Base Case: Low for Longer
In simple terms, our base case view is that global sovereign bond yields will stay low for some time. This scenario is supported by many factors. First, for structural reasons related to the global working age population, labor force participation, and productivity, it’s difficult to envision a sustained and meaningful pickup in potential real growth rates in most of the developed world.
On top of slow real growth, we have to factor in inflation expectations to derive a nominal change in yields. Here the current trend argues for continued modest inflation. While bank balance sheets remain bloated with reserves and assets from global quantitative easing (QE)1 operations, little of that cash seems to be “chasing goods.” Low rates have impaired the market’s natural competitive forces, leading to zombie companies who keep the aggregate supply of goods and services high. These zombies can survive, but they can’t thrive, so wages rise slowly (if at all) and the Phillips curve2 remains relatively flat, so the transmission to inflation has been almost nonexistent. Central bankers can’t seem to reach their inflation targets and most are beginning to worry that won’t change.
With central banks still more concerned about deflation than inflation, their forward guidance is clear: Few are in a hurry to raise rates. Not surprisingly, as sovereign and corporate borrowers have binged on historically low/negative rates, leverage ratios have shot up. Any meaningful increase in yields will cause debt service to skyrocket. Sovereign fiscal space would be crowded out by interest payments and corporate defaults would rise. As policy approaches the zero-bound, there is a gravitational pull to low rates and central bankers are already feeling it. The European Central Bank (ECB) impaired the Eurozone recovery by leaving rates too high in 2011–12 while the Fed’s attempt to “normalize” (raising rates and winding down its balance sheet) was met with an almost 20% drawdown in the S&P 500®3 late last year. Perhaps we’re over-extrapolating recent trends, but we see low for longer as the most likely scenario. (We’ll deal with lower for longer below.)
We believe the investor implications are fairly straightforward. Bonds derive the bulk of their returns from current income (i.e. “clipping the coupon”), so low yields translate into low returns. We can restate that more pessimistically: historically low yields will result in historically low long-term returns for bonds.
Now for somewhat better news. In this scenario, stocks could essentially decouple from global interest rate dynamics. The status quo yield environment we describe is likely to coexist with an economy that is growing, but not very fast – again, extrapolating the current trend. Earnings won’t collapse, but they won’t thrive either. Bottom-line earnings are unlikely to materially outpace sluggish top-line growth as profit margins are already high. Finally, equity valuations aren’t exorbitant, but they are elevated, so investors shouldn’t expect much of a boost to total returns from multiple expansion. Where does this leave the typical “moderate” 60%/40% investor in the long run? With positive but sub-par returns on 100% of their portfolio. (We’ll leave the credit sectors of the bond market aside for now, as we view them as a blend of interest rate risk and equity-like/credit risk, with lower quality bonds acting more equity-like.)
Finally, let’s not forget the good news: If inflation remains benign (as implied by this forecast), real returns may hold up a bit better even if investors are disappointed by their nominal returns.
Scenario #1: Rates Rise
Sadly, for all our blather, you can probably ignore the previous paragraphs. While low for longer is our base case, rates are notoriously difficult to forecast and we have no magic powers in this area. (We’re skeptical of everyone else’s “skill” in this realm as well.)
Having confessed to our inability to accurately forecast rates, it’s only responsible to investigate other scenarios. What if we are wrong and rates rise, either because we have taken too dour a view of real growth or because inflation mysteriously begins to perk up? Additionally, strength in the economy might finally allow central bankers to normalize policy.
Sadly, we’re not sure this would change much. Yes, in the very long run, investors and savers will gradually start pocketing the benefits of higher income as yields rise. But this would occur only after they had endured potentially horrific near-term losses on their bond portfolios due to falling prices, with little income buffer and crushingly long durations.
But wouldn’t stocks do better? Maybe, but that’s no slam dunk either. Organic earnings growth could certainly improve commensurate with a stronger global outlook, but even then, rising debt servicing costs would be a drag on profits. Moreover, the upside constraints to both profit margins and price-earnings ratios4 would still exist. Whatever gains equities might experience would almost certainly come with higher volatility as investors cope with the uncertain implications of a rising rate regime.
Scenario #2: Rates Fall
As we have noted many times in recent months, the likelihood of a US or global recession is growing. However, recession is not yet our base case. As a result, we think the late-August low in global yields probably marked the bottom for rates and peak for bond prices.
Again, we could be wrong. The global economy could stall for any number of reasons (trade tensions, oil shock, etc.) and yields could fall to, or likely through, recent lows. This is the lower for longer scenario. By the simple math of discounting, we know this would be good for high quality bond allocations.
However, the discounting process for stocks is not nearly as clean. Many investors believe that lower rates should be a boon for stocks – focusing on the denominator (the discount rate) in any cash flow model. However, at these already low rates, we can’t help but assume that lower rates will be accompanied, or driven, by slower growth. We doubt more central bank accommodation will help much as the Fed, ECB, and Bank of Japan are all approaching the so-called “reversal rate” – where further rate suppression actually tightens financial conditions rather than easing them. With limited help from central banks, our focus in this scenario would be the numerator – where the future cash flows being discounted fall – perhaps significantly. Given their volatility ranges, there is little doubt that equity losses could more than eat up fixed income gains in this scenario.
All of this is to simply say that given the current status of markets, we believe stock prices and bond yields will be highly correlated moving forward. Rising yields will signify growth expectations, lifting stocks but punishing high quality bonds. Conversely, falling yields will accompany slower growth, elevating bond prices but punishing equity prices.
Markets have already begun to exhibit this dynamic. Previously, falling yields from the Christmas Eve 2018 bottom through April 2019 helped propel a 25% gain in the S&P 500® (price only). However, since May 1st, the grind lower in global yields through early September was accompanied by a -1% loss on the index. So much for lower yields and falling discount rates pushing stocks higher.
While it will be hard to sidestep this math as equities and high quality bonds make up a considerable part of most investors’ portfolios, there are some actions they can consider.
One, seek alternative assets that don’t rely principally on either equity risk or interest rate risk. Two, consider increasing exposure to emerging market assets where the economies are growing faster and aren’t ruled by the zero/negative rate regimes of developed markets. And three, allocate to active strategies that have the potential to generate alpha (but not guarantee it) in a world where returns to broad market beta are likely to be wanting. Finally, investors should adjust their expectations: Cheap money and timid central bankers may no longer be able to propel stock prices.
2 The Phillips curve is a single-equation economic model that describes an inverse relationship between rates of unemployment and the rate of wage increases in a given economy.
3 S&P 500® Index is a widely recognized measure of U.S. stock market performance. It is an unmanaged index of 500 common stocks chosen for market size, liquidity, and industry group representation, among other factors. It also measures the performance of the large cap segment of the US equities market.
4 The price-earnings ratio (P/E) or price-earnings multiple is the current market price of a company share divided by the earnings per share of the company.
All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.
CFA® and Chartered Financial Analyst® are registered trademarks owned by the CFA Institute.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed are as of September 26, 2019 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted, and actual results may vary.
This document may contain references to third party copyrights, indexes, and trademarks, each of which is the property of its respective owner. Such owner is not affiliated with Natixis Investment Managers or any of its related or affiliated companies (collectively “Natixis”) and does not sponsor, endorse or participate in the provision of any Natixis services, funds or other financial products.
The index information contained herein is derived from third parties and is provided on an “as is” basis. The user of this information assumes the entire risk of use of this information. Each of the third party entities involved in compiling, computing or creating index information disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to such information.