From the Yardarm

Among all scarce resources, time has no substitute. Time cannot be renewed, expanded, or replaced regardless of price. A person's lifespan limits their earnings, savings, and spending. Today, interest rates in developed world economies approach and even move below the so-called "zero bound," constraining the ability to grow savings through compounding over a reasonable period. The opportunity cost of lost time for compounding savings is irretrievable.

The forces creating the yield famine are persistent and powerful.

The impact of today's rate environment can be especially damaging to young savers and their future standards of living because low/zero/negative rates eliminate the highest powered compounding periods in their lives. This could result in a generational loss that may only be recoverable by inheriting from a generation that had the opportunity to earn higher returns in the past.¹ Young working adults need to compound their savings for down payments on homes, rising college education expenses for their children, and, of course, their eventual retirement income. The first dollar they save has the longest possible period to compound. Every year of zero real returns creates an irrecoverable loss of time that delays those goals.

Today's environment may not be transitory

Yield Curves as of June 28, 2016

The Yield Curves graph shows the breadth of negative rates in Europe and Japan. The US yield curve is presented for perspective. Substantial portions of Japanese, eurozone sovereign, and eurozone corporate yield curves are below zero. In some countries, more than 75% of sovereign debt issues are trading below zero.²

The forces that led to this phenomenon are complex and entrenched. Nominal interest rates have been generally falling since the early 1980s, mirroring the decline in inflation after a period of rampant price increases in the 1970s. The demographic element of rapidly aging populations across the developed world factors significantly. Lower productivity during the past 40 years versus earlier in the 20th century has limited the economy's growth rate. As interest rates fell, borrowers could afford to take on more debt without increasing their debt service payments. With declining economic growth and the associated effect on incomes, increased borrowing was a way to plug the hole.

Total US Public Debt as a Percent of GDP

These patterns continued for some time until the global financial crisis exposed the consequences: the US, along with much of the rest of the world, had piled up considerable debt. Without the capacity to continue borrowing, consumption growth was limited, further constraining economic growth. In the aftermath of the financial crisis, these dynamics threatened to evolve into a dangerous feedback loop: debt servicing costs soak up an increasing proportion of economic output, requiring further cutbacks in consumption, which further cripple growth. In an attempt to prevent these dynamics from leading to a miserable debt-deflation cycle similar to the Great Depression, central bankers have coordinated to enact policies that keep interest rates historically low to prevent debt service expenses from building up so high that they derail the economy.

Case Study: US Pension Funds

By 1980 — the zenith of the defined benefit pension — 46% of private sector workers in the United States were covered by a pension plan through their employer.³ At the time, pension managers could reasonably assume an 8% long-term rate of return. After all, the 30-year US Treasury bond yielded more than that. Pension managers, insurance companies, and governments set contribution limits, premiums, tax rates, and benefit levels assuming their assets could compound comfortably at or above 8% for the next 30 years. Beneficiaries armed with the same information demanded commensurately higher benefits.

Since that time, bond yields have fallen dramatically, while benefit levels have not. Pension managers are now in a more difficult situation as the investment-grade yields required to fund their net pension liabilities are well short of requirements.

Considering the difficulty of amending the accrued pension benefits, plan sponsors cannot expect relief for their funding deficits to come from beneficiaries.

Long-Term Asset Allocation Model

Nobody will bail out individuals either, but despite the minimal returns currently provided by fixed income instruments, workable strategies are available. A well-diversified asset allocation portfolio still holds promise for compounding savings, even if the "safe" investment-grade bond portion of the portfolio offers so little in the way of real or even nominal investment returns. Such an allocation might include high-yield equities or municipal bonds. While equities present the possibility of capital loss, a sufficiently long investment horizon mitigates the risk. Yes, the yields on municipal bonds have declined along with the rest of the market but future higher tax rates — a distinct possibility — have yet to be priced in. A long-term (greater than 20 years) asset allocation model might look something like the one presented at right.

The yield famine is ongoing

Savers today must recognize the yield famine could persist as the forces that led to hyperlow rates show few signs of abating. Rates will remain low as long as global economic activity remains moribund. Although it is possible that higher inflation could eventually erode the real value of high debt levels, monetary policy directed at this goal has so far failed to interrupt the deflationary trend, boost the velocity of money, or accelerate economic growth. Should another financial crisis trigger a broad-based asset price decline that compels debtors to liquidate leveraged assets to repay debt, a systemic deflationary reaction could result; but with rates already so low, it is difficult to know how effective other unconventional attempts at crisis mitigation may be.

A silver lining for investors

Unlike pension administrators, whose investment policies may be constrained to various degrees, individual investors have greater flexibility and, depending on their age, the flexibility to ride out the volatility of various investment cycles without compromising long-term investing goals. The low level of inflation implied by the current term structure of interest rates also indicates that savings do not need to grow as aggressively as in the past to fund future liabilities. Additionally, while the catalysts are not currently visible, it is not out of the question for a new regime to eventually take over, leading to higher rates and better long-term returns, even if the transition is bumpy.

Although the hyperlow rates in the US have been linked to rising prices in other asset classes, such as US equities, other parts of the world have not been so fortunate — European and Emerging Markets stock markets in particular. Some investors claim that the relatively high valuations of US stocks are warranted by the low interest rates, but if that is indeed true, it argues that lower-valuation European and emerging markets stocks may be real bargains by comparison. Interestingly, we have seen a rebound in emerging market stocks this year, although developed international markets have yet to join in.

In the end, it is our conviction that markets have long rewarded patient investors who diversify their portfolios. Despite today's rate environment, the market continues to offer opportunities to diversify, and we believe investors who take advantage of those opportunities will have a better chance of success in the years to come.



¹ Assuming they have never read Die Broke: A Radical Four-Part Financial Plan, in which author Stephen Pollan argues that leaving a large estate should not be the goal.

² Eurozone yields courtesy of European Central Bank

³ Employee Benefit Research Institute: History of Pension Plans


Copyright 2016 Saturna Capital Corporation and/or its affiliates. All rights reserved. Vol. 10 · No. 6

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