by Dominic Rossi, Global CIO Equities at Fidelity
What determines the level of real interest rates critical to investment? The principles of orthodox monetary policy are so well entrenched in the financial mainstream as to be virtually sacrosanct. Yet, as the timing of the first US rate rise is pushed out again, it is pertinent for investors to question the validity of bedrock monetary assumptions after five years of record low interest rates. Why? Because the implications for asset allocation will be tremendously significant.
There are two schools of thought on the forces that determine the level of real interest rates. Yet, this is more than an interesting intellectual debate for investors – the implications for asset allocation and portfolio performance will be stark depending on which school is right.
On one side, there is central-bank monetary orthodoxy, best espoused by the US Federal Reserve and its governors, who believe that the business cycle will reassert itself and rates will normalise, with perhaps 2% inflation and 2% interest rates in the US. Contrasting that, there is a loose group of economists who suggest there is a persistent deficiency in aggregate demand that is keeping real interest rates low, due to the presence of a global excess of capital, or a “savings glut”.
The savings glut thesis has been promoted by renowned economists Charles Dumas and Paul Krugman, repositioned as the secular stagnation hypothesis by Larry Summers and given real backing in terms of hard historical data by the work of Thomas Piketty in his book Capital in the Twenty-First Century. For a counter thesis prepared to go up against central bank orthodoxy, it is not lacking in heavyweight intellectual support.
While there are some differences to the various theories put forward by the counter-orthodox camp, the concept of a savings glut is a central theme. The thinking is that there are more countries with excess savings than there are with excess investment opportunities. With the accumulation of savings continuing, nominal and real yields will grind lower over time.
Global gross savings are about 24% of global GDP and, when adjusted for depreciation of fixed capital (savings wealth consists of fixed assets as well as financial capital), we are still seeing savings of 11% to 12% on a net basis, which is substantively in excess of nominal economic growth.
This scenario describes a world where too much capital is chasing too little income. This realisation has a profound implication for asset values and investor asset allocation. If it is a persistent trend, then we will see a desperate search for yield, a bid for fixed income and interest in equity income as well as real estate and multi-asset income. Indeed, if we are to remain in a world in which nominal and real yields feel the downward force of excess savings, then there are four key factors that investors should consider.
The first is that in a world where too much capital chases too little income, tomorrow’s returns are effectively being brought forward to today. Capital markets will capitalise future returns to the present. Valuations for all asset classes will typically tend to move higher over time and remain defiantly high for longer periods, and there will be a greater propensity for bubbles. Historical comparisons and valuation “norms” become much less helpful in valuing assets.
The second is that as future returns are capitalised today, the gap between the present and future value of assets will narrow. Moreover, assuming the factors affecting future values are constant, then the scope for short-term capital loss also narrows, due to the presence of excess capital. If present value falls for any other reason (other than a fall in its predicted future value), then excess savings will flow towards and consume the excess returns that the fall in present value temporarily creates.
The third is that as the gap between present and future values narrows, then the greatest risk that investors face is not short-term capital loss, but reinvestment risk. This is the risk that the proceeds from the payment of initial principal and interest will have to be reinvested at a lower rate than the original investment. It means market-timing strategies are risky. In a world of excess capital, the risk of being out of an asset class is greater than being in it. Reinvestment risk is a greater consideration in short-duration investments where the proceeds may have to be reinvested at a less attractive rate than was initially available.
Finally, as the gap between present and future values narrows, the factors influencing future values in discounted-cash-flow models become increasingly important. These factors are duration, the forward-looking investment rate and terminal values. These factors suggest three key investment strategies on the part of investors.
The first strategy is that in a savings-glut environment, investors should be wary of stocking up on short-duration investments to protect against an interest-rate cycle that is persistently delayed and forecast to be benign. Rather, investors should build their portfolios around core allocations to long-duration real assets such as equities and real estate. The accelerated capitalisation of future returns will have a more pronounced impact on the capital values of these longer-duration assets than it will on short-duration assets. This will support investment flows to equities and real estate. What is clear, at present, is that the last place investors should be is in cash. There is more danger to wealth preservation and foregone accumulation by being out of the stock market than in the market.
The second strategy is that as reinvestment risk becomes the greatest risk that investors face, the focus of attention will move to asset classes that can reset the reinvestment rate in nominal terms over time. Again this implies investors should steer towards property with the capacity to upwardly adjust rental income or equities that make annual distributions to shareholders through dividends. The reinvestment rate is the critical judgment here and can be easily eroded by excessive turnover. This makes the age-old case for “buy-and-hold” strategies even more compelling.
In a savings-glut environment, it worth considering whether the discount rate used in discounted-cash-flow models may be wrong. Weighted average cost of capital is a commonly used discount rate in equity-valuation models, where the discount rate reflects the cost of raising debt and equity financing in proportion to their use. A few years ago, the weighted average costs of capital of 12% were common; now analysts are using 8% (with some assumption of rising rates built in). But, who is to say they won’t be using weighted average costs of capital of 5% in five to 10 years’ time if the savings-glut thesis prevails?
Strategy three is that, in a world of excess savings, terminal values will account for a greater proportion of present value. Overall, terminal values will, in general, be under pressure as low real interest rates point to lower real returns on all assets (i.e., lower beta). Therefore, in a nominally constrained environment, investors must invest in innovative areas of the economy that can offer rising productivity, a real return on capital and a demonstrable addition to economic value. At present, this means investing in the US economy and in intangible intellectual property sectors such as pharmaceuticals, biotech, software and media.
Sustained dividend growth in the US
Source: FactSet Dividend Quarterly, March 2015
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