Unintended consequences of low interest rates

By Rob Price Time of article published Aug 23, 2019

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The performance of emerging market equities relative to developed markets has been disappointing so far this year, but the valuations of the emerging market relative to developed market are compelling, which, combined with the overvalued nature of the dollar, suggests good return prospects from the former over the coming years.

South African equity markets have gained in line with global peers. Our real (after-inflation) return expectations from global equities are reasonable (about 5percent a year over five years), although this is not comparable with historical levels. Lower interest rates can keep equities more supported than otherwise, which is what central banks intended. But what about the unintended consequences?

Economic growth remains a challenge, and lower rates are unlikely to improve the prospects dramatically, because the global economy is saturated with debt. Will people really be emboldened to save and invest at low rates of interest? This question is important, because savings and investments are the real drivers of long-term growth. If we're unable to generate savings and investments, the global economy needs to question whether these unorthodox economic policies are achieving the desired outcomes.

South African equities have also benefited from the lower interest rates in the developed world. Long-term South African equity return expectations are lower than those from developed and emerging markets because of the weak economic growth prospects offered by South Africa (as well as more expensive valuations).

South African equities have barely produced positive real returns over the past five years, highlighting the challenge for South African funds. Private markets can extract pockets of economic outperformance and contend against the volatility we expect in listed financial markets.

While the SA Reserve Bank is under pressure to assist the local economy, lower interest rates are unlikely to provide significant support. South Africa’s economic constraints are not due to a lack of debt, but poor economic policy and capital allocation. Using low interest rates as a tool to paper over the cracks through a short-term increase in credit card debt would be slipping into the same trap as many developed markets.

Global bonds might continue to benefit from lower growth, inflation and interest rate expectations in developed markets, but we aren't enamoured by this asset class for long-term focused portfolios. Bond yields are low (negative in some regions), which doesn't bode well for long-term returns when yield should be the primary determinant of bond performance.

About 20 percent of the $50 trillion (R758 trillion) global bond market has negative yields, which is an increasingly troublesome factor for capital allocators.

The first aspect to consider is the “search for yield”.

Low rates in the developed world imply that investors will likely seek out higher returning assets elsewhere. Equities and emerging market debt are two of the beneficiaries of these flows. Unfortunately, the flows don't necessarily imply an improvement in the credit risk of the recipients.

South Africa is a prime example. South African bond markets have performed well this year despite the fiscal risks posed by the state-owned enterprises and the increasing debt burden.

Rob Price is the head of asset allocation at Alexander Forbes.


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