Pacific Life Fund Advisors, August 2016
Below is the latest commentary from Pacific Life Fund Advisors, the investment advisor to Pacific FundsSM.
Negative interest rates are a new and untested monetary phenomenon rolled out by central bankers around the globe. Currently, $13.4 trillion of global debt earns less than 0% interest. More than 70% of global government debt yields less than 1% and more than 30% carries a negative yield. We will examine this phenomenon and why it matters to investors in the U.S. first by explaining the theory behind negative interest rates and second by surveying their potential impacts on global financial markets. Finally, we will outline what we believe are the major investment implications behind this monetary experiment.
Why Negative Rates1?
Global central banks are largely tasked with two objectives: maintain a healthy level of inflation, and maintain labor markets near full employment. While they have several tools to help achieve these goals, most central bankers have historically utilized one primary tool: setting short-term interest rates. With the global financial crisis and recession of 2008, central banks around the world and in the U.S. cut interest rates in an effort to stimulate the economy and stem the rise in unemployment. Slow growth in the ensuing recovery and limited fiscal responses from global governments encouraged central banks to keep rates extremely low thereafter.
Quantitative Easing (QE)
In the U.S., the Federal Reserve (Fed) pioneered the strategy of buying bonds as a complementary policy tool after they hit the zero bound, which is an interest rate near 0%, on short-term interest rates and desired greater stimulus. The resulting QE policy quickly became part of the toolkit of central bankers and has subsequently been deployed by many other nations. However, several regions experienced additional recessions after 2008, and central bankers overseeing those regions were unable to sufficiently reinvigorate their economies, even when adopting aggressive QE measures. With interest rates in these countries already at zero, the primary policy tool of cutting interest rates was no longer possible unless central banks could take rates into previously unimaginable territory—below the zero bound.
Negative Rate Experiment
In 2014, Europe's central banks cut rates below zero in an effort to stimulate a sputtering economy, and the impact on the yield curve can be seen in Figure 1. They theorized that going negative should act as the logical next step when interest rates were already at zero and QE proved insufficient.
Figure 1: German Sovereign Yield Curve3
However, negative rates pose a unique challenge to central banks. They can only charge commercial banks for assets held as collateral and banks are unlikely to pass those rates on to consumers. When faced with a negative interest rate, a consumer could pull money out of the bank and hold physical cash, which would not lose value. Passing negative rates on to consumers could thus have the unintended effect of causing a run on the bank.4
To stimulate lending by banks, central bankers created a layered approach to charging for deposits. First, they determine an appropriate level of capital required for banks to remain financially solvent given an unexpected rise in defaults. For amounts above this required capital, central banks begin to charge progressively higher interest on deposits. The end result is that banks are penalized for hoarding capital and are incentivized to lend, which is a crucial component for an expanding economy. However, central banks are now dictating how commercial banks do business at a more granular level than ever before.
Do Negative Interest Rates work?
While it is too early to determine whether negative interest rates are an effective policy tool, it makes sense to step back and review some of the broader potential impacts that may not be intended.
We already reviewed the most obvious potential consequence if banks pass negative interest rates on to consumers: a potential run on the bank. But as banks exhaust their lending opportunities within their higher credit-quality client base, they may feel pressured to turn to less credit-worthy borrowers—a flashback to the risky lending that drove the subprime crisis in mortgages. From a behavioral economics standpoint, people have repeatedly shown a preference to take greater risk to avoid an almost certain loss. This push away from a small but guaranteed loss could drive risk-taking investments that have positive expected return but much greater potential for loss. The expansion of ownership of riskier assets by more conservative investors increases the odds of outlier-type events triggered by spikes in volatility.
Another potential consequence of negative interest rates is further competitive devaluation of currencies, commonly called currency wars. Currency exchange rates influence the attractiveness of exports; if China’s currency weakens, one U.S. dollar buys more Chinese yuan, which means the same goods cost less—a clear price advantage. As a result, most countries would prefer a weaker currency when looking to stimulate their economies by boosting exports. Lowering interest rates tends to cause the subject country’s currency to fall in value and can be interpreted by trading partners as manipulation.
Figure 2 illustrates the impact on the euro relative to the U.S. dollar after negative interest rates were announced by the European Central Bank (ECB). Negative interest rates expand the potential for manipulation and increase the likelihood that countries engage in further competitive devaluations to stimulate their respective economies and to retain competitive export prices.
Figure 2: EUR/USD After Negative Rates5
One important factor about negative interest rates is decreased effectiveness as rates become more negative. Due to the tendency for depositors to move to physical cash, negative interest rates have a built-in limitation to how much they can stimulate for each subsequent drop. Central bank effectiveness hangs largely on how credible this policy tool looks to market participants, and negative interest rates can appear to be a play of desperation. We believe central bankers need to carefully weigh the potential damage to credibility if negative interest rates are ineffective or if they create unanticipated consequences that outweigh the intended positive effects. Finding the depth of negative yields at which that fine line is crossed could potentially be dangerous for their credibility.
Shifting Efficient Frontier
Low-to-negative interest rates and global uncertainty indicate that the efficient frontier has shifted down, a reality with which investors must come to terms. Seeking to generate the same returns as in the past will require greater risk, while similar risk may yield lower return than before. We look to shift the frontier back up through absolute-return style alternatives, and we also look toward both U.S. bonds and domestic-value stocks as asset classes that may offer protection from low yields and the tail risk6 created by global uncertainty.
Shift It Back Up!
With the reality of lower-return expectations, our first objective is to shift the efficient frontier back up to improve performance without simply inflating risk. To do that, we look to add diversified returns to the portfolio through all-weather style alternatives that are much less correlated to major equity and fixed-income markets. However, investors should tread cautiously because the challenge of identifying a high-quality manager or strategy is greater than for traditional asset classes.
We focus on strategies with sound economic rationale for their returns as well as proven capability in tracking and managing portfolio risk. One additional focal point for us in selecting these managers is how the strategies behave (or correlate) during the worst markets for equities and the worst markets for fixed income. By truly assessing downside risk across different economic regimes, we can better understand the trade-offs inherent for each manager and ways in which our overall alternative exposure is likely to behave in more extreme market conditions.
Although rates in the U.S. are near historic lows, the global interest-rate picture leaves our ultra-low interest rates as some of the highest in the developed world. When compared to negative interest rates overseas, demand for U.S. bonds is heightened simply because they have a positive yield. Domestic investors could, therefore, continue to benefit from foreign flows into U.S. bonds that drive up bond prices and hold down rates. Also, while the return expectation for fixed income is admittedly modest from such a low starting point, bonds have continued to exhibit low volatility and a tendency to move opposite to equities, especially in rapid sell-offs. We feel this characteristic as a diversifier is one of the best arguments for continuing to hold quality bonds in the portfolio in spite of historically high prices (and low rates).
Get Paid to Wait
Not unlike U.S. bonds, domestic-value stocks may provide a unique opportunity within U.S. equities as investors continue to search for a combination of higher yield and lower volatility amid negative interest rates globally. High-quality value stocks in sectors like Utilities and Real Estate are attractive for their high-dividend yield and more limited downside compared to higher beta growth stocks.7 Figure 3 shows how much higher this dividend yield can be compared to the yield on government bonds in certain developed countries.
Figure 3: The Yield Picture
A continued rebound in energy stocks may also provide a tailwind for value as oil has rebounded from extreme lows, and U.S. shale operators enjoy break-even profitability at lower prices than many larger-scale foreign competitors such as deep water drilling companies.
Finally, financials may be well positioned within value stocks to deliver some upside balance if the Fed does raise rates within the next year, as financials benefit from greater net interest margin with higher interest rates.
Negative interest rates are an unprecedented policy tool that has yet to prove its effectiveness as a stimulus measure. However, it has solidified lower expected returns across asset classes and underscored the need to find alternative return sources and managers that have the potential to shift the efficient frontier back up. The global reach for yield driven by negative interest rates also favors the continued use of U.S. bonds for positive nominal yield and diversification. Value stocks, especially in higher-quality sectors like Utilities and Real Estate, may also fit the sweet spot of yield and relative safety.
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1 A negative interest rate means the central bank will charge negative interest. Instead of receiving money on deposits, depositors must pay to keep their money with the bank.
2 Yields move opposite to bond prices.
3 This chart depicts the relationship between the interest rate of bonds issued by the German government and the time left until they have to be paid back (yield curve of debt).
4 A bank run occurs when a large number of customers withdraw cash from deposit accounts simultaneously due to concerns about the bank’s ability to pay all of its debts.
5 This chart shows that the euro fell 18.3% relative to the U.S. dollar when negative interest rates were announced by the ECB.
6 A form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution.
7 A stock that is more volatile than the index it is being measured against.
PLFA is the investment adviser to Pacific Funds. PLFA also does business under the name Pacific Asset Management and manages certain funds under that name.
This publication is provided by Pacific Funds. These views represent the opinions of PLFA and are presented for informational purposes only. These views should not be construed as investment advice, the offer or sale of any investment, or to predict performance of any investment. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are based on current market conditions, are as of August 2016, and are subject to change without notice.
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