Home / How I learned to stop worrying and live with higher interest rates and yields

by Matthew Peter*

Movie buffs will know that the full name of Stanley Kubrick’s 1964 satirical masterpiece is “Dr Strangelove or: how I learned to stop worrying and love the bomb.” It’s a mouthful, so it’s no wonder that most people only know it by the far shorter “Dr Strangelove.”  

Compared to the threat of nuclear war, qualms over the prospect of higher global interest rates and their impact on investment markets seem banal. Be that as it may, investors do worry that higher interest rates may threaten returns across asset classes.

Unusually persistent and low market volatility, midwifed by quantitative easing, has been a feature of the post-GFC era and a boon for prices across all asset classes.

We think fears that higher interest rates and yields will scuttle markets are overblown.   

For starters, ‘higher’ interest rates will not mean ‘high’ rates by historical standards. The below-par global economic recovery (Figure 1) all but rules out a rapid run up in interest rates. Moreover, structural economic headwinds suggest that a gentle rise in rates, rather than a sharp upturn, is ahead.  

Despite improvements in most large economies’ public finances, the overall level of government debt remains elevated. Ongoing fiscal consolidation will be required to lower debt from where it currently sits, at just above 100 per cent of GDP (Figure 2), to a more sustainable level closer to 60 per cent. Steeply rising interest rates would make the fiscal consolidation task harder and central bankers are aware of this. 

Household balance sheet repair is well-advanced in the US and UK, but less so in the euro area and Japan where consumer spending remains lacklustre. Likewise, while the US and UK banking systems have relatively clean bills of health, high leverage, poor asset quality and weak earnings tell the sad tale of European and Japanese banking today. Remedies to fix European and Japanese banks over the long-term will slow credit growth and inhibit the pace of recovery.

Ageing populations will slow the rate of economic growth

Structural headwinds, including ageing populations will contribute to suppressing the long-run equilibrium level of interest rates.  The plus-65 age cohort is forecast to rise sharply over coming decades (Figure 3) and will shrink the global workforce and numbers of taxpayers on a relative basis while placing upward pressure on savings rates.

The world’s major creditors – Japan, China and Germany – are already significantly aged, while the debtors, including the US, Mediterranean Europe and Anglo-countries, have younger populations. Creditor nations’ high savings rates will come down only slowly, while the debtors’ low savings rates will rise slowly. This dynamic will limit the pace at which global demand can be generated from the high saving creditor nations and put a ceiling on interest rate rises in low-saving debtor nations.

Finally, slowing urbanisation in emerging market economies (right hand panel of Figure 3) will blunt productivity growth. It all aggregates to our belief that the rate of global economic growth and thus the level of interest rates are likely to be lower over the medium to longer term than has been the case in recent generations.  

Lower returns do not equal dire returns

While the world’s great macro forces will combine to slow the pace of future economic growth, this does not mean that asset class returns are about to fall off the cliff. We do expect all asset classes to underperform their longer-term equilibrium returns over the next five years (Figure 4), but not to be so low that it becomes a cause for alarm.  

Indeed, lower returns to overvalued classes should be welcomed by discriminating investors. Instead of allocating capital according to time-tested risk principles, the banishment of volatility by extraordinary central bank policies has caused capital to be invested as if all risk is broadly equal.

A gradual normalisation of interest rates, and hence volatility, gives investors time to migrate towards assets that are best suited to a new regime of rising interest rates.

In line with the gradual pace of interest rate rises, we expect the upward pressure on yields in risk assets to be gradual. The corollary is that the downward pressure on asset prices should also be gradual, as low interest rates support low yields and elevated price/earnings multiples.

While we expect fixed income benchmarks to lag over the next few years, the environment we foresee should be more conducive to active strategies that can take advantage of mispricings between sectors and across securities. Simply surfing fixed income benchmarks whether they be government bond indices or credit indices is not expected to deliver the kind of returns that investors have become accustomed to in the recent past.

The era of unusually low volatility and interest rates has hidden a multitude of investment sins. But that’s about to change. Rather than fearing it, active investors should embrace it. As Warren Buffett memorably said, “You never know who’s swimming naked until the tide goes out.”

*Matthew Peter is Chief Economist at QIC

 

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