Remember the phrase “lower for longer” that the market used to use to describe the outlook for US interest rates? In a post-Brexit world, “lower forever” seems more appropriate. The continued, and possible permanent, low interest rate environment worldwide holds significant consequences for investors. And also for investment advisors who want to avoid a “Clexit,” that is, a client exit.
Interest Rate Policies and Low Interest Rates
How did we get here? The answer that many people will give to this question is monetary policy – meaning that central banks around the world, through their interest rate policies, are responsible for low interest rates. While this is accurate on the surface, the reasons central banks need to lower interest rates in the first place reveal the true answers: The Great Recession. The great recession is the single largest contributor to continued low interest rates, although by no means the only factor. The collapse in credit associated with the great recession destroyed all kinds of growth: asset prices (think real estate), economic output (think company earnings) and, of course, employment. These outcomes are all very deflationary, and the monetary policy response to deflation is to lower interest rates to stimulate credit and economic growth. Central banks around the world – including the United States – are still fighting deflationary forces unleashed by the great recession. Demographics. One need only look at Japan to see the economic and growth consequences of an aging population. In comparison with its 10 percent real GDP growth rate between 1950 and 1960 and a 4 percent growth rate between 1970 and 1980, Japan has only managed an average growth rate of 1 percent since the early 1990s. This declining trend has been driven by Japan’s considerable demographic challenges. Population aging is a significant demographic issue for Japan and a common feature among developed economies – the United States included. Deflationary to be sure. Globalization and the Democratization of Uncertainty. Uncertainty breeds conservatism and conservatism is, you guessed it, deflationary. Because of the interconnectedness of a globalized world, we have new and seemingly never ending sources of uncertainty. Brexit is one example of a global uncertainty generator, and there are many others. The problem is compounded by the fact that financial markets and people have not yet developed the models and mental frameworks to deal with an increased uncertainty output from around the world.
Implications for Investors
Investors of all types, and their investment advisors, need to sharpen their yield hunting skills. This doesn’t mean piling into the highest yielding bond fund or preferred stock, but rather it requires understanding the fundamentals of yield. What role does yield play versus growth in a portfolio? What is an appropriate expectation? Where can yield be found?Yield and return expectations are especially important since they set the goal posts. Expectations that are too low can result in missing opportunities and failing to reach future portfolio goals. Expectations that are too high – which I believe is the typical expectation error – can lead to stretching for yield (and taking too much risk relative to your risk tolerance) and creating a false sense of security regarding the probability that your portfolio will grow to its targeted number.It’s very easy to increase the expected return assumption in a retirement planner and think that everything is on track. I’ve done this myself and it’s magical when you see your portfolio value in 2040 after just a point or two increase in expected return. Realistic, maybe not, but magical for sure.##TRENDING##
Opportunities for Advisors – and How to Avoid a Clexit
Financial advisors have an important role, and opportunity, in helping clients cope with a low yield environment. “Lower forever” doesn’t mean your clients will have to work forever, but it does challenge the typical asset allocation models.As I’ve mentioned before, I believe appropriate expectations are key to the equation, including the happiness and retention of your clients. I’ve had advisors tell me, in an effort to get my business, that they could easily beat the return goals that I’d set for my own portfolio. Understanding the fundamentals of yield allowed me to evaluate these claims in a rational and consistent way. It will also help your clients do the same, should this situation arise for them, which it probably will.Finding the appropriate yield instruments is surely an area where advisors can add value. This requires the advisor to explore and become knowledgeable about where to find yield. Fortunately, there are several investments vehicles where yield can be found.These broadly fall under the category of alternative investments and include Real Estate Investment Trusts (REITs), Business Development Companies (BDCs), and life insurance based investments, which are gaining popularity due to their potential to create yield that is not correlated to traditional financial markets. Every advisor needs to understand alternative investments and how they can add yield to investment portfolios. (See also Looking for the Right Alternative Investments? Be Sure You're Dipping Your Toes in the Right Place!)
Mastering the fundamentals of yield will set expectations and build a healthy practice that retains clients rather than spurring a Clexit!