The do's and don’ts of investing in a negative rate

Structural challenges

The punch line here is that negative rates are a bad sign for the economy, you can make plenty of arguments for and against them, but the fact remains, the knock-on effects are large. The most obvious pain point is the banking system, and we’ve seen this first hand over the past five years in Europe and the last twenty years in Japan. There, banking shares have been in a structural bear market, we’ve seen the occasional lift from cyclical rallies, but overall, it has been a long downward trend of declining market capitalisation. That’s one of the reasons the US have been so reluctant to enter negative rate territory.

One of the other big drawbacks is that while negative rates make sense in theory - because they give scope to monetary policy to support the economy by stimulating demand – in practice they are limited by the existence of physical cash. While that remains, you have a lower bound set by the cost of cash storage. You can’t have negative yields operating in the mainstream while cash remains an alternative, because you can store cash in a bank, or even under your mattress. And while it may not feel like it, large scale economies like the US are still largely cash-based economies in many respects, so this presents real difficulties.

What does this mean for asset allocators?

So, we know that overall negative rates have major adverse effects, suppressing banking systems and distorting the ability of prices to direct demand; the cornerstone of the capitalist system. We also know that there is a great deal of debt building up in the system, and that one of the ways to get out of that is financial repression; to keep rates low while you try and stimulate inflation by increasing the monetary base and debt monetisation. In that case while you might avoid negative rates, but you can still have destruction of value for bond holders if rates are kept below inflation for a sustained period of time. All of this means that asset allocators need to think very carefully about how to position portfolios. If financial repression works, and you have low rates but increasing inflation, then you’ll want to hedge your portfolio with reflationary assets; certain equities, real estate, inflation linked bonds and commodities are your protective assets in that kind of environment.

The Japan scenario

And if it doesn’t work? Then we need only look to Japan to see what that kind of environment might look like. Japan has tried and failed to stoke inflation through low rates for the last 20 years, and over that time equities and bonds have both suffered from mediocre returns, both delivering under 4% per annum in real returns. Gold was a relative winner, which is unsurprising in a period in which your opportunity cost of capital is low. But perhaps less obvious, is the fact amongst the top performing assets over this period were the ones that were most unloved in 2000; small cap value and real estate, delivering around 7.1% and 5.2% annualised per annum, respectively. Meanwhile growth equities delivered around 0.8% annualised per annum. So, while equities overall suffered, there have been pockets of opportunity. That’s an echo for today; one way to protect your portfolio is to buy unloved assets, and value equities are certainly in that camp.

Now whether we see low rates and higher inflation, or a Japan style scenario, bonds are not going to be your friend in the long term starting from this level of interest rates. Our view is that investors are best served limiting duration risk, having exposure to cash and inflation linked bonds, and looking to unloved assets, which could do well in either of these environments.

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