Once upon a time, economics truly lived up to its moniker as the “dismal science” as central bankers sought to control interest rates and fiscal policy in a bid to control inflation. But having experienced two epoch-defining financial crises in 2008 and 2020, policymakers are once again getting behind former US president Richard Nixon’s proclamation that “We are all Keynesians now”, as central banks resort to quantitative easing to keep their economies afloat. The last thing on their minds is inflation, as interest rates were pushed down to near-zero levels in a bid to jump start sputtering economies.
However, repeated aggressive use of monetary expansion may have created a permanent low interest investing environment. While the periods between 1990 to 2007 has largely seen interest rates hovering within a 2% to 5% band, Federal Fund rates in the wake of the 2008 Global Financial Crisis peaked at 2.27% in 2018, as the global economy was then enjoying some semblance of recovery before being stymied by first the US-China trade war and then, the Covid-19 pandemic. The Fed has guided for rates to be near zero till 2022. The longer low rates are maintained, the more likely they will be to become a permanent fixture of the global economy.
On the surface, this appears to be a boon for investors, who can now binge on cheap, plentiful credit to unleash their animal spirits. The S&P 500 hit record levels as investors placed bigger bets. All this has occurred while main street languishes with high unemployment and high fatalities as a direct result of the Covid-19 pandemic. And this growth is not yet finished — a technical analysis note by Bank of America on Sept 28 reckons that the S&P 500 could rise 30% to 3,700 to 4,300 points despite a September correction for US equities.
“Dealing with low interest rates is by far the most significant shift modern-day investors have had to adapt to… one of the greatest surprises in the last decade has been low inflation and very strong risk asset returns. However, low interest rates have not imposed poor equity returns as growth stocks outperformed,” says Jenny Sofian, CEO of Fullerton Fund Management in her foreword to a report on how investors can take advantage of this brave new investing environment. Fullerton Fund Management is a subsidiary of Singapore state investor Temasek Holdings.
But embedded within the report is a warning that market exuberance may be built on quicksand. As central banks increasingly resort to low interest rates, says New York University finance professor Aswath Damodaran, their powers to influence growth rates begin to diminish.
Japan, for instance, has struggled to jumpstart its stagnant rate despite maintaining zero-level interest rates since 1999 as it slipped into negative inflation. Banks’ profit margins could come under pressure as a result of the higher costs of storing money with central banks — especially in light of the regulations implemented following the 2008 crisis.
Ultimately, the ability of central banks to drive growth is limited, says London School of Economics professor Charles Bean, a former deputy governor of the Bank of England. Central banks are constrained in reflecting the underlying global phenomenon of declining borrowing costs, and they can do little to stimulate the fundamental drivers of economic growth, he says.
Bean’s view is not unique. “Most central bankers would concede that their powers are very good at giving the right environment for growth to come back, but it is not as direct as fiscal policy [in driving growth],” says Fullerton strategist Robert St Clair.
Growth versus yield
While the trauma of the 2008 crisis remains fresh in the memories of most investors, St Clair, a former economist with the Monetary Authority of Singapore, says that the Covid-19 recession differs in two respects.
Aside from the sheer scale of global government intervention — which dwarfs that seen in 2008 — the crisis takes place amid significant political risks stemming from the rivalry between the US and China and the prospect of a contested US Presidential election outcome. Both factors could see investors wrestling with greater market volatility in the coming years.
Paradoxically, however, investors may actually go after riskier assets as they take more chances in their bid for higher returns amid low to negative interest rates. “Yieldstarved investors have proved eager buyers of sub-investment grade debt, allowing the leveraged loan market and the private debt market to expand rapidly,” observes the Fullerton report. BBB-rated bonds — the lowest grade of investment grade bond — have risen from less than a quarter of the investment grade market in 2001 to more than half in 2019.
“Flush liquidity and low yields have seen investors willing to pay more for weaker covenants despite regulators warning that growing corporate leverage poses risks to financial stability,” the report continues.
Yet, the report proposes that investors can have their cake and eat it too. For example, by investing in Asia’s high quality bond market. Fullerton’s head of fixed income Ong Guat Cheng writes that the dominance of investment grade bonds in Asian credit markets with positive real yields from low inflation could prove to be a safe haven.
“Low interest rates make it cheaper for companies to refinance and put a lid on default risks. At the same time, low interest rates will underpin demand for assets with positive yields,” remarks Ong of the Asian credit market. From his perspective, Asian credit markets enjoy stronger regional support and tend to exhibit lower spread gyration as compared to other EM corporate blocs. A weakening US Dollar could also see potential forex gains for trades in Asian currencies as well.
On the side of equities, growth strategies are firmly in the limelight as investors pay a premium on the promise of future growth and cash flow. Demand for tech stocks has been strong due to their perceived strong growth potential, with the former gaining a record high share of the S&P 500 of 29% as of July 31. This has created a bifurcated market where tech stocks have raced ahead while other counters languished because of the Covid-19 recession.
“With growth becoming scarce, investors should look to sustainable growth companies that will be on the right side of technological disruption with strong balance sheets and high return on equity,” says Fullerton’s head of equities research Andrew Maule. He sees e-commerce, technology, healthcare, mass consumption and premium consumption, infrastructure and the hunt-for-yield as promising themes for equity investors.
On the other hand, Maule is cautious on stocks offering high dividends like banks and energy stocks, as they face cyclical growth headwinds and structural challenges to their business models. His preference, instead, is for those with high dividend potential.
But value investing is far from dead, says St Clair, despite the queue of pundits lining up to pronounce it so as value investing gurus like Warren Buffett lost big in the recession and missed the tech rally. While flush liquidity has distorted asset valuations, St Clair believes that investors should not neglect analysing stock fundamentals; he thinks that investors can use value investing methods to pick strong counters at a bargain within growth themes. But investors must be prepared to pay a premium for counters with the potential to expand market share due to the high liquidity of present markets.
However, St Clair warns that it is still early days in the recovery and that a key indicator for a rebound is when global earnings growth expectations become positive again year-on-year. This, he believes, would trigger a broad-based market rally that will include other sectors currently laid low by the pandemic such as the industrial sector and those more reliant on global trade. “Other sectors that are most dependent on social interaction such as air travel may only recover strongly when we get a vaccine for Covid-19,” he tells The Edge Singapore.
Investors may yet have to rethink their strategy vis-a-vis bonds as equities, with the report noting a fundamental change in the role of both asset classes in portfolio building. With government bond yields falling below zero due to low interest rates, they may become more suited for capital appreciation than yield, drawing in new short-term buyers instead of typical “buyand-hold” players. Meanwhile, cheap equities have pushed up dividend yields, allowing investors to obtain strong returns at a relative bargain.
Strength in diversity
Given how stretched equity valuations are and how bond yields have turned negative, Fullerton is recommending investors to take a closer look at alternative assets such as gold and real estate. Global assets under management in the alternative space have reached record levels exceeding US$10 trillion ($13.6 trillion).
“We believe alternative assets are beneficial in all economic environments, primarily because they allow for more diversification and portfolio customisation,” says James Davis, chief investment officer at Canadian pension fund OPSEU Pension Trust. “Alternative assets provide access to different risk premia and allow for more value creation potential than conventional asset classes.”
Though most of such assets remain out of reach for retail investors, gold has proven a popular means of hedging against the chaotic investment environment. Prices hit a record high in August above US$2,000 a troy ounce, with UBS Global Wealth Management regional CIO Kelvin Tay expecting a repeat of this record despite a recent correction of around 10%. Even Buffett, who once called gold “useless” due to its lack of yield, has since started investing in gold companies.
Real estate, says St Clair, is another popular alternative asset, especially in Singapore. Besides income generation and potential for capital gains, real estate is resilient under deflationary pressures while also protecting from inflationary pressures. Retail investors can buy into REITs to expose themselves to the property market, he says.
Ultimately, the key to maximising opportunities within the low interest rate environment is to stick to some good old-fashioned traits. “The key ingredient to build a balanced portfolio is that investors still need to focus on fundamentals, diversification of assets and to be nimble with active portfolio management,” adds St Clair. Considering the choppy waters that lie ahead for financial markets in the coming months, a good dose of luck would not hurt as well.
