Investing at a time of negative real interest rates
The market environment is beginning to brighten thanks to the start of COVID-19 vaccination campaigns, and optimism in the stock markets is growing. But even if the economy recovers over the course of the year, there is no prospect of a significant rise in interest rates. Conservative fixed-income assets are among the losers in this world of negative real rates of return. But where are the winners?
The coronavirus crisis has hit the economy and the capital markets hard. An even more severe collapse was averted only thanks to decisive monetary and fiscal policy action around the globe. Gradually, emergency measures to stem the crisis are being replaced by measures to stimulate growth, with major central banks going ever further down the path of quantitative easing. A question that is often raised in this context is what makes a central bank strategy ‘appropriate’. After all, support measures such as bond purchases, interest-rate cuts and long-term refinancing operations were adopted in an environment of persistently low inflation. Against this backdrop, economists have been discussing for a long time whether fixed inflation targets are still suitable as a guideline for monetary policy. This discussion is not limited to the technical adjustment of inflation targets but also looks at matters such as higher employment, the distribution of wealth and environmental aspects. If inflationary pressure remains absent in the foreseeable future, what should monetary policy be guided by?
Central banks will make sure that interest rates stay low
In October 2020, the US Federal Reserve (Fed) took the lead as the first major central bank to realign its strategic approach. It will now be pursuing an average inflation target, meaning that the basis of analysis has shifted from a point in time to a period of time. If inflation drops below the target level for a certain amount of time, the bank will subsequently allow inflation to rise above the target by a similar margin for an equivalent duration. The Fed is thereby effectively giving its inflation target a ‘memory’ and will tolerate inflation ‘overshooting’ the target temporarily. What this means is that ultra-expansionary monetary policy is here to stay. The European Central Bank (ECB) has not officially announced its new strategy yet, but thoughts in Frankfurt seem to be heading in a similar direction.
Inflation is becoming increasingly relevant again for the capital markets
Inflation expectations are rising, especially in the US
Bleak outlook for government bonds from core eurozone countries
For the bond markets, loose monetary policy for the foreseeable future is likely to go hand in hand with higher inflation expectations and a steeper yield curve. This is due to the fact that monetary policymakers will delay their response to rising inflation in future, which creates heightened uncertainty about the trajectory of inflation. As a result, investors will probably expect higher compensation for the risk they take when investing in bonds with longer maturities. Inflation premiums on ten-year US treasuries have already increased noticeably. At the same time, yields at the near end of the curve will remain low due to the Fed’s zero-interest-rate policy, meaning that the yield curve as a whole will steepen somewhat. This is why the strategic outlook for the government bond markets is gloomy. Union Investment expects that government bonds from core eurozone countries will generate negative annual returns over the next five years.
Higher-yielding bond segments offer opportunities
But there are promising alternative strategies that can actually take advantage of the trend towards negative real rates of return. The outlook for higher-yielding government bond segments, for example, is much brighter. Paper from the eurozone periphery should benefit not only from the ECB’s continuing asset purchases in 2021, but also from the fact that periphery countries will have lower funding needs as the coronavirus pandemic subsides and will therefore issue fewer bonds than in 2020, which should support prices.
With regard to the corporate bond segment, many industries have been hit hard by coronavirus containment measures, but in many cases companies have been able to access the financing they needed at low interest rates. In addition, there has been no widespread deterioration in credit quality in the bond market. In terms of credit risk, individual companies will be in danger of defaulting but this is unlikely to become an issue that affects the wider market. The central banks’ expansionary monetary policy should also continue to support corporate bonds because the low level of interest rates is driving investors towards paper with higher risk premiums.
Investing in broad-based corporate bond portfolios can further improve the diversification profile. For example, international industrial and financial bonds denominated in US dollars offer a risk premium compared with European paper. The upside potential can be further improved if a portfolio of senior and subordinated bonds is supplemented with high-yield paper as a yield booster. Regional differences in yields can be exploited to tap additional potential. Issuers in currency areas other than the eurozone may offer a superior return, even after hedging costs, because the pricing in the corporate bond market is not always completely efficient for all securities.
Bonds from the emerging markets also offer opportunities, but should be carefully analysed to assess relevant risks and identify likely beneficiaries of the post-coronavirus recovery.
Equities are the asset class of choice
The pressure being created by the environment of negative real interest rates to find alternative forms of investment is forcing many investors to opt for equities. Overall, companies are generating high – and, in most cases, growing – profits from which investors can benefit through dividends, share repurchases or increases in enterprise value. Union Investment expects global corporate profits to grow by around 30 per cent in 2021. However, growth stocks will probably not be able to outperform the market again in the way they did in 2020. Instead, the performances of different stock styles and regions should converge. The revival of economic activity that will set in when coronavirus-related restrictions are lifted will primarily benefit early-cycle stocks. So-called ‘reopening stocks’ will also offer good potential for price gains. These are shares in companies that have been delivering a weaker performance than the overall market while coronavirus restrictions are in place but that will be among the beneficiaries of a gradual normalisation. Investors should also keep an eye on ‘reflation trade stocks’, i.e. equities that would benefit from rising inflation in the wake of the economic recovery after the coronavirus pandemic.
It’s all one trade - real interest rates in the US are driving various asset classes
Both risk assets (equities) and safe havens (gold) benefit from falling real interest rates
Attractive total returns only at the top end of the risk ladder
What we know for sure is that 2021 will offer opportunities. In the current environment of low interest rates, equities and higher-yielding bonds will remain the first choice. Investors can improve the upside potential in the equity segment if they take account of the anticipated style and sector rotations. The focus in the government, corporate and EM bond markets should be on careful issuer selection.
As at 16 February 2021