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The low interest rate world isn't going anywhere: The Fed

Lewis Jackson  |  03 Sep 2021Text size  Decrease  Increase  |  
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Federal Reserve chairman Jerome Powell wouldn’t be drawn on what the Fed will do this month, or even this year, but he was candid about what’s likely for markets post-covid. 

The pre-pandemic world of low inflation is set to return, said Powell in remarks to the Jackson Hole Symposium last Friday—the Davos of central banking.

While the world has seen inflationary pressures during the pandemic, he said the long-run deflationary forces of technology, globalisation and demography haven’t gone anywhere.

“While the underlying global disinflationary factors are likely to evolve over time, there is little reason to think that they have suddenly reversed or abated.

“It seems more likely that they will continue to weigh on inflation as the pandemic passes into history.”

Low inflation means low interest rates. Central banks set rates with an eye to inflation, and persistently low inflation has sent global interest rates marching downwards for years.

The usual suspects are a cocktail of technology, globalisation and demography. The explanation begins decades ago, with the fall of the Soviet Union, the rise of China and the peak of the baby boom pouring hundreds of millions of workers into labour markets around the world.

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Those markets were then linked up in global supply chains powered by new technologies like the internet and container ships. Guangzhou was pitted against Geelong, putting downward pressure on wages and prices.

Technology and innovation helped in other ways too, says Oliver Blackbourn, a portfolio manager at Janus Henderson. A company like Amazon has forced prices down for everything from books to headphones by making it easier to shop around and compare prices.

This combination of lower prices and lower wages can be self-reinforcing says Richard Holden, a professor of economics at UNSW.

“If you’ve got downward pressure on wages, there is less need to put prices up and then there is less case for higher wages in turn,” he says.

Decades of falling inflation and falling rates have lifted equity valuations and helped bonds to a multi-decade rally. Between 1980 and 2019 the annualised return on long duration US government bonds was 5.64%, versus the -1.69% recorded between 1950 to 1979.

“Structurally low inflation leads to lower real yields and has been a real boon for many assets, driving up valuations to, in some cases, quite extraordinary levels,” says Blackbourn.

Dissenters see a new world order

But there is an alternative scenario. Others argue that the structural forces of demography and globalisation may be about to switch gear, ushering in an era of upwards pressure on inflation and interest rates.

In an influential 2020 book, Charles Goodhart and Manoj Pradhan argued inflation will tick up as ageing populations spend the savings stored up through their working lives. More retirees and fewer workers will also help lift wages and inflation.

They predict a world—the Goodhart world—where inflation is a recurring problem. This creates pressure for central banks to raise rates in response, squeezing indebted governments and households.

This shift in structural forces could create a perfect storm for inflation, coming as central banks have thrown caution to the wind and engaged in a massive program of stimulus, says Stephen Miller, an advisor GSFM management.

“It might be just as they’ve changed their approach to monetary policy that some of the structural forces that kept inflation low have let up and we might get an uplift in inflation independent of the stance of policy,” he says.

Moving to Goodhart’s world is likely to be very disruptive says Miller. Rates will go up and investors could see a replay of the 1970s, where equity and bond markets fell at the same time.

The challenge to navigating this world is to find sources of return uncorrelated to equities and bonds, he says, with options like inflation linked bonds or long/short equity portfolios.

Putting aside their differences, advocates for Powell and Goodhart’s worlds both agree that future returns will be lower. In a 2020 interview, Pradhan warned investors that the good times are coming to an end.

“The easy pickings of the last 30 or 35 years that many of us have gotten used to are behind us,” he said.

Portfolios in Powell’s world

Powell’s world will be good news for US equities, growth stocks and the traditional 60/40 portfolio, even if returns are going to be lower across the board, according to several analysts who spoke with Morningstar.

The 60/40 portfolio—60% equities and 40% bonds—is meant to be an all-weather mix. Equities deliver growth when markets rise and bonds rally when markets fall. Many have called time on the portfolio but in Powell’s world it will continue to serve, says Miller.

Even in a low inflation world, bond yields are likely to pick up a few per cent, and investors will still be able to rely on bonds rallying when equities fall and vice versa.

“Your conventional portfolio which has served you pretty well for most of this century will continue to do so,” he says.

“You’ll probably still live in a world where bond and equity returns are negatively correlated.”

A world of low inflation and low interest rates is also one where the last decade’s standout performance for US equities, especially growth sectors like technology, could continue, says Blackbourn.

“Those new world disruptive technologies will do well, while old economy parts of the world like Japan and Europe will continue to lag the US,” he says.

But a world where rates are falling isn't the same as one where they simply hover around zero.

Much of the juice has already been squeezed and even if rates don’t rise, investors must accept future returns will be lower, says Mark Delaney, chief investment officer at Australian Super, speaking at the Australian Institute of Superannuation Trustees annual conference Thursday.

“Our 15-year return is 7.2% while the 10-year return is 10%. The 15-year number is more realistic because it includes the financial crisis. So you’re getting numbers around 7 as the underlying base return.”

“For everyone who picked up their super statement last year and thought, goodness how much it’s gone up, not every day is perfect, and last year was perfect.”

Australian Super’s balanced option returned 20.4% over the 2021 financial year.

is a reporter and data journalist with Morningstar. Tweet him @lewjackk or get in touch via email

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