When the bank of Canada’s overnight interest rate plummeted from 4.25% in early 2008 to 0.25% in April 2009, no one thought that, seven years later, this bellwether would still be at barely there levels like the 0.5% we see today. In early July, the yield on 10-year Government of Canada bonds dipped below 1% for the first time. Not only that, rates are going negative in Europe and Japan. In America, the only developed country that’s actually raised rates recently, Federal Reserve chair Janet Yellen is now saying that market forces could keep rates low for years.
But even that may be too optimistic an outlook, market watchers are beginning to think. With global growth barely budging and government and consumer debt at extremely high levels, it’s conceivable that rates could stay this low indefinitely. “The longer rates are low, the harder it will be to raise them and the more painful that raise will be,” says Eric Lascelles, RBC Global Asset Management’s chief economist. “Absolutely yes, rates could stay low for a very long time.” And that will require investors to adjust their strategy and their expectations henceforward—by paying more for equities, taking on more risk with fixed income and socking away more than they used to.
It wasn’t supposed to turn out like this. When central banks around the world cut rates after the recession, it was meant to be a temporary measure to help stimulate the global economy. By making lending cheaper, consumers, corporations and governments would be able to borrow money inexpensively and put those dollars back into the economy, whether by buying goods or investing in businesses. Once global growth started revving up again, rates would revert to levels investors had grown used to, in the mid-single digits.
While some of this stimulus has worked—it’s no coincidence that home prices in Canada have soared since rates fell in 2009—for the most part, it hasn’t played out the way the experts thought it would. Global growth is still too slow—the planet’s GDP is expected to grow by 2.4% this year, according to the World Bank, which is actually below its 2.8% growth in 2011. The gradual shrinkage of the working-age population in developed nations as well as China has so far failed to stoke inflation through wage increases. Some observers point the finger at labour-saving technology, others at the demographics of aging itself—seniors simply buy less stuff.
Central banks have backed themselves into a corner, says Juliette John, founder of Calgary-based Iris Asset Management. Economies are not expanding fast enough for them to raise interest rates, but the longer rates stay low, the less impact they’ll have on growth. “Low rates have become less and less effective as time has gone on,” she says. “We’ve got a situation where rates are not helping, and if they do raise them, then that will squash any fledgling momentum that there is.”
All of that’s to say that interest rates aren’t rising any time soon, and when countries do raise them, they are certainly not going back to the double-digit figures seen in the 1980s and 1990s. It’s unlikely rates will even get back to the 5% we saw prior to 2008, says Lascelles. What a “normal” rate environment may be is now anyone’s guess. The Federal Reserve says a normal long-term rate is about 3%, but Lascelles thinks it could be around 2%. In any case, it’s not moving much higher from here.
Up until now, many people have been building portfolios with the idea that rates will at some point rise, protecting themselves against interest-rate risk. But if you invest with the idea that rates will never rise again, or at least not for decades, then a lot of the tried-and-true investing rules that people have been following suddenly change.
For one, investors are going to have to get comfortable taking on more risk in their equity portfolios by buying stocks at higher valuations. Because people can’t make much money in bonds on both rates and capital gains—since rates can’t fall much further, we won’t see the big fixed-income returns we’ve seen over the last 30 years of falling yields—investors need to be in the stock market. That’s pushing valuations higher. “You can argue that there has been a distortion with respect to security valuations,” says John. “There’s greater risk-taking.”
It’s not unusual to see companies trading well above 20 times earnings these days, especially more bond-like businesses, such as dividend-paying consumer staples, utilities and other defensive equities, says Arthur Heinmaa, chief investment officer at Cidel Asset Management. “Anything that has a whiff of an annuity can easily trade at 30 times earnings,” he says.
While that looks expensive based on past experience, if rates stay low for long, then it’s easier to justify paying that kind of price. Essentially, it comes down to how much you’re willing to pay for a 5% income stream on a stock versus 1% with a bond. “In that case, stocks may actually be relatively inexpensive compared to the interest rate,” says Heinmaa.
Investors also have to make high-yield bonds, such as corporate or emerging-market bonds, a more permanent feature of their portfolios, says Lascelles. These products pay well above the 10-year Canadian government rate, but they are riskier to own—the higher coupon corresponds to a higher chance of default. One option is to purchase provincial bonds, says Lascelles. Ontario Savings Bonds are paying a percentage point higher than the 10-year Government of Canada note, and the province is still extremely unlikely to default. “That’s a popular strategy,” he says. “You can more than double your return without incurring material risk.”
While investors will have to find stocks with higher yields, pay more for them and take on more risk in bonds, the biggest change in a permanently low-rate world is that people will need to set aside more of every paycheque if they want to keep the same goal for retirement income.
The prospect of lower-for-longer rates isn’t all bad. It offers a rare light of hope for young people with more debts than financial assets. It is savers who get hurt most in an extended low-rate world. With overall returns projected to range in the mid-single digits—that includes dividends—and guaranteed savings vehicles paying literally nothing, they will need to do more of the heavy lifting to meet their retirement goals. “The lower the rate, the more people need to save,” says Lascelles. “And that’s difficult enough as it is.”
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