Market Economic Commentary: Lower for Longer

One of the world’s most important economic indicators has gone into reverse in recent months. In this commentary we look at the implications for investors and clients of Clarion.

What has changed is the outlook for American interest rates. These rates are, in effect, “the global price of money” and set the risk-free rate for a variety of financial transactions throughout the world. As such they have important implications for investors everywhere.

The key event was a change in policy direction by the Federal Reserve, America’s central bank. It signalled that it’s previous policy of steadily increasing interest rates and reversing “quantitative easing”, or money printing, was being abandoned.

This about turn by the Federal Reserve, even by the standards of the unconventional monetary policies in recent years, is a significant event which has serious implications for investors everywhere and particularly income investors. At the same time an equally dramatic change took place in China where the Authorities pointed to a change in policy to relax the squeeze in money supply.

Another significant development in America was when yields on short-term government bonds overtook the yields on long-term bonds. Investors normally expect to receive a higher return to tie up their money for longer but instead found themselves being penalised compared to short term investors.

This is highly unusual and means that banks find it difficult to make a profit when they lend money with the result that they pull back on their lending. This is normally interpreted as a sign of impending recession, because the implication is that interest rates are about to fall to help cushion the impact of economic contraction.

The simple message from these events is that interest rates, at least in America, have now peaked. While other central banks do not always move in step with the Federal Reserve, many commentators now expect that the next rate move in the UK will be down. We are therefore faced with the extraordinary prospect that the official cost of borrowing has peaked at a mere 0.75%.

Some economists are concerned that these very low interest rates imply that bond investors expect a recession while higher share prices seem to indicate a continuing recovery. This need not be a contradiction. Both stock and bond markets are suggesting that interest rates will have to stay lower for longer, or even fall, so that economies can continue to expand modestly. No one thinks inflation is a problem in the advanced world, allowing central banks to be more relaxed about interest rates and credit growth.

This has inevitable consequences for investors in shares and bonds. While cheap borrowing has a direct effect on the operations of many businesses because they have been funded partly by debt, and therefore face the cost of interest payments, the more profound effect is found in the interconnected nature of all financial markets.

This can be seen in the decision-making process of private investors many of whom have been forced to embrace equity style investment because of the negligible returns on cash that have been offered since the financial crisis. Money has flowed out of cash deposits into stock markets helping to support prices. Recent events suggest this trend is set to continue for quite some time to come.

IN ORDER TO ENCOURAGE EVEN A MODERATE ECONOMIC EXPANSION, INTEREST RATES ARE SET TO REMAIN LOW FOR LONGER AND MAY QUITE POSSIBLY FALL FURTHER.

How then do we invest our hard-earned money in this environment of low economic growth and low interest rates? In the midst of all the uncertainty there is a thirst for yield and income. Individuals, pension funds, charities, insurance companies, life companies and trusts all require income and yet yields on both cash and government bonds, both traditional sources of income, are too low. Indeed, anyone who invests in either cash or bonds is faced with the near certainty of a capital loss in real terms over a short space of time. The perceived safety of both assets comes at a very high price indeed.

On the other hand, corporates have already paid down debt and are in very good shape financially. In 2018 for instance, dividend payments from UK FTSE companies reached a record level and are likely to be at similar, or even higher, levels in 2019. As sovereign debt has become increasingly expensive and returns on cash deposits remain very low, almost miserly, quality income assets such equities, corporate bonds and high yield debt will be in demand for many years to come.

Generating a sustainable income without eroding the original investment is a challenge facing a large proportion of the population, especially given the introduction of pension freedom a few years ago. Interest rates have been near zero for the best part of a decade which has put enormous pressure on savers and their ability to find decent returns.

At Clarion Wealth we take a multi asset approach to investing and believe that diversification provides the best option for investors. This applies as much to those seeking to build up their investable assets as it does to those aiming to derive an income from their hard-earned cash.

Spreading your portfolio across a range of asset classes and underlying securities is a great way to reduce volatility while benefiting from the different risk and reward profiles available. Allocating funds to investment managers who invest in companies with strong balance sheets, sound profitability, good cash flow and prudent dividend payments has been a Clarion Investment theme for some time and is likely to remain so for the foreseeable future.