Last week Wednesday 31 July, Chris Lemmon presented at the 2019 NFB Private Wealth Management Knowledge Session Event, if you missed it, this is what he covered
On one side of the Atlantic, US President Donald Trump is putting pressure on the Federal Reserve (Fed) to lower interest rates. On the other, investors are snapping up negative-yielding government bonds that are guaranteed to lose them money if they hold them to maturity. For the South African investor seeking to grow their portfolio and mitigate risk, this landscape means making the right offshore investment decisions is not as easy as simply betting against the rand.
Let’s start with the US – where occasional trade war-related market turbulence aside – the economy appears to be in rude health, Joblessness is low, stock markets have performed well over a three-year horizon, and consumer confidence is robust.
So why is President Trump so displeased with the Fed’s hawkish stance? Could it be that there is trouble brewing beneath the surface?
One sign that things may not be as they seem is in the underwhelming results President Trump achieved by cutting the corporate tax rate from 35% to 21%. In theory, trillions of dollars of US corporate earnings trapped offshore should have come flooding into the country – a tidal wave of job-creating cash.
Instead, the immediate response from US corporations following the tax cuts was to buy back their own shares, rather than to invest in productive capacity. That represents a win for stockholders, but has little benefit for the wider economy in years to come.
As the stock market heats up and with employment near record highs, is the Fed correct to be concerned about general levels of inflation? Or is asset price inflation the bigger risk as an anticipated response to lower interest rates in future?
Paying to lend money
That brings us to the likes of Switzerland, Sweden, Germany, France, the Netherlands, and Japan, where investors are holding bonds with negative yields. By some estimates, there is around $12 trillion worth of negative-yielding foreign government bonds in issue at the moment.
To get a handle on much money that is, consider that $1 million weighs 10kg. And when it comes to $1 trillion? A whopping 10 000 tonnes. Final comparison. Think of $1 dollar as one second. A billion seconds ago was 31 years ago. A trillion seconds was 31 688 years ago.
Bond-maven Joe Rosenberg believes it is ‘nuts’ for investors to lock in guaranteed losses by buying these bonds. He argues that people who buy these are ‘paying for the right to own a government IOU.’ It would be better to stash your money under your mattress, he says.
And even with these low interest rates, the Eurozone and Japanese economies are not shooting the lights out.
Joining the dots
So what does that mean for an equity investor in South Africa investing offshore? One major factor to consider is the impact of low interest rates on relative valuations. Broadly speaking, quality stocks look attractive even at elevated levels, when the alternative is to pay for the privilege of owning a government bond. Against this backdrop, the hurdle rate for equity returns will continue to remain low and therefore support higher prices, provided interest rates remain at these ultra-low levels.
That remains a crucial caveat for investors at present. As the debate rages on about the appropriate level of interest rates, we should expect to see elevated levels of volatility in asset prices for the remainder of this year. When evaluating a portfolio, it is prudent to think not only about protecting it against devaluation of the rand, but also about how diversification can position it for material changes in interest rate expectations and the associated knock on effects across all asset classes over time.