviator Capital Pty Ltd (AFSL 432803) or relevant third party. Any views expressed in this transmission are those of the individual, except where the individual specifically states them to be the views of Aviator Capital Pty Ltd. Except as required by law, Aviator Capital Pty Ltd does not represent, warrant and/or guarantee that the integrity of this document has been maintained nor is free of errors, interception or interference. You should not copy, disclose or distribute this document without the authority of Aviator Capital Pty Ltd. Aviator Capital Pty Ltd does not accept any liability for any investment decisions made on the basis of this information. This information is intended to provide general information only, without taking into account any particular person’s objectives, financial situation, taxation or needs. It does not constitute financial advice and should not be taken as such. Aviator Capital Pty Ltd urges you to obtain professional advice before proceeding with any financial investment.
Register your interest in this Fund
Lorem ipsum dolor sit amet, consectetur adipiscing elit. Ut elit tellus, luctus nec ullamcorper mattis, pulvinar dapibus leo.
No Interest
No Interest
With a great deal of interest, I’ve been thinking a lot lately about the lack of interest.
There’s a sense that interest rates throughout the western world have – to paraphrase famed Economist Irving Fisher’s famous last words prior to the Great Depression – hit a permanently low plateau. Indeed, the US 30-year bond has recently been yielding less than 2% – a record low. It’s certainly been a one-way street since the ‘80’s:
The Global Financial Crisis is often blamed as the start of our low interest world – a slashing of official interest rates to zero by several of the world’s major central banks and the commencement of “unconventional monetary policy”. However, as can be seen above, the trend was well entrenched long before the GFC.
The business cycle in most nations has certainly been quite different to “normal” since the GFC. Typically, during this phase of an expansion you have relatively full employment, rising inflation and central banks tightening to avoid a possible overheating, resulting in a decline in lending activity. Little of this is the case this time around.
The reasons why interest rates have been on this downward trajectory has surely been the subject of many a PHD thesis. And like many economics subjects, slightly differing theories exist. The simple explanation I’d like to provide at the moment is that it’s a function of the “maturing” of the global economy and western nations in particular. Inflation has been minimal, the growth outlook stable (not necessarily “positive”) and the policy outlook is quite certain. Further, whilst many are unwilling to admit it may be true, central banks have had a positive influence on economic stability. Finally, the creation of significant debt (aka “money”) has created its own demand for risk-free debt securities.
The market is saying “lower for longer”. Surveying the global economic landscape, it’s difficult to say that the market has got this wrong…
I realise that the above statement will enrage quite a few people. Many hold the view that bond yields are being artificially suppressed by central banks, desperate to keep rates low because the “system” is broken and if central banks let yields rise governments would be screwed.
This is simply not true. Whilst central banks may be active traders of bonds across the entire curve, it’s the short end that’s their focus. We’re seeing record inflows into bond ETF’s – these are real investors – Insurance companies, banks, others with restricted investment options – at the long end, this is all legitimate market forces.
At least there’s still yield here in Australia! How about the Swiss:
That’s right – the yield on Swiss government bonds is now negative going out at least 50 years!
Of course, what these yields represent is our “risk-free rate” – our benchmark rate from which to evaluate alternative investment options. We’ve never had such low risk-free rates as we have now and assuming this continues it stands to have a significant impact on investors. What’s captivating me is what this means with respect to prospective returns on other assets. Are traditional wealth creation strategies still going to work in this new world?
I don’t hear a lot of fuss being made about this in Australia. In the US and Europe, a lot of esteemed commentators are talking about this as a new paradigm that stands to have meaningful repercussions throughout the economy. I know that “this time is different” is a dangerous and generally foolish attitude. But there’s real evidence to suggest that when it comes to interest rates we have entered a different world. And not necessarily a “bad” world.
Are these rates “fair”?
Focusing on Australia, here’s 10 years worth of price action on our 10-year bond:
It seems the market is basically saying two things – the economic outlook is not great and the inflation outlook also benign.
Despite recent volatility, it’s fair to say that share markets globally are telling a slightly different story – many major indices are a strong few weeks away from yearly highs – some all-time highs.
Here’s 10 years worth of price action in the ASX200 versus 10-year bond yields:
Or is there another way to look at it? According to many observers, the narrative the stock market is telling is “the growth outlook remains robust, interest rates have come down thus reducing borrowing costs for the corporate and household sectors…the stock market is not at odds with the bond market and is in fact being supported by the bond market.”
It’s true that business and consumers globally are enjoying lower interest rates. Indeed, Denmark’s third largest bank, Jyske Bank recently launched the world’s first negative interest rate mortgage – an interest rate of -0.5%! That one still hurts my head a little. Banking is about collecting a spread between lending and borrowing rates – I can’t quite understand how a bank can turn a profit on such a product.
Its here where we stumble on a key dilemma in terms of interest rate policy. I’ve discussed the mechanics of monetary policy at length in recent months. If the economy isn’t performing as solidly as the central bank wants, they have one, blunt tool – cut interest rates.
The reason I describe this as a “blunt” tool is that whilst they can reduce interest rates (either via “conventional” or “unconventional” policy tools), they have incredibly little control over what impact it has – specifically, what sectors of the economy are the biggest beneficiaries.
RBA Governor Phil Lowe has commented quite specifically on this in recent weeks – his warning to the government is that they need to take fiscal policy action to help the economy…that monetary policy can only do so much and an acknowledgement it can even be counterproductive – robbing savers of interest income and inducing speculation in nonproductive assets.
Speculation certainly is a factor at the moment. One of the most obvious effects of low rates as been to induce yield-hungry investors to bid up the price of anything with any prospective return. This more than anything explains the decoupling of debt and equity markets. It is also logical that during this search for yield, investors are taking risks they wouldn’t normally take – for a prospective return they would normally not be satisfied with.
Whilst I’m not willing to go out on a limb and call this economic and market cycle at an end just yet (although there’s mounting evidence we are close), I believe that hindsight will show that we are very close to the end of the “easy money” trade – with the benefit of hindsight, the continued falling in interest rates has made it easy to make money with simple investment strategies such as being long shares and bonds.
Indeed, many observers believe the trend has caused a bubble in “passive” investing strategies. It’s true that a number of the major index Exchange Traded Funds now own a staggering amount of shares. Its still unclear what the ramifications of this will be when investor appetite declines.
Whilst we may see some continued push higher in risk assets and/or some prolonged sideways action, my expectation is that the returns are going to be much more muted on a medium-term basis.
Let me remind you about one of the iron laws of investing:
The higher the price you pay for an asset, the lower its prospective returns.
This brings me to the big question that’s on my mind. What do prospective returns look like over the medium/long-term?
There are a few “rule of thumb” tools that are often used to estimate prospective returns for various assets. For shares, dividend yield plus nominal GDP growth is seen as a reasonable guide. For property; rental yield plus inflation. For bonds; expected return is seen to be the yield – i.e. if you hold the bond to maturity you get reimbursed its face value thus no capital growth achieved.
These tools have been a relatively poor estimator of potential returns in recent years – investors have enjoyed returns quite a bit above what these models would predict! That’s cause for concern.
Again, the higher the price you pay for an asset, the lower your prospective returns. It doesn’t matter what valuation tool you use, how accurate it is or isn’t – the higher price you pay the lower your prospective returns.
Prices are high in many markets we here in Australia typically focus on – Australian shares, Australian property, US shares… At the same time, the growth outlook is not good. The inflation outlook is not good.
Drilling down into some examples, our banking sector has experienced dramatic growth over the past 20 years or so. CBA for example, has seen its “assets” grow by around 10% per year. “Assets” for a bank are of course largely loans it has made. Then we have BHP, Rio Tinto and Fortescue – riding a wave of higher commodities prices.
It’s these companies that have driven our share market over the past 10 and 20 years. Can they continue their performance against the headwind of low growth and inflation? Can CBA continue to grow its loan book at a pace vastly beyond GDP? Can the banks continue to generate strong profit growth in a falling interest rate environment while its margins begin to get eroded? Will Rio continue to enjoy buoyant commodity prices against a backdrop of slowing global growth? Sure, new leaders will rise up, mature businesses will stagnate, but the economic winds are not in anyone’s favour and our investment managers (be it ourselves or our advisers) need to find the opportunities and bravely shun those investments that have proven so good for so long.
What about residential property? Should we expect price appreciation to continue at a clip that out-paces wage growth and GDP/inflation? From a point in time when we’ve experienced stellar growth for 20+ years?
The typical Aussie investor has enjoyed much success over the past 20 or 30 years with a strategy of “buy a home, buy an investment property, set the super fund to “growth”. My suspicion is that it isn’t going to be as easy over the next 10 to 15 years.
It’s fascinating to study long-term returns – for the stock market in particular. Calculating a long-term average is of course easy. What’s fascinating is to observe how often the return for any given year actually matches the average – very rarely! Indeed, there have been multiple occasions in the past 100 years or so where the 10-year average return on major markets has been negative.
We can think of every day as the new start of a new investment journey. Surveying the economic landscape of today, where we’ve come from and where markets are at right now, it’s an uncomfortable time to be starting a journey.
I believe investors will need to be more focused. A more creative approach will be required to generate what most of us would consider an acceptable return.
I wish us all well on our journey…
This document contains information which is the copyright of Aviator Capital Pty Ltd (AFSL 432803) or relevant third party. Any views expressed in this transmission are those of the individual, except where the individual specifically states them to be the views of Aviator Capital Pty Ltd. Except as required by law, Aviator Capital Pty Ltd does not represent, warrant and/or guarantee that the integrity of this document has been maintained nor is free of errors, interception or interference. You should not copy, disclose or distribute this document without the authority of Aviator Capital Pty Ltd. Aviator Capital Pty Ltd does not accept any liability for any investment decisions made on the basis of this information. This information is intended to provide general information only, without taking into account any particular person’s objectives, financial situation, taxation or needs. It does not constitute financial advice and should not be taken as such. Aviator Capital Pty Ltd urges you to obtain professional advice before proceeding with any financial investment.
Register your interest in this Fund
Lorem ipsum dolor sit amet, consectetur adipiscing elit. Ut elit tellus, luctus nec ullamcorper mattis, pulvinar dapibus leo.