What should income investors do if inflation doesn’t arrive?
With interest rates rising during 2018, and market murmurs about inflation, income investors might have been hoping for juicier opportunities this year. But David Stevenson fears they’ll be disappointed.
Income investors looking forward to a brighter 2019 of higher yields and rising interest rates might have to adjust their expectations. I suspect the interest rate available on savings probably won't rise by much. In fact, it looks as though central bankers, led by those in the US, might slow down or even end rate hikes this year. As a result, income investors might be left desperately scrabbling for yield, yet again. So why might income-producing assets remain overvalued and low yielding for the forseeable future?
It's down to what I call the "Lower for Longer" scenario. A few years ago, I did an informal survey of some banking analysts. I asked when they thought rates would head back towards the long-run average of around 5%. Many answered "never" that is, not during their careers while the majority thought it wouldn't happen before the mid-2040s. In short, the consensus expected a multi-decade period where rates averaged closer to 2%-2.5%, with the odd year where rates get as high as perhaps 3.5%.
It's a "lower for longer" world
So what could keep us in this low-rate world? There are four main factors. Firstly, the developed world has binged on debt, with debt levels now well above pre-financial crisis levels, as recorded by consultancy McKinsey. In other words, we simply can't afford to pay higher interest rates, even if central banks wanted us to. Secondly, and relatedly, GDP growth in many developed economies is below the long-term average. This in turn, means weak wage growth, which "forces" consumers to take on more debt in order to maintain their standard of living. Whether this below-trend growth represents deficient demand (the "great stagnation" theorised by US economist Larry Summers), or just lower productivity growth, depends on the country.Third comes globalisation, which despite President Donald Trump's threats is still a dominant structural force. Global competition in goods and labour is keeping inflation and wage growth under control. Globalisation also has an impact at the capital account level. The US government is a massive borrower due to its huge trade deficit and growing fiscal deficit. The world seems happy so far to fund US government debt at relatively low rates of interest (compared to the long-term average) because it is both highly liquid and seen as "safe". The final, critical factor is inflation or lack of it. All of these structural factors could be unpicked if inflation rates shot up to above maybe 4% to 5% for a prolonged period. Yet price indices suggest that prices aren't rising at much more than an annual 2%-3.5% in the UK and the US, with lower rates on the continent and in Japan. Many of the factors above help to explain this lack of inflation, as does the influence of technology.
"Debt levels in the developed world are now well above 2008 levels"
Add it all up, and while the Federal Reserve would probably love to push rates closer to 4% (if only to have room to cut again when the US inevitably slows down), it seems to have run out of room for manoeuvre, as signalled by Fed governor Jerome Powell's U-turn last week (see page 4). As a result, we'll probably see US rates peak at around 3% this year if they even get that far. We'll probably also see investors move back into US government bonds, pushing up prices as has already happened and pushing down yields on longer-dated bonds.
And if the Fed already well ahead of its peers in the UK, Europe and Japan, at least in terms of rate hikes does gives up on "normalisation", what chance is there that the Bank of England will keep raising rates? In my view, close to zero, unless it was faced by a Jeremy Corbyn-inspired emergency (where a Labour victory followed by a sterling collapse and capital flight by international investors could force the Bank into emergency rate hikes). In short, rates might already have peaked, and could start coming down over the next few years as the global economy slows. China could try to reflate its way through this sorry state of affairs but the markets are telling us a different story long-term rates are already falling.
What would this mean for your money?
I don't think this scenario is certain by any means, but it is bordering on the probable. And that has several important investment implications. The first is that the long-expected bonds rout where investors dump bonds en masse looks less and less likely. As a result, some bonds and income-producing assets will still prove attractive. For example, US government ten-year bonds look appealing on yields not much lower than 3%, compared to the paltry rates on offer in Europe and Japan. So institutional investors are likely to keep buying US bonds for the next few years, unless Trump does something incredibly stupid.
This also suggests many income-producing assets still churning out 5% or more a year will prove hugely attractive to investors, assuming they aren't hit by rising defaults as a result of a global slowdown. This scenario also suggests astute bond fund managers who can get ahead of these moves willmake money as they switch back and forth between different currencies and different parts of the bond spectrum. Corporate credit, for instance, looks less attractive at the moment but once rates start to head down, we might see a swift reversal in sentiment, especially around safer, lower-risk, investment-grade issuers.